Section IV Financial management Part One Valuation and financial engineering In this Part, we will first see that valuing a company is a risky but necessary undertaking for all financial decision-making. We will then examine the issues an investment banker deals with on a daily basis when assisting a company in its strategic decisions: . organise a group; . launch an IPO; 1 . sell assets, a subsidiary or the company; . merge or demerge; . asset-based financing and more. In short, the stuff that all-nighters are made of ! 1 Initial Public Offering. Chapter 40 Valuation Just how rosy is the future? In Chapter 25 we reviewed the major principles of valuation and saw that equity value is not the primary focus of the valuation exercise even if it is often its ultimate goal. This chapter contains a more in-depth look at the concepts introduced in Chapter 25 and presents the problems you will probably encounter when using different valuation techniques. Section 40.1 Overview of the different methods Generally, we want to value a company in order to determine the value of its shares or of its equity capital. Broadly speaking, there are two methods for valuing equity capital, the direct method and the indirect method. In the direct method, obviously, we value equity capital directly. In the indirect method, we first value the firm as a whole (what we call ‘‘enterprise’’ or ‘‘firm’’ value), then subtract the value of net debt. In addition, there are two basic approaches, independent of whether the method is ‘‘direct’’ or ‘‘indirect’’. ? The fundamental approach of valuing either: e a stream of dividends, this is the Dividend Discount Model (DDM);or e free cash flows, this is the Discounted Cash Flow (DCF) method. This approach attempts to determine the company’s intrinsic value, in accordance with financial theory, by discounting cash flows to their present value using the required rate of return. ? The ‘‘pragmatic’’ approach of valuing the company by analogy with other assets or companies of the same type. This is the peer comparison method. Assuming markets are efficient, we should be able to measure the value of one company by reference to another’s value. Indirect approach Direct approach Discounted present value of Present value of free cash Present value of dividends financial flows (intrinsic flows discounted at the at the cost of equity value method) weighted average cost capital: k E of capital (k) À Value of net debt Multiples of comparable EBIT 2 multiple  EBIT À Value Multiple (P/E 3 )  Net income companies (peer of net debt comparison method) Next you will see that the sum-of-the-parts method consists in valuing the company as the sum of its assets less its net debt. However, this method is more a com- bination of the techniques used in the direct and indirect methods rather than a method in its own right. Lastly, we mention the use of options theory, whose applications we saw in Chapter 35. In practice, nearly no one values equity capital by analogy to a call option on the assets of the company. The concept of real options, however, had its practical heyday in early 2000 when it was used to explain the market values of ‘‘new economy’’ stocks. Needless to say, this method has since fallen out of favour . If you remember the efficient market hypothesis, you are probably asking yourself why market value and discounted present value would ever differ. In this chapter we will take a look at the origin of the difference (if any!) and try to understand the reason for it and how long we think it will last. Ultimately, market values and discounted present values should converge. Section 40.2 Premiums and discounts A newcomer to finance might think that the market for the purchase and sale of companies is a separate market with its own rules, its own equilibria, its own valuation methods and its own participants. In fact, nothing could be further from the truth. The market for corporate control is simply a segment of the financial market. The valuation methods used in this segment are based on the same principles as those used to measure the value of a financial instrument. Experience has proven that the higher the stock market, the higher the price for an unlisted company. Participants in the market for corporate control think the same way as investors in the financial market. Of course, the smaller the company is, the more tenuous is the link. The value of a butcher shop or a bakery is largely 814 Valuation and financial engineering 2 Earnings Before Interest and Taxes. 3 Price/Earnings ratio. intangible and hard to measure, and thus has little in common with financial market values. But, in reality, only appearances make the market for corporate control seem fundamentally different. 1/ Strategic value and control premium There is no real control value other than strategic value. We will develop this concept hereafter. For a long time, the control premium was a widely accepted notion that was virtually a pardon for dispossessing minority shareholders. When a company was valued at 100 and another company was willing to pay a premium of 20 to the controlling shareholder (holding 50.01%, for example), minority shareholders were excluded from this advantageous offer. The development of financial markets and financial market regulations has changed this. The current philosophy is that all shares have the same value. Regulated markets have made equality among shareholders a sacrosanct principle in most countries. Recent changes in stock market regulation (Germany, European directive) show clearly a trend in that direction. The Netherlands are becoming more and more peculiar in this regard in the European environment. Shareholder agreements have become a common method for expressing this principle in unlisted companies. When control of a listed company changes hands, minority shareholders receive the same premium as that paid to the majority shareholder. We subscribe fully to this concept, so long as protecting minority shareholders does not hinder value-oriented restructuring. Nevertheless, entrepreneurs we have met often have a diametrically opposed view. For them, minority shareholders are passive beneficiaries of the fruits of all the personal energy the managers/majority shareholders have invested in the company. It is very difficult to convince entrepreneurs that the roles of manager and shareholder can be separated and that they must be compensated differently and, especially, that risk assumed by all types of shareholders must be rewarded. What, then, is the basis for this premium, which, in the case of listed com- panies, can often lift a purchase price to 20% or 30% more than current market price? The premium is still called a ‘‘control premium’’ even though it is now paid to the minority shareholders as well as to the majority shareholder. If we assume that markets are efficient, the existence of such a premium can be justified only if the new owners of the company obtain more value from it than did its previous owners. A control premium derives from the industrial, commercial or administrative synergies the new majority shareholders hope to unlock. They hope to improve the acquired company’s results by managing it better, pooling resources, combining businesses or taking advantage of economies of scale. These value-creating actions are reflected in the buyer’s valuation. The trade buyer (i.e., an acquirer which already has industrial operations) wants to acquire the company so as to change the way it is run and, in doing so, create value. The company is therefore worth more to a trade buyer than it is to a financial buyer (i.e., usually a venture capitalist fund which has no operations in the 815 Chapter 40 Valuation industry), who values the company on a standalone basis, as one investment opportunity among others, independently of these synergies. The peculiarity of the market for corporate control is the existence of synergies that give rise to strategic value. In this light, we now understand that the trade buyer’s expectations are not the same as those of the financial investor. This difference can lead to a different valuation of the company. We call this strategic value. Strategic value is the value a trade buyer is prepared to pay for a company. It includes the value of the projected free cash flows of the target on a standalone basis, plus the value of synergies from combining the company’s businesses with those of the trade buyer. It also includes the value of expected improvement in the company’s profitability compared with the business plan provided, if any. We previously demonstrated that the value of a financial security is inde- pendent of the portfolio to which it belongs, but now we are confronted with an exception. Depending on whether a company belongs to one group of companies or another, it does not have the same value. Be sure you understand why this is the case. The difference in value derives from different cash flow projections, not from a difference in the discount rate applied to them, which is a characteristic of the company and identical for all investors. The principles of value are the same for everyone, but strategic value is different for each trade buyer, because each of them places a different value on the synergies it believes it can unlock and on its ability to manage the business better than current management. For this reason, a company’s strategic value is often higher than its standalone value. Consider a company that earns Net Operating Profit After Tax (NOPAT) of 10 and whose value, based on a multiple of 20, is estimated at 200. Now suppose an industrial group thinks it can buy the company and increase its NOPAT by 2 and that these synergies have a value of 20. For this potential acquirer, the strategic value of the company is 200 þ 20 ¼ 220. This is the maximum price the group will be willing to pay to buy the company. As the seller will also hope to benefit from the synergies, negotiation will focus on how the additional profitability the synergies are expected to generate will be shared between the buyer and the seller. But some industrial groups go overboard, buying companies at twice their standalone value on the pretext that its strategic value is high or that establishing a presence in such-and-such geographic location is crucial. They are in for a rude awakening. Sometimes the market has already put a high price tag on the target company. Specifically, when the market anticipates merger synergies, speculation can drive the share price far above the company’s strategic value, even if all synergies are realised. In other cases, a well-managed company may benefit little or even be hurt by teaming up with another company in the same industry, mean- ing either that there are no synergies to begin with or, worse, that they are negative! The following table shows the premia (bid price compared with share price 1 month before) of public deals in Europe. 816 Valuation and financial engineering 1998–2004 2002–2004 – transactions above C ¼ 100m (%) (%) France 12.3 21.0 Germany 9.9 16.3 UK 19.5 13.3 Italy 14.6 15.4 Spain 7.5 18.2 Northern Europe 17.0 16.6 Benelux 20.9 7.7 Total Europe 16.6 16.1 Source: Mergermarket.com 2/ Minority discounts and premiums We have often seen minority holdings valued with a discount, and you will quickly understand why we believe this is unjustified. A ‘‘minority discount’’ would imply that minority shareholders have less of a claim on the cash flows generated by the company than the majority shareholder. False! Whereas a control premium can (and must) be justified by subsequent synergies, there is no basis for a minority discount. In fact, a shareholder who already has the majority of a company’s shares may be forced to pay a premium to buy the shares held by minority shareholders. On average in Europe, the premium paid to buy out minorities is in the region of 25%, equivalent to that paid to obtain control. Indeed, majority shareholders may be willing to pay such a premium if they need full control over the acquired company to implement certain synergies. As an example, the minorities of StudioCanal were bought back by the Canalþ Group with a 26% premium over the last market price. In 2003 the offer to buy back Pizza Express minority shareholders at a 16% premium failed to convince two large shareholders and the company was delisted with these institutional investors keeping 10% of capital. This said, the lack of liquidity associated with certain minority holdings, either because the company is not listed or because trading volumes are low compared with the size of the minority stake, can justify a discount. In this case, the discount does not really derive from the minority stake per se, but from its lack of liquidity. Lack of liquidity may increase volatility of the share price. Therefore, investors will discount an illiquid investment at a higher rate than a liquid one. The difference in values results in a liquidity discount. 817 Chapter 40 Valuation Section 40.3 Valuation by discounted cash flow The Discounted Cash Flow (DCF) method consists in applying the techniques of the investment decision (see Chapter 16) to the calculation of the value of the firm. We will focus on the present value of the cash flows from the investment. This is the fundamental valuation method. Its aim is to value the company as a whole (i.e., to determine the value of the capital employed, what we call ‘‘enterprise value’’). After deducting the value of net debt, the remainder is the value of the company’s shareholders’ equity. As we have seen, the cash flows to be valued are the after-tax amounts produced by the firm. They should be discounted out to infinity at the company’s weighted average cost of capital (see Chapter 23). In practice, we project specific cash flows over a certain number of years. This period is called the explicit forecast period. This length of this period varies depending on the sector. It can be as short as 5–7 years for a consumer goods company and as long as 20–30 years for a utility. For the years beyond the explicit forecast period, we establish a terminal value. The value of the firm is the sum of the present value of after-tax cash flows over the explicit forecast period and of the net present value of the terminal value at the end of the explicit forecast period. 1/ Schedule of cash flows over the explicit forecast period As we saw in Chapter 25, free cash flow measures the cash-producing capacity of the company. Free cash flow is calculated as follows: Operating income (EBIT) À Normalised tax on operating income þ Depreciation and amortisation À Capital expenditure À Change in working capital ¼ Free cash flow after tax You buy a company for its future, not its past, no matter how glorious it was. Consequently, future cash flows are based on projections. As they will vary depend- ing on growth assumptions, the most cautious approach is to construct several scenarios. But, for starters, are you the buyer or the seller? The answer will influence your valuation. The objective of negotiation being to reconcile the buyer’s and seller’s points of view, we have found in our experience that discounted cash flow analysis is an extremely useful discussion tool. It is alright for a business plan to be optimistic – our bet is that you have never seen a pessimistic one – the important thing is how it stands up to scrutiny. It should be assumed that competition will ultimately eat into margins, that increases 818 Valuation and financial engineering [...]... Construction and building materials 9.9 8.9 Telecoms 9.9 8.9 Chemicals 10 .3 9.8 Aerospace and defence 10 .3 Industry services 10 .5 9.4 Electronics 10 .8 10 .3 Food retail 10 .9 10 .1 Other retail 11 — Media 11 .2 10 .2 Food and beverage 11 .5 10 .5 Luxury 12 10 .2 Utilities 12 .1 — Pharmaceuticals 12 .2 10 .9 Transportation 12 .8 11 .4 Cosmetic 14 .1 12.4 All sectors 9.3 — — — Source: Exane BNP Paribas (b) EBITDA multiple... 30,660 30, 712 31, 208 EBIT margin 20.9% 19 .9% 19 .0% 18 .3% 17 .6% 16 .9% 16 .4% 15 .5% 15 .0% þ À À À 4,246 4,428 1, 292 7,299 4, 713 4,664 À3,928 7,0 71 5 ,18 8 4,746 À4,224 6,7 21 5,0 51 4 ,10 1 505 6,639 5,304 4,306 868 6,703 5,622 4,563 1, 093 6,824 5,987 4,860 1, 255 7,052 6,347 5 ,15 2 1, 234 7,064 6,664 5, 410 1, 090 7 ,17 8 23,639 26,787 27,042 22,670 22,574 22,808 23,479 23,609 24 ,19 5 Revenues Revenue growth Depreciation... 1, 212 1, 340 1, 477 À238 À250 À270 À280 À295 À 310 462 538 627 723 824 932 1, 045 1, 167 2,500 2,550 2, 610 2,680 2,759 2,8 01 2,840 2,850 500 525 5 51 579 596 614 632 642 À255 À2 61 4 Earnings Before Interest, Taxes, Depreciation and Amortisation Balance sheet Fixed assets þ Working capital ¼ Capital employed 3,000 3,075 3 ,16 1 3,259 3,355 3, 415 3,472 3,492 Operating margin after 35% tax 6.0% 6.7% 7.4% 8 .1% 9.0%... 23,609 24 ,19 5 Revenues Revenue growth Depreciation Capex Change in working capital Tax Free cash flow 2008e 2009e 15 7,700 16 5,585 2 010 e 2 011 e 17 5,5 21 186,930 2 012 e 2 013 e 19 8 ,14 5 208,053 Assuming a risk-free rate of 5%, a beta of assets of 1. 1 and a risk premium of 5%, we find a WACC of 10 .5% You may also assess that the long-term growth rate of cash flows will be a bit higher than the economy in general,... capital ¼ Normalised 2 012 free cash flow 1, 185 ( 415 ) 315 ( 315 ) (10 ) 760 Using a rate of growth to infinity of 1. 5%, we calculate a terminal value of ¼ 8,941m Discounted over 7 years, this gives us ¼ 4,588m at end-2004 The value C C of Fralia is therefore ¼ 4,588m þ ¼ 2 ,16 4m, or ¼ 6,752m Note that the terminal C C C 8 21 822 Valuation and financial engineering value of ¼ 8,941m at end-2 011 corresponds to a... 3 ,16 1 3,259 3,355 3, 415 3,472 3,492 Operating margin after 35% tax 6.0% 6.7% 7.4% 8 .1% 9.0% 9.9% 10 .7% 11 .8% ROCE 5 after 35% tax 10 .0% 11 .4% 12 .9% 14 .4% 16 .0% 17 .7% 19 .6% 21. 7% The least we can say about the business plan is that it is ambitious The operating margin, after taxes of 35%, rises from 6.0% to 11 .8% Asset turnover improves significantly enough that investment in fixed assets and working capital... 2005–2 013 (valued as at 01/ 01/ 2005) is SEK136,954m The terminal value is SEK333,272m; with a present value of SEK135,280m The enterprise value of Ericsson is hence SEK299,232m Ericsson has a net cash position as at 31/ 12/2003 of SEK42, 911 m Therefore, the equity value of the group will be higher than its enterprise value at SEK 315 ,14 5m With 15 ,8 61 million shares, the value per share comes out at SEK19.9... 2005 Alcatel 1. 0 0.9 6.3 6.2 19 .3 17 .8 Ericsson 2.4 2.3 10 .4 8.8 18 .1 16 .1 Nokia 1. 3 1. 3 7.7 8.2 16 .6 17 .4 Chapter 40 Valuation Ericsson’s multiples are clearly on the top of the range In other words, if Ericsson was valued by applying competitors’ multiples, value would be significantly lower than the actual market value The question then is: Are these multiples (in particular, EV/EBITDA)... rises from 10 .0% in 2004 to 21. 7% in 2 011 ! This business plan deserves a critical analysis, including a comparison with analysts’ projections for listed companies in the same sector 5 Return On Capital Employed 820 Valuation and financial engineering Projected after-tax free cash flows are as follows: (in ¼ m) C EBIT 2005e 2006e 2007e 2008e 2009e 2 010 e 2 011 e 538 627 723 824 932 1, 045 1, 167 (18 8) ( 219 ) (253)... part abstracts from brokers’ notes on Ericsson Alongside brokers, we aim at benchmarking the market value of the Ericsson share 835 836 Valuation and financial engineering 1 / DCF One of the brokers you read provides the following estimates (in SEKm) 2005e 2006e 2007e 14 2,825 15 0,472 15 3 ,10 7 11 .4% 5.4% 1. 8% 3.0% 5.0% 6.0% 6.5% 6.0% 5.0% EBIT 29,828 29,882 29,096 28,864 29 ,14 7 29,666 30,660 30, 712 31, 208 . France 12 .3 21. 0 Germany 9.9 16 .3 UK 19 .5 13 .3 Italy 14 .6 15 .4 Spain 7.5 18 .2 Northern Europe 17 .0 16 .6 Benelux 20.9 7.7 Total Europe 16 .6 16 .1 Source: Mergermarket.com. 2009e 2 010 e 2 011 e Profit and loss statement Turnover 5 000 5,250 5, 513 5,788 5,962 6 ,14 1 6,325 6,420 EBITDA 4 700 788 882 984 1, 094 1, 212 1, 340 1, 477 À