Part 2 : Valuation Recent Trends

www.clairfield.com

2010

M&A activity is driven by multiple macro-economic and industry forces and opportunities
CHANGE IN INDUSTRY STRUCTURE Consolidation Pre-emptive M&A by competitors Technology advances CHANGE IN CAPITAL MARKET OPPORTUNITIES Availability of funding Investor expectations and sentiment Performance of stock market
World M&A
1,400 300

UK M&A

Relative values of stock prices versus hard assets

billion

billion

REGULATORY AND POLITICAL PRESSURE Europe as a trading block post EMU Deregulation of global trade Interest in emerging markets: China etc

1,000 600 200 0 H1 H2 H1 H2 H1 H2 H1 H2 H1 H2 2004 2005 2006 2007 2008

200

RISK OF UNDERPERFORMANCE Need to reduce debt (whilst preserving the core) Change in performance of different elements of the portfolio

100

H1 H2 H1 H2 H1 H2 H1 H2 H1 H2 2004 2005 2006 2007 2008 UK Cross Border UK Domestic

World Half-Year Total Telecoms specific

Note: Includes all cross border and domestic deals completed 1st Jan 2004 - December 2007. Excludes MBOs & Privatisations. Source: Datalogic, Thomsom Financial, KPMG analysis

DESIRE FOR FOCUS AND SIMPLICITY Complexity of business unit Overload of business unit priorities Identification of synergies across the portfolio

SEARCH FOR GROWTH OPPORTUNITIES Extend geographic coverage Acquire complementing assets Extend within or across industries

Do we value them correctly?

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Buy-side deals are becoming more successful

BUY-SIDE EXPERIENCE Value creation

100% 31% 53% 60% 38% 40% 30% 20% 17% 0% 1999 Enhance value
Source:

SELL-SIDE EXPERIENCE

35% of vendors completed their most recent disposal at a price significantly below their own valuation
32% Deals that do not add value 34%

80%

Of these, an average 20% price reduction from valuation to selling price was experienced
Deals adding value

31%

34%

2004 Neutral

2007 Reduce value

60% of all vendors suffer post deal issues

KPMG survey Beating the Bears - 2008

Source: KPMG survey Increasing value from disposals A case study for professionalising the sell side - 2009

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Almost 70% of deals add no value

UK-WIDE M&A VALUE CREATION

WHY MERGERS FAIL

100% 80%
53 31

Resistance to Change Limitations of Existing Infrastructure Deals that do not add value
39

60% 43% 38% 36% 33% 30% 28% 18% 14% 10 20 30 40 50 60 70

Lack of Executive Alignment Lack of Executive Champion Unrealistic Expectations Lack of Cross-Functional Teams

% of deals

60% 40%
30

Inadequate Team and User Skills 20%

17 30

Deals that do add value

Key Stakeholders Not Involved Project Charter Too Narrow

0% 2001 2008 Deals destroyed value Deals produced no discernible difference Deals added value

Contribution to Merger Failure (%)

Source: KPMG surveys

Source:

Financial News, Briefing Note 19, 17 Sept 2001, Offer Information Week

Underestimating the management effort required to realise benefits is the primary reason for failure to deliver value from mergers
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Almost 70% of deals add no value, why?

Operational performance improvement is recognised as being key to realising value from transactions
RATIONALE FOR DEAL
Operational improvements: e.g, improved back office processes, expanded customer service functionality, etc.

Value m

Consideration

Value Creation
Rationalisation of manufacturing

Create Shareholder Value

Deal Costs Premium

Price Paid
Product development Sales growth

Operational factors

Destroy Shareholder Value

1992 was the last time the most common form of exit was receivership, as it is now.(1) The ability to supplement deal skills with appropriate management expertise will allow proactive assistance to be given to portfolio companies to add to product value.(2) I wonder if people are coveting operational skills simply because they are more operationally involved in the businesses at the moment than they want to be [because of under-performance].(3)

Standalone Value

Synergies

New Strategies Source: (1) Jon Moulton, Managing Partner, Alchemy Partners, Super Return 2002 Conference (2) KPMG/Manchester Business School Survey (3) Simon Turner, joint Chief Executive Inflexion, FT February 28

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Choosing Valuation Methods

There are basically three valuation methods (market, asset-based and economic methods) which contain many models. For example, under economic methods, there are three main models - DCF, Economic Profit (EVA, ROIC and CFROI) and option pricing models. Within DCF models there are further sub-models depending on whether you are discounting dividends, FCFE or FCFF. Even within each sub-model, further choices can be made as to whether 2-stage, 3-stage or multi-stage explicit growth periods are used.
Dividend Discount FCFE

MarketMethods Methods Market

Asset-BasedMethods Methods Asset-Based

DCF Models

APV Model

EconomicMethods Methods Economic

Economic Profit Option Pricing Economic Methods

FCFF

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Prior Theories of valuation

Miller and Modigliani the primitive firm (1963)

Expected free cash flows from operations Discounted at a constant weighted average cost of capital Assumes that operating cash flows are unaffected by capital structure Optimal capital structure a tradeoff between the benefit of a debt tax shield and the present value of business disruption costs

Leland Four terms in the valuation equation (1998)

Value of the unlevered firm PV of the tax shield on debt Minus the PV of tax shield lost if debt becomes extreme Minus the PV of business disruption costs (as a function of debt)

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Prior Theories of valuation

Schwartz and Moon (1999) The value of the primitive firm is enhanced by real options They model the value of an abandonment option Other real options are also important: Growth options (Myers 1977) Options to exit and re-enter Options to abandon (liquidate) Options to enter and exit Chapter 11

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But are we happy with those theories?

None of the prior theories does a very good job of explaining the significant and persistent differences in capital structure across industries
Market Debt-to-Equity (2002)
A-rated Companies
Confidential

Pharmaceutical

Median = 0.07

Retail

Median = 0.13

Media (Print)

Median = 0.13

Food and Beverages

Median = 0.20

Chemical

Median = 0.34

Energy

Median = 0.87

Commercial Banking 0.0 0.5 1.0 1.5 2.0

Median = 1.21
2.5

Market Debt-to-Equity Ratio

ZKN-MFB-Stoll_Charts-5-18-05-TC

13

Copyright 2005 Monitor Company Group, L.P. Confidential CAM

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The Reality a new theory of the firm

A firm is like a three-layer cake:

The cost of debt is suboptimal exercise of the firms real options and the benefit is its tax shield Greater operating flexibility allows for greater debt capacity

Financial Options Debt and Equity are options on the firms portfolio of assets (with flexibility) Financial Options Real Options The Primitive Firm Real Options Payouts on the portfolio of assets are modified by real options (e.g., capacity caps, expansion, and bankruptcy) The primitive firm is modeled without flexibility (DCF)
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New trends in Valuation Methodologies

Comparable Multiples Discounted Cash Flow (the primitive firm) New trends such as APV, EVA and Monte Carlo Option Pricing: real options Option Pricing: financial options The future of valuation: the firm as a 3-layer cake

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Comparable Multiples: Valuation based on actual transactions

First, we should acknowledge that There are rarely any close comparables Often neither the assets nor the liabilities have liquid markets for trading All comparables are going concerns Recommended approach is a multiple regression V (houses) = a + b (number of square feet) + c (number of rooms) + d (age of house) + e (acreage) + f (number of fireplaces) + g (taxes) + h (swimming pool) Entity multiple = a + b (earnings before interest and taxes) + c (growth in earnings) + d (capital turnover) + e (return on invested capital)
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Traditional DCFlow Valuation the primitive firm

Most valuations of non-financial companies start with estimated free-cash flows to the entity, discount them at the weighted average cost of capital, then subtract out the value of debt

PV of (Expected Free Cash Flows + Continuing Value) = Entity Value

+CV=Entity Value
Discounted at the weighted average cost of capital

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DCF - Predicted FCF follow an irregular pattern

Free Cash Flows of company X could be

($ millions, 2004-2014)

70 60 50 40 30 20 10 0 -10 1 2
Brisbane

Revenue growth: -- one year 31.6% -- 3-5 years 17.5% -- long-term 10.2%

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DCF Valuation

The continuing value (CV) assumptions are also crucial Will the companys ROIC fall to equal its WACC or remain at current levels? What is the cost of capital given the two alternatives? How will its cost of capital change, and what will its value drivers be? E.g., revenue growth, operating margin, capital turns? Which Continuing Value formula should one use? Are the ROIC and growth assumptions consistent with the assumed amount of earnings retention?
Entry multiple = Entity Market val ue/EBITDA = 26 .6 CV = NOPLAT 11 (1 g / r ) WACC g = multiple x NOPLAT = 10 .1x(243) Exit multiple = 3.1x
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DCF Valuation (Cont.)

A model in evolution
From fixed discount rate to iteration process From fixed WACC to changing wacc per year From mono input to Monte Carlo Analysis

Equity Debt Total Ratio equity Ratio debt Levered beta WACC

31/12/2005 31/12/2006 31/12/2007 1.184.838 2.963.995 3.092.459 1.066.826 803.598 2.643.064 2.251.664 3.767.593 5.735.523 52,6% 47,4% 0,71 7,71% 78,7% 21,3% 0,52 9,14% 53,9% 46,1% 0,69 7,78%

31/12/2008 31/12/2009 3.277.123 3.497.139 2.727.972 2.637.111 6.005.095 6.134.250

XYZ NV 54,6%

31/12/2010 3.752.617 2.497.997 6.250.614 60,0% 40,0%

45,4% 0,69

57,0% 43,0%

Cash flows in EUR per :

31/12/2006 457.502 87.879 (142.614) 402.768 0 0 0 0 0 (695) (185.007)

31/12/2007 365.590 247.410 (114.860) 498.140 0 0 1.680.000 0 0 (709) 440.979

31/12/2008 510.021 249.279 (161.168) 598.133 0 0 119.740 0 0 (723) 287.081 192.035 7,82% 153.179

31/12/2009 703.419 243.119 (225.918) 720.620 0 0 138.465 0 0 (738) 213.634 369.259 7,95% 271.829

31/12/2010 723.840 258.344 (230.519) 751.665 0 0 152.250 0 0 (752) 186.047 414.120 8,12% 280.230

31/12/2011 921.384 225.011 (295.161) 851.234 0 0 164.426 0 0 (767) 31.372 656.203 8,45% 403.134

31/12/2012 827.735 228.692 (259.580) 796.847 0 0 168.311 0 0 (783) 62.900 566.418 8,96% 310.570

31/12/2013 831.074 245.853 (254.865) 822.062 0 0 171.612 0 0 (798) 49.063 602.186 9,53% 290.537

31/12/2014 834.476 263.351 (250.320) 847.506 0 0 174.978 0 0 (814) 49.839 623.503 9,72% 270.385

31/12/2015 837.939 281.192 (245.335) 873.796 0 0 178.410 0 0 (831) 51.939 644.277 9,69% 255.354

RV 837.939 281.192 (245.335) 873.796

0,66

0,64 8,12%

EBIT Depreciation 7,82% 7,95% Taxes on EBIT (-) Net operating cash flow

Forecast: Expected Annual Return Investment Formation Expenses 1,000 Trials

.035

Frequency Chart

.026

Investments Intangible Assets Investments Tangible4 Assets Outliers Investments Leasing 35 Divestment leasing Investments Net Working Capital Long Term Investments Net Working Capital Short Term 26.25 Free Cash Flow WACC

281.192

0 592.605 9,69% 2.423.625

588.470 (1.622.130) 9,14% 7,78%

.018

17.5

Present Value of annual future FCF

539.176 (1.396.308) 1.378.085 2.423.625 0 0

.009

.000 -75% -31% 13%

8.75 Present Value of future FCFs Present Value of Residual Value Excess marketable securities as per 0 Financial Assets (+) / Hidden liabilities (-) 56% 100% Value of Company as per Debt as at (-)
Value of Equity as at Equity value as of Equity value as of

31-dec-05

3.801.710 31-dec-05 31-dec-05 (1.066.826) 31-dec-05 31-dec-05 30-jun-06 2.734.884 2.734.880 2.763.708

EQUITY VALUE AS OF

30/06/2006 in Euro

2.763.708 EUR 2.763.708 000

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But DCF tends to undervaluate

The histogram below shows the DCF value of a company minus its market value as a percentage of its market value for 27,123 valuations between January 31, 2000 and July 31, 2004.
68.1%

9000 8000 7000 6000 Number of 5000 Companies 4000 3000 2000 1000 0

56.3%>0

3.2%

x< -.8 -.8 <x <.7 -.7 5 5< x< -.6 7 -.6 7< x< -.5 -.5 <x <0

0< x< .5 .5 <x <1

1< x< 2

2< x< 3

3< x< 4

4< x< 5

Lognormal distribution

(DCF-Market)/Market
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Bias in the DCF model?

We hypothesize that DCF works well for large, diversified companies that have low volatility and low growth, but undervalues companies that have high volatility and high growth. Cells Contain median difference between DCF and market value at the end of a month scaled by market value.
Analyst projection of 3-5 year revenue growth

Lowest g<5.3% g<7.9% Lowest v<1.50x

Volatility one Year forward as a % of SPX volatility

g<10.9 8.7% 1,344 13.6% 1,281 20.2% 1,130 16.7% 1,031 2.9% 639

g<16.3% 7.7% 861 18.4% 1,044 15.8% 1,150 2.7% 1,326 -7.3% 1,043

Highest g<113.4% 40.4% 239 3.0% 497 9.4% 857 -3.1% 1,275 -21.7% 2,555
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5.4% 1,463 12.9% 1,218 27.6% 1,091 50.7% 994 51.4% 659

1.1% 1,518 10.6% 1,384 19.9% 1.197 34.7% 798 21.8% 527

v<1.82x v<2.22x v<2.91x Highest v<660.5x

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Criticism on DCF

False mutually exclusive scenarios Volatility ignored A key driver of value given option-pricing methodology Difficult to incorporate in a DCF approach Does not capture value of flexibility (real options) Abandonment (divestiture, close-down) Expansion/growth (greenfield, M&A)

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Evolution from DCF to APV

Adjusted Present Value

Value of all financing side effects
Interest tax shields

Base-case value
Financial distress costs Value of the project as if financed only with Equity

+/-

Subsidies and guarantees

Hedges

Issue costs

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How Does the APV Model Work?

1. Value the firm as if it were financed entirely with equity 2. Evaluate the financing side effects of the interest tax shield 3. Assess the costs of financial distress 4. Estimate the other financing side effects 5. Aggregate the components to arrive at an enterprise APV value

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Specific Applications for the APV Model

1. Changing debt structures (eg. LBOs and MBOs) 2. Multi-business valuations (especially HQ functions) 3. Tax loss carry forward situations 4. Project finance 5. Optimizing debt levels 6. Presenting synergies 7. As a quick sanity check
Gearing levels
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APV tends to infinity

Enterprise value

WACC

The Gap between APV and WACC is the cost of bankruptcy

New trends in valuation

What is EVA
1. Registered trademark of Stern, Stewart & Co 2. Performance measure 3. Re-arrangement of DCF 4. Positive EVA implies shareholder value creation 5. McKinseys EVA is called ROIC
Residual Income Models ROIC EVA
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Economic Profit Models

CFROI

Economic Value Added defined

EVA is the profit (or loss) remaining after deducting the cost of capital from the operating profit after taxes. EVA measures the shareholder value created (or destroyed) over a certain period. EVA shows that a company creates value only if operating earnings are sufficient to earn back its cost of capital

EVA = NOPAT ((Cost of Capital) x (Capital)) EVA = Net assets x (RONA WACC)

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Real Options (the second layer) -- Value trees

Positive cash flows are dividends while negative cash flows are investments. All cash flows are proportional to the value in each state of nature so that expected cash flows are preserved
Value at year t

Company X
1320 Volatility = 97% U= 2.65 = eT D = .38 = 1/u P=.32

FCF
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The firms real options 1. Real options is the term used to denote the explicit valuation of the opportunities associated with changing decisions in response to the resolution of relevant uncertainty.

2. A real option is the right, but not the obligation, to take an action (eg deferring, expanding, contracting or abandoning) at a predetermined cost (exercise price), for a predetermined period (Stewart Myers, MIT)
This is not an option
Good news Cash flow

This is an option
Cash flow Invest Good news Dont Invest Cash flow

Invest

Bad news

Cash flow

Dont Invest

Good news

Cash flow

Bad news

Invest Dont Invest

Cash flow

Bad news

Cash flow

Cash flow

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What is a Real Option?

A real option is the right, but not the obligation, to take an action in the future upon the receipt of information. A call is the right to buy (or invest) at a fixed price, and a put is the right to sell. Examples: Defer Expand Extend Shrink Abandon Five factors affect the value of an option Value of an underlying asset (+) Exercise price (-) Volatility (+) Time to expiration (+) Risk-free rate (+)
D V
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Simple Options

Probability of V Higher volatility increases the probability of finishing in-themoney where V > D

A Few War Stories That Introduce More Real Options

Compound Options are options on options Phased construction Research and development New product development Exploration and production Equity in a levered firm Call option on equity Switching Options Shutting down and reopening Mines Automobile assembly plants Exit and reentry Turning off then on Peak load power plants Switching between modes of operation Dual fuel power plants

Sequential

Simultaneous

Examples $650 million chemical plant $7,000 million hightech clean room

Depends on Switching cost Volatility of underlying Non-recombining binomial tree

Examples Valuation of peak-load power Exit from PC assembly Exit from aerospace division Mine operation

Rainbow options (multiple sources of uncertainty) Price and quantity uncertainty Quadranomial
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Switching Option An Example of an Exit and Reentry Decision

Despite the strong growth, consumer PC assembly players have found their market participation to be mostly dissatisfying as they are not earning their cost of capital
Consumer PC Assembly (Mid-1990s)
Gateway 29.7%

Acer

-2.0%

Compaq

-4.1%

Apple

-7.0%

Packard Bell

-11.0%

-20%

0%

20%

40%
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Spread: ROIC WACC

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Real Options A Four Step Process

Steps

Compute Present Value of PrimativeFirm Using DCF

Model the Uncertainty Using Event Trees

Identify and Incorporate Managerial Flexibilities Creating a Value Tree

Calculate Real Option Value (ROA)

Objectives

Compute base case present value without flexibility at t = 0

Identify major uncertainties in each stage Understand how those uncertainties affect the PV Still no flexibility; this value should equal the value from Step 1 Explicitly estimate uncertainty Monte Carlo analysis Management estimates

Analyze the event tree to identify and incorporate managerial flexibility to respond to new information Incorporating flexibility transforms event trees, which transforms them into decision trees The flexibility continuously alters the risk characteristics of the project, and hence the cost of capital A detailed scenario tree combining possible events and management responses

Value the total project using a simple algebraic methodology

Comments

ROA includes the base case present value without flexibility plus the option (flexibility) value Under high uncertainty and managerial flexibility option value will be substantial ROA of the project and optimal contingent plan for the available real options

Output

Projects PV without flexibility

Detailed event tree capturing the possible present values of the project

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Financial Options -- the third layer

The cumulative cash flow along each possible path determines the cash available for payment of zero-coupon debt. The equity is an option on the second layer of the cake And the real options on the second layer are options on the primitive firm. Assumptions: 1. Cumulative cash flows calculated along each path 2. Zero coupon debt Due if liquidation occurs Otherwise due in year 10 At face value 3. Liquidation value 4. Growth (Expansion) option Expansion factor = X% Execution cost = $xxx million 5. Equity is an option on the firm with real options residual CF is valued

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With and Without Debt Interactive boundary conditions

2500

2000

1500

1000

500

0 0 1 2 3 4 5 6 7 8 9 10

This panel shows that the entity value (layer 2) is affected as one adds debt in layer 3 the abandonment decision without debt is altered when the firm takes on (zero coupon) debt because abandonment (liquidation) amounts to early payment, therefore abandonment occurs later with debt.

Entity Value w/o Debt

Entity Value w/ Debt

900 800 700 600 500 400 300 200 100 0 0 -100 Cumulative Cash w/o Debt Cumulative Cash w/ Debt 1 2 3 4 5 6 7 8 9 10

Here abandonment takes place in year 7 when there is no debt. But if there is debt, abandonment is deferred because the entity value is greater than the residual after liquidation and debt payment.

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Optimal Capital Structure

$ Value

494 500

Parameters
400

Tax rate = 20% Abandonment price = $1,100

411

329 322

300

Tax Benefit of Debt

200 169

247 217 169 145 194 160 102 172

Net Benefit of Debt

100

84 52

102

67 0 0 32 500 1,000 1,500

Cost of Debt suboptimal exercise of abandonment

2,000 2,500

Debt 3,000
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Next Steps

Extension from value branch to value tree Need to study ways of estimating volatility Model growth as a series of one-period European call options Capture inter-dependency between financial and real options Optimal capital structure is tradeoff between Cost of debt as suboptimal exercise of abandonment and growth options Benefit of debt as tax shelter Explains why DCF undervalues high growth and high volatility situations There are cross-sectional regularities in debt-to-equity ratios CFOs say that flexibility is the single most important variable when considering capital structure
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Syncap Management gmbh, member of Clairfield Partners

Hans Buysse, Partner

+32 475 44 46 32 www.clairfield.com

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