Rethinking Valuation So You Don’t Miss

MERGERS & ACQUISITIONS

a Good Deal
by Alexander B. van Putten, Mehrdad Baghai, and Ian C. MacMillan
December 02, 2010

The odds of a successful acquisition are long — something research has proven time
and again — yet executives show no signs of losing interest in M&A. Even Dell, famous
for eschewing acquisitions in favor of organic growth, has thrown in the towel with its
$5 billion acquisition of Perot Systems.

Most commonly noted in hindsight analysis of M&As are the effects of what we will
call false positives, where in the fullness of hindsight it becomes clear that an
acquisition effort was flawed from the start. But what may be equally important
concern is the issue of false negatives — where constructive acquisitions are lost due to
low bids constrained by outdated valuation methodologies.

We have constructed a framework that allows an acquiring company to avoid the bias
in valuation that often leads to wrong conclusions. To do this, we combine two
separate frameworks: the first is the Three Horizon strategic model developed by
McKinsey . The other is a process called Opportunity Engineering (OE) that instills a
different way to look at value.

The 3 Horizons model breaks down strategy into three parts.

1. Horizon 1 (H1) represents the current core operations of a company that produce
the cash flow needed to sustain operations, to meet investor expectations, and to
invest in future growth.
2. Horizon 2 (H2) represents businesses that are generating fast-growing revenue
streams. These may not be making as great a contribution to profitability or cash
flow at this point, but they show promise to do so in two to three years.
3. Horizon 3 (H3) represents opportunities for future growth that may take the form
of new products, services, capabilities, and perhaps extensions into non-adjacencies
that show great promise but are highly uncertain.

To define the full value of acquisitions analyze the target’s assets and assign them
across the Three Horizons of the acquirer to understand how they add value. In
general, the more horizons that a target’s assets reach, the stronger and more valuable
the acquisition is.

Since the Three Horizons represent different levels of uncertainty, they need to be
managed and valued differently. This is where Opportunity Engineering comes into
play. The higher level of uncertainty associated with H2 and H3 necessitates an
updated valuation methodology that takes into account more than the net present
value (NPV) of the target. We call this the Opportunity Value (OV) of an asset. Think of
OV as capturing the potential value of the target’s H2 and H3 assets if they become
successful. The two together, NPV + OV, provide an inclusive but not inflated
valuation. In discussions with managers we find that even experienced acquirers do
not consider anything beyond the H1 assets of a target when arriving at a bid price.

The third component of opportunity engineering is what we call Abandonment Value

[AV]. AV results from having the flexibility but not the obligation to sell all, or any part
of the acquisition in the future if it is not working out as hoped. This creates real value
because the cash can be redeployed elsewhere. We find that this is rarely considered
because it cannot be captured through a NPV analysis that is based on a linear set of
projections, but an approximation of AV can often be captured using simple option
pricing models.

The three sources of value combined provide a different and powerful way to look at
acquisitions where: Target Value = NPV + OV + AV.
Let’s consider the example of an actual banking company that was chasing an
important acquisition that it had valued at $800 million using the NPV analysis. It lost
the acquisition to an archrival that bid $840 million. The target had both H2 and H3
assets that were never valued because they were not generating cash flow and
therefore added nothing to the NPV. Had the company considered AV it would have
been able to bid up to $866 million because the option to regain $700 million of the
price two years later, a disaster scenario, would have generated $66 million of value
using simple option pricing.

Make sure you don’t miss your next good deal by thinking too narrowly about how to
value it!

Alexander B. van Putten is a principal of Cameron & Assoc. LLC and is an affiliated
faculty member at the University of Pennsylvania’s Wharton Business School.
Mehrdad Baghai is the managing director of Alchemy Growth Partners, a boutique
advisory firm in Sydney, and co-author of The Alchemy of Growth, The Granularity of
Growth, and the forthcoming As One. Ian C. MacMillan is the Ambani Professor of
Innovation and Entrepreneurship and Director, Sol C. Snider Entrepreneurial
Research Center at Wharton, and a principal of Cameron & Assoc. LLC.

Alexander B. van Putten is a principal of Cameron & Assoc. LLC and is an affiliated faculty member at the
University of Pennsylvania’s Wharton Business School. Mehrdad Baghai is the managing director of Alchemy
Growth Partners, a boutique advisory firm in Sydney, and co-author of The Alchemy of Growth, The Granularity
of Growth, and the forthcoming As One. Ian C. MacMillan is the Ambani Professor of Innovation and
Entrepreneurship and Director, Sol C. Snider Entrepreneurial Research Center at Wharton, and a principal of
Cameron & Assoc. LLC.

This article is about MERGERS & ACQUISITIONS

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Ahmed Kherati 3 years ago

How do you value Opportunity Value (OV) and Abandonment Value [AV]. Please give examples please.
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