Crest Sep13 Sesssion 4

Business Valuation & Synergy Trap

Session 4

AbhimanyuSeptember 13, 2009

Other Approaches

Business Valuation

September 13, 2009 Corporate Restructuring | Session 4 3

Methods

• Market Approach– Current Market Prices, Historical Market

Prices, Price to Earnings, Price to Revenue, Price to Book Value, Price to Enterprise Value

• Comparable Transactions/Relative Valuations– Comparable International and Domestic

Transactions.

• Sum-of-parts Method


Market Approach

• Key issues– Representative comparative companies– Time period– Variables to be considered

• Among the common variables used are– P/E, P/BV– M-Cap/Revenue, M-Cap/EBIDTA

• Important to compare apples to apples


Comparable Transactions

• Key issues– Representative comparable transactions– Time of consummation– Applicable markets and their dynamics

• Usual variables– EV/Revenue, EV/EBIDTA– P/E, P/BV

• Important to segregate and eliminate company specific premiums and discounts in the valuation


Sum Of Parts Method

Land Parcel 100 acres EPC Company With All Own Equipment

Toll Road Under BOT Generating Toll Fees

New Venture Into Nuclear Energy


Sum Of Parts Method

Land Parcel 100 acres

Asset Valuation (FMV)

Revenue Generation Potential

EPC Company With All Own Equipment


Add Company Premium/Discount


Discounted Cash Flow


Negotiated Depending on Stage of

Development


Sum Of Parts Method

Land Parcel 100 acres


Revenue Generation Potential

EPC Company With All Own Equipment


Add Company Premium/Discount


Discounted Cash Flow


Negotiated Depending on Stage of

Development

Add SCRP, Liquidity Premium & Control

Premium

The Synergy Trap

Acquisitions & Their Pricing


The Synergy Trap

• Essentials for an Acquirer:– Should not pay “too much”– The deal should make “strategic sense”– Corporate cultures need to be managed carefully

• The problem is:– How do we predict up front whether a company is

overpaying for an acquisition?

• Acquisitions are capital budgeting decisions


The Synergy Trap (Contd.)

• Dreams of synergy may lead to lofty acquisition premiums.

• A quantifiable post-merger challenge is embedded in the price of each acquisition. Higher the premium, greater is the challenge.

• Using the acquisition premium, we should be able to calculate what the required synergies must be.

• This calculation may often show that the required performance improvements are far greater than what any business in a competitive industry can reasonably expect.



• A McKinsey & Co. study found that 61% of the acquisition programs were failures because the acquisition strategies did not earn a sufficient return on the funds invested.

• A BCG study found that during the pre-merger stage, 80% of companies did not even consider how the acquired company would be integrated into operations following the acquisition!!

• Thus, a bad acquisition is one that does not earn back at least its cost of capital.



• When an acquirer pays acquisition premium, he/she has two business problems to solve:– to meet the performance targets the market already expects;– to meet the even higher targets implied by the acquisition

premium. • Hence, Synergy can be defined as “increases in

competitiveness and resulting cash flows beyond what the two companies are expected to accomplish independently”


The Acquisition Game

• Acquisition is a business gamble where the acquirer pays up front for the right to control the assets of the target firm and earn, hopefully, a future stream of cash flows.

• But while the acquisition premium is known with certainty, the payoffs are not.

• NPV (of playing the acquisition game) = Synergy- Premium.


Losing In The Acquisition Game

• When Novell acquired WordPerfect for $1.4bn, they did not calculate what WordPerfect was already required to accomplish given the first bid for WordPerfect by Lotus for $700mn.

• Novell lost $550mn of market value on announcement of acquisition.

• Microsoft has, since then, continued to gain market share and ultimately Novell sold WordPerfect (less than two years after acquisition) to Corel at a loss of over $1.2bn!


Empirical Evidences of Acquisitions

• Some studies concluded that related acquisitions were better than unrelated acquisitions;

• Some show that unrelated acquisitions were better than related acquisitions; and

• There is a third group which show that the relationship just did not matter!

• But most of these researchers assumed that acquisition prices are highly correlated with potential value.


Problems with Past Research

• Because many researchers have assumed that the premiums represent fair prices in the beginning, a failed acquisition was dubbed as the result of “managerial problems” such as culture clashes, leadership failures etc.

• The practical problem with this approach is that it does not realistically address whether the acquisition strategy could have worked even in the absence of implementation problems.

• It is wrong to assume that if the management problems were not there, all or any of the synergy promised by the premium would occur.


Post-Acquisition Integration

• Nelson and Lagges, Principals with A. T. Kearney advised, “During the first year, it is important to combine two cultures and organizations, but it is fatal to get bogged down in heavy operations integration. Start out by picking the low hanging fruits.”

• However, it is observed that for an average acquisition premium of over 40%, it is crucial to understand that the possible performance improvements should also be worked out initially. This is because each year of delay would cost heavily!


Justifying Acquisition Premium

• The synergy (or Required Performance Improvement) as indicated by the acquisition premium has to be estimated up front.

• The process of such estimation would show how difficult it is to justify the premium!

• Any delay in realizing synergy would further put the acquisition premium at risk.

Economy & Finance

Crest Sep13 Sesssion 4