Basics #
Definition of takeover/acquisitions: An acquisition or takeover is the purchase of one company (target) by another (acquirer or bidder), and the target firm’s shareholders cease to be the owners of that firm
Merger: Combining two business entities under one ownership
In economics, a takeover and a merger have the same economic outcome and they are seem indifferent
Types of Takeovers #
From the perspective of industrial structure
- Horizontal takeovers: Target and acquirer are in the same industry - Facebook’s takeover of WhatsApp
- Vertical takeovers: Target’s industry buys or sells from acquirer’s industry - Tele Atlas(digital map)’s takeover by TomTom(Car Navigation)
- Conglomerate takeovers: Target and acquirer operate in unrelated industries - Wesfarmers’ acquisition of Coles
From the perspective of motivations
- Friendly takeovers: Typically approved by the target’s management
- Hostile takeovers: Typically disapproved by target’s management
- Reverse takeovers
- A private company acquires a public company
- Easier route to becoming publicly listed than by doing a proper IPO - Sigma Healthcare’s takeover of Chemist Warehouse
- Used to be common in the US, yet very popular in China - 借壳上市
Financing of Takeovers #
Cash bid #
Definition: Pay cash to the target’s shareholders for their shares Pros:
- Certain and easily understood by target’s management and shareholders
- Improves the chance of a successful bid
Cons:
- Raising the necessary cash can be difficult
- Possible to negatively impact bidder’s debt rating if the bidder were to issue more bonds to fund this transaction
Share bid (Scrip bid) #
Definition: The bidder issues new shares to swap them with target shares
Pros:
- Avoids strain on the cash position of the bidder
- Has a relative tax advantage b/c cash acquisitions may create immediate tax liabilities
Cons:
- Equity issue is an expensive way of raising capital: Dilution of wealth, control, change of capital structure, etc
Empirical Evidence #
Fincancing: Many of the takeovers can be financed by a mix of cash and share bids
Takeover activities in waves: Peaks of heavy activity followed by quiet troughs of few transactions in the takeover market
- Said to be a merger of banks on its way, as smaller banks tend to be less competitive nowadays. They tend to form bigger entities with greater resources to compete with JP Morgan, UTS etc, or they will have to be eaten to the bones.
- Even this happens, there is a reason on good grounds why this may not continue always and meet a trough - the regulators will stop the banks from merging when it touches the line of monopoly.
Facts
- Waves cluster in a relatively small number of industries - Takeover activities are often prompted by deregulation and by changes in technology or in the pattern of demand
- Markets reaction to takeovers on average
- Target: Enjoy a gain
- Acquirer: Suffer a lose
- Potential reasons to market reaction:
- Competition among potential bidders, raising the final bid
- The target firm’s various legal and financial counterattacks, ensuring that capitulation is at the highest attainable price
Motivations of Takeovers #
Sensible #
Operating synergies
- Lowering the costs, bringing up the revenues
- Economies of scale - produce more of the same/similar product - bringing up the revenues
- Economies of scope - share expertise/complementary resources across firms - lowering the costs
Replace poor current target management: The current management does not operate the resources well
Market power
- Reduces price competition and increases profits
- Subject to regulation due to antitrust laws
Tax savings - Extra outcome, not primary
- A conglomerate may have a tax advantage over a single-product firm because losses in one division can offset profits in another division
Dubious #
Diversification - similar to home-made dividends, shareholders can diversify themselves by purchasing shares in different companies, and they do not need managers to do costly takeovers
Managerial Motives - Empire-building behavior (managerial agency costs) and overconfidence (hubris hypothesis)
Empirical Evidence #
Motivations: Mostly for synergy benefits
Source of synergy: Mostly for operating economies - improved productivity/cost cutting
Valuation of Acquisition #
Price is what you pay, value is what you get. They are not the same. - Warren Buffett
Terminology for Valuation #
Two market values for a public company
- Market capitalization (market value of equity) = # of shares outstanding $\times$ current stock price
- Enterprise value (market value of the whole company or its claims) = Market value of equity + market value of debt - cash
In acquisition valuation, we determine how much to pay for the targets’ shares in a takeover deal - estimating its equity value or market capital
Keypoints:
- The valuation not necessarily equivalent to its market value before the takeover
- There is no current market value if the target is a private company
- Can be estimated directly or by estimating its enterprise value first and then deducting its debt outstanding from enterprise value
Valuation Techniques #
Overview #
- Intrinsic valuation: Discounted Cash Flows analysis
- Relative valuation
- Comparable Companies Market Multiples Method
- Comparable Transactions Method
- Contigent claim valuation: Real Option Analysis
Intrinsic Valuation - DCF analysis #
Basic Idea #
Formulae:
$$ \begin{aligned} \text{Firm Value} &= \sum_{t = 1}^\infty\frac{FCF_t}{(1+WACC)^t}\\\\ &=\text{Forcast Cashflows in T periods} + \text{Terminal Value @ T}\\\\ &=\sum_{t=1}^T \frac{FCF_t}{(1+r)^t}+TV_0\\\\ \end{aligned} $$$$ \begin{aligned} TV_0 &= \frac{1}{(1+r)^T}TV_T\text{ (Discounted back T periods)}\\\\ &=\frac{1}{(1+r)^T}\frac{FCF_T(1+g)}{r-g}\text{ (Gorden Growth Model)}\\\\ \end{aligned} $$
Constant growth cash flows start @ T+1, here the FCF refers to FCFF
Forecast Cashflows:
- Within forecast period
- With high growth and volatility
Terminal Value:
- After forecast period
- Firm is stable & mature, changes at constant rate forever
Keypoints #
Keypoints
- The value of the firm (enterprise value) is the maximum price a buyer willing to pay without any synergies
- The Enterprise value + expected synergies gives a economic ceiling of the price to offer to the original shareholders - above which making the buying decision is a negative NPV decision
Pros
- Forward looking and focuses on cashflows, not on profits
- Allows operating strategies/synergies to be built into a model
- Valuation is tied to underlying fundamentals
Cons
- Only as accurate as assumptions and projections used - If the forecast cash flows underperforms too much, the whole takeover could have been a negative NPV project
- Need to forecast managerial behavior after the takeover - yet the new managements may not operate the firm as competent as before, or their behaviors may be inconsistent
- Need to estimate the discount rate using a theory (e.g. CAPM) that may be imprecise or tricky in some cases
Relative Valuation #
Comparable Companies Market Multiples Method #
Def: Estimate a firm’s market value based on those of publicly traded comparable companies
Procedures
- Identify comparable firms and obtain their market values (market cap)
- Convert their market values into standardized values using common variable (e.g. earnings) which creates market multiples (e.g. P/E ratios)
- Combine these multiples (typical to take the average of comparable companies’ multiples)
- Multiply the average multiple by the common variable (e.g. earnings) of the target firm, resulting in the estimate for its market value (e.g. market cap)
Keypoints
- For firms without earnings or limited asset base (e.g. high tech firms), there may be price-to-patent, price to subscribers or even price-to-PhD multiples.
- Since multiples are rough approximations (
indeed very rough! It assumes linearity in between different variables)- Check different multiples
- Check if multiples give consistent valuations across firms in the same sector
- Look at the asset size, profitability, growth, Return On Investment and creditworthiness
- The motivation we use multiples is that we assume in the same industry, firms tend to behave similarly on aspects involved by the multiples (e.g. payout rates, growth rates and cost of equity as to P/E ratios)
Pros
- Very common, convenient market-based method
- Provide an alternative way to perform terminal value estimation
Cons
- Subject to market distortions (price) and accounting policy (earnings)
- Do not directly incorporate the operational improvements and other synergistic efficiencies that the acquirer intends to implement
- Identifying closely comparable firms is challenging
- Choice of dates used to estimate comparing multiples can be arbitrary - different report periods may lead to this and the data needs to be adjusted
Comparable Transactions Method #
Def: Use historical takeovers of a similar firm to compare
Keypoints:
- Look at comparable acquisition transactions as an additional benchmark
- This reflects actual price paid and hence useful for negotiations
- The more similar the firm in the deal, the better the comparison
- Identifying comparable recent transactions can be challenging
Valuation summary #
Keypoints
- Different valuation techniques give different prices and ranges
- The actual takeover price is determined by a game between the two parties - and hence there is no best valuation, but a valuation that both parties agree with
Contingent claim valuation - Real Option Analysis #
Def: Regarding the firm as a call option
Characteristics of firms
- The firm may be a troubled-firm - with high leverage, negative earnings and a significant chance of bankruptcy
- Natural resource companies where the undeveloped reserves can be viewed as options on the natural resource
- Start-up firms or high growth firms which derive bulk of their value from the rights to a product or a service (patents)
- Facebook’s acquisition of WhatsApp can be considered as purchasing a call option - just very expensive
Summary - Valuation Myths #
Myth 1 - A valuation is an objective search for true value
- Truth 1.1: All valuations are biased. The only question is how much and in which direction
- Truth 1.2: The direction and magnitude of the bias in your evaluation is directly proportional to who pays you and how much you are paid
Myth 2 - A good valuation provides a precise estimate of value
- Truth 2.1: There are no precise valuations
- Truth 2.2: The payoff to valuation is the greatest when valuation is least precise
*Myth 3 - The more quantitative a model, the better the valuation
- Truth 3.1: One’s understanding of a model is inversely proportional to the number of inputs required for the model
- Truth 3.2: Simpler valuation models do much better than complex ones
Basics supplemented on balance sheets #
Free Cash Flows to Firm (FCFF) #
Formula
$$ \begin{aligned} \text{FCFF} &= \text{Cash from Operations} - \text{Capital Expenditures} \\\\ &= \text{EBIT}(1-t_c)+\text{Depreciation}-\Delta\text{NWC}-\text{Capital Expenditures} \end{aligned} $$Net Working Capital #
Formulae
$$ \begin{aligned} \text{NWC}&=\text{Current Assets}-\text{Current Liabilities}\\\\ &=\text{Inventory}+\text{Accounts Receivables}-\text{Accounts Payables} \\\\ \implies\Delta\text{NWC}&=\Delta\text{Current Asset}-\Delta\text{Current Liabilities}\\\\ \Delta\text{NWC}&=\Delta\text{Inventory}+\Delta\text{Accounts Receivables}-\Delta\text{Accounts Payables} \end{aligned} $$Keypoints in $\text{NWC}$:
- $\Delta\text{NWC}$ measures how much of inventory/liabilities has changed in the last fiscal year of a company
- A positive change indicates that the company has:
- an increase inventory - which is not counted as expenses for cash flows so have to be counted again (it will be counted as an expense once the company sold the product),
- an increase in receivables - which means the company missed the cash flow and count as a cash outflow as its expenses have been already taken into account, or
- a decrease in payables - which means that you paid down the outstanding invoices and there is a cash outflow.
- My understanding on $\text{NWC}$: The reason why $\text{NWC}$ is needed in the calculation is because without this term, we may not be able to account for the cash flows incurred by dynamic inventories, payables and receivables
EBIT #
Formulae:
$$ \begin{aligned} \text{EBIT} &= \text{Revenue(Sales)} - \text{Depreciation} - \text{COGS} - \text{SGnA} \\\\ &= \text{(or) } \text{Revenue}\times\text{Operating Margin} \end{aligned} $$- COGS: Costs of Goods Sold - Only to incurr if were to sold
- SGnA: Selling, General & Administrative Expenses
Capital Expenditures (CapEx) #
Keypoints in $\text{Capital Expenditures}$ (CapEx):
- Intuitively speaking, Capital Expenditures are measures of cash flows of long-term investments, especially fixed assets
- Typical capital expenditures: Property, Plants & Equippments
- Interests&etc are not taken into account when building FCFF
Gross Margin #
Formula
$$ \text{Gross Margin}=\frac{\text{Revenues}-\text{COGS}}{\text{Revenues}} $$Operating Margin #
Formula
$$ \text{Operating Margin}=\frac{\text{EBIT}}{\text{Revenues}} $$Net Income Margin #
Formulae
$$ \begin{aligned} \text{Net Income Margin}&=\frac{\text{Net Income}}{\text{Revenues}}\\\\ &=\frac{\text{R-COGS-E-I-T}}{\text{R}} \end{aligned} $$where
- R: Revenues
- COGS: Cost of Goods Sold
- E: Operating Expenses and other expenses
- I: Interests
- T: Taxes