1. USING DCF TO COMPUTE ENTERPRISE VALUE AND BOOK VALUE

Using the information from APPLYING THE DISCOUNTED CASH FLOW METHOD OF BUSINESS VALUATION (Mergers, Acquisitions and Corporate Restructurings - Patrick A Gaughan, page 569-570),

How the Market Determines Discount Rates 569

0Valuation

TABLE 15.2 Black-Scholes Call Option versus Business Real Option Parameters

Call Option Parameter Symbol Business Real Option Parameter

Underlying stock price S Present value of future cash flows

Exercise price E or X Investment

Volatility of the stock price " Volatility of the cash flows

Risk-free rate r Risk-free rate

Time to option expiration t Time to end of relevant business period

successfully employed to showthe real option approach. The model is still a mainstay in

the valuation of options. For a call option:

C = SN(d1)EertN(d2) (15.16)

d1 = ln(SX) + rt

"

t

+ 1

2"

t (15.17)

d2 = d1 "

t (15.18)

Table 15.2 shows the !ve parameters that are used in the typical Black-Scholes calculation

and their equivalent if this model were applied to business valuation.

CASE STUDY: BIG PHARMA ACQUISITION OF

BIOTECH USING REAL OPTIONS

Let us assume that Big Pharma Corp. (BPC) contemplates the acquisition of a

medium-sized biotech company (BIOT) that conducts research in an area where

BPC sees great potential. Let us further assume that it has certain patent-protected

drugs (protection period assumed to be 15 years) that BPC expected to yield BIOT

impressive cash flows and that DCF analysis shows that BIOT should have a value

of $500 million given these projected cash flows and a weighted cost of capital

(WACC) of 12%.

However, BIOT demands a price of $750 million. BIOT argues that its research

into a specific new drug has a potential DCF value of $1 billion three years from

now if an investment of $1.2 billion is made. The management of BPC is quite

puzzled about why a seemingly negative NPV project in the future would give

more value to BIOT. In fact, BPC responds to BIOT that this news may cause it

to lower, not increase, its offer for BIOT. BIOT responds that the new drug DCF

value has a standard deviation of 70% and claims that this gives the required value

to the company as long as the three-year T-note has a yield of 5%. BIOT's CFO

explains to BPC that this growth potential is analogous to a call option with a

current value of the stock of $1 billion discounted for three periods at 12% (BIOT's

WACC), which is approximately $712 million. He proceeds to use the call model

How the Market Determines Discount Rates 569

(see equations 15.16-15.18) where S is $712 million, the exercise price E is $1.2

billion, the maturity of the option is three years, the risk-free rate is 5%, and the

volatility is 70%.a Doing the computation with these inputs, the CFO obtains a value

for the growth potential of BIOT of $253 million. Therefore, he maintains that the

asking price of $750 million is more than justified. BPC is not yet convinced of

all the arguments, but it is willing to take this valuation into consideration. After

several rounds of discussions BPC agrees to offer $650 million for the company

with contingency valuation rights of $100 million. This means that BPC will pay $100

million to the current shareholders of BIOT if in three years the new drug goes into

production. The BPC CFO is quite pleased with how he structured the deal and

thinks of himself as a clever financial engineer.

Across the ocean, La Grande Pharma (LGP) is looking at BIOT for its potential

to develop the new drug. Given the sure stream of cash flow coming from existing

patents and the potential of the new drug, it is prepared to make an offer of $650

million for the company. Well versed in their market, they know that BPC would still

be interested in buying BIOT in three years mainly for the current drug for which

they hold what LGP believes is a strong and defensible patent. LGP figures that

BPC would pay about $455 million for the company, representing the remaining

value over 12 years of the "annuity," which would value the company today at $500

million with a WACC of 12%.

LGP has a CFO quite versed in real option valuation (ROV) who recognizes

that having the right to sell BIOT after three years is akin to having a put option

(equation 15.19). He proceeds to value the put option with S, $650 million, an

exercise price E of $455 million, and an overall volatility of the firm of about 50% (an

average between the existing product and the much greater volatility for the new

drug). The result is about $72 million. He is thinking that the total offer for BIOT

could be as high as $720 million and makes an immediate offer to BIOT of $700

million (see equation below and 15.17 and 15.18).

P = EerT [1 N(d2)] S[1 N(d1)] (1)

where:

P = put premium

S = stock price

X = exercise price

T = time to expiration

r = the interest rate

Since the discounted value of the $100 million that BPC is willing to offer is

today about $71 million, BIOT has now to decide if it likes the bird in hand ($700

million) or the one on the fence (about $720 million) along with the usual issues

and other concerns that comes from an acquisition. This case study is provided by

Professor Sorin Tuluca, Fairleigh Dickinson University.

a BPC finds this discussion curious but notes that BIOT's CFO was a former finance professor

at a well-known academic institution, so it decided to "humor him."

570 Valuation

Comparable Multiples

Comparablemultiples are regularly used to value businesses. They are a quick and easy

method to come up with a value for a company. Like DCF, they can be used to value

both public and closely held businesses. There are three basic steps in using comparablemultiple

analysis: (1) selecting the appropriate comparable companies, (2) selecting

the correct multiple, and then (3) applying it to the relevant earnings base.We will see

that there are abundant areas for judgment and subjectivity in the selection of these two

parameters.

Common multiples that are used are price-earnings multiples, so-called P/E ratios,

price-to-book, enterprise value to EBITDA, price to revenues, and other combinations.

Usually some normalized value of these measures is used, especially when the levels of

the values "uctuate greatly. Once the multiple is derived, it is then applied to either the

current year or an estimate of the next year's value of the base selected. Perhaps the

most commonly cited multiple is the P/E ratio, which is the ratio of a company's stock

price (P) divided by its earnings per share (EPS). When we multiply a derived P/E ratio

by a target company's EPS, we get an estimated stock price. For example, let us say that

we have analyzed 10 comparable companies and have found that the average P/E ratio

is 17. We can then multiply this value by the target company's EPS, which we assume

in this example is $3: 17 $3 = $41.When the multiples are derived from an analysis

of historical earnings, they are referred to as trailing multiples.When they are based on

forecasts of future earnings, they are called forward multiples.

Other commonly usedmultiples are EBITDAmultiplessometimes called cash "ow

multiples because EBITDAis sometimes used as a proxy for cash "ows.We usually obtain

EBITDA multiples by dividing enterprise value, including the sum of equity and debt

capital, by a given company's EBITDA level. This is done for our group of comparable

companies to derive our average value. That value is then applied to the target company's

EBITDA value to obtain its enterprise value. We then back out the debt of the

target from this value to get the value of its equity.

Establishing Comparability

Whenwe use comparablemultiples, one obvious key issue is comparability.Are the comparable

companies from which we derived the multiple truly similar to the target being

valued? Are theymore valuable or less valuable? If, for example, the company being valued

is a troubled concern, then it may not beworth the samemultiple of other, healthier

companies in the same industry. The target's dif!culties should be re"ected not only in

a lower earnings base but also inlower comparablemultiples,whichmight re"ect lower

earnings growth in the future.

Comparablemultiples are forward-looking measures. For example, a buyermay pay

seven times EBITDA, not for access to the past EBITDA level, but for future cash "ows.

When the market establishes speci!c acquisition multiples for different companies that

have been purchased in the industry, it is making a statement about the ability of those

companies to generate future cash "ows. When using such multiples, comparability

is key. It is more than just saying that a company being acquired shares the same

How the Market Determines Discount Rates 571

Standard Industrial Classi!cation (SIC) or North American Industry Classi!cation

System (NAICS) code and is in the same industry. It is a more speci!c examination

of comparability. Finding multiples for companies in the same business as the target

is a !rst step, not the !nal step, in the comparability process. Having established a

range based on prior acquisitions and the multiples that were paid, the evaluator

needs then to see how the target compares with those companies from which the

average multiple was derived. If the target has many features that would enhance its

future earning power, then perhaps a higher multiple should apply. It is likely that

the buyer is aware of this and may be asking for such a multiple. If it is not, either the

buyer is naive or this assessment of higher-than-average future earning power may be

misguided.

The Delaware Chancery Court has held that theremust be a reliable basis for establishing

comparability.13 One of the ways this can be done is through speci!c research.

In Global GT LP v. Golden Telecom the court rejected the use of comparable multiples due

to the fact that neither expert presented a reliable basis for establishing comparability

and neither had detailed knowledge of the relevant industry and the companies in

particular.

Dealing with Outliers

Users of industrymultiples should knowwhich companies entered into the computation

of the average. It is useful to be aware of the degree of dispersion. It may be the case that

many of the companies in the industry have multiples very different from the average.

If one or two outliers have skewed the average, then we need to consider whether they

should be eliminated. If the outliers are very different from the company being evaluated,

then there may be a good case for eliminating the outliers from the computation of the

average.

USE OF COMPARABLE MULTIPLES TO DETERMINE

ENTERPRISE VALUE

Enterprise value is a broad measure that reflects the value of the capital, both

debt and equity, that has been invested in the company. In this case study,

we will measure enterprise value using comparable multiples derived from similar

businesses that have been sold before the current valuation. As previously noted,

comparable multiples are applied to specific performance measures. Some common

performance measurements are as follows:

EBITDA: earnings before interest, taxes, depreciation, and amortization

EBIT: earnings before interest and taxes

(continued )

13 Global GT LP et al v. Golden Telecom Inc., Court of Chancery of Delaware, 2010 Del. Ch. Lexis 76, decided

April 23, 2010.

572 Valuation

(continued )

Net income: earnings after interest and taxes

Free cash flow: operational cash flow less capital expenditures

The example depicted in Figure A uses an EBITDA performance measurement.

This is used as a base in Figure A, which shows how an enterprise value/EBITDA

multiple may be computed.

Net Income $2,000,000

Taxes $700,000

Interest $250,000

Depreciation and amortization $150,000

EBITDA $3,100,000

Equity acquisition price $12,000,000

Interest bearing debt $2,500,000

Total enterprise value $14,500,000

Multiple 4.68

FIGURE A EBITDA Multiple

Figure A illustrates the relationship between total enterprise value ($14,500,000)

and EBITDA ($3,100,000). The application of the multiple indicated to the EBITDA

performance of a target company to be acquired will result in an estimate of total

enterprise value. Equity value can then be determined by deducting interest-bearing

debt from total enterprise value.

Figure B, however, shows how such a multiple can be derived from other

comparable historical transactions.

Court Company Rotary Company Bay Products Western Manufacturing

Net Income $748,125 $304,000 $776,000 $2,374,000

Taxes $785,625 $110,000 $400,000 $1, 411 000

Interest $48,750 $45,000 $182,000 $1,407,000

Depreciation/Amortization $458,125 $233,000 $392,000 $3, 498,000

EBITDA $2,040,625 $692,000 $1,750,000 $8,690,000

Equity Acquisition Price $14,052,000 $4,600,000 $14,600,000 $54,300,000

Interest Bearing Debt $498,000 $1,863,000 $2, 616,000 $15, 954,000

Total Enterprise Value $14,550,000 $6,463,000 $17,216,000 $70,254,000

Multiple 7.13 9.34 9.84 8.08

Average EBITDA Multiple 8.601

Weighted Average EBITDA Multiple 8.24

FIGURE B OCI Inc., Summary of Acquisitions

An example of the application of comparable multiple valuation can be illustrated

in the following case. We are attempting to determine the appropriate value

of Wilson Company, which is being acquired by OCI Inc. OCI has made several

acquisitions over the past years (see Figure B). Historically, OCI has paid between

How the Market Determines Discount Rates 573

7 and 10 times EBITDA, averaging 8.6 times on an unweighted basis or 8.24 times

on a weighted basis, depending on the size of the transaction.

We can apply this multiple to the financial results of the Wilson Company, the

target acquisition, to determine an approximate value to be assigned to the Wilson

acquisition (see Figure C). It should be pointed out that the results of Wilson's

historical financial performance should be adjusted for nonrecurring or unusual

items, which are not anticipated in the future. The valuation results in an enterprise

value of $33.2 million and an equity value, after deducting liabilities" answer the following question.

Year

1

2

3

4

5

6

FCFs

$27 500 000

$30 100 000

$32 800 000

$35 400 000

$37 900 000

$40 200 000

WACC (r) = 15%

Growth rate (g) = 7%

Market Value of Debt & Preferred Equity = $100 000 000

Shares Outstanding = 40 000 000

(a) Calculate the capitalization rate (1)

(b) Calculate the terminal value (2)

(c) Calculate the Total Enterprise Value (TEV) (5)

(d) Calculate the share price (2)

2. POST ACQUISITION VALUE

CPI, Inc. is acquiring JW for R470 000 in cash. CPI has 27 000 shares outstanding at a market value of R320 a share. JW has 32 000 shares outstanding at a market price of R140 a share. Neither firm has any debt. The synergy value of the acquisition is R18 000.

What is the value of CPI after the acquisition? (3)

3. NUMBER OF NEW SHARES TO BE ISSUED FOR ACQUISITION

GM Corporation is being acquired by BKF Ltd. for R1 290 000 worth of BKF Ltd. shares. BKF has 75 000 shares outstanding at a price of R54 a share. GM has 15 000 shares outstanding with a market value of R27 a share. The synergy value of the acquisition is R37 000.

How many new shares will be issued to finalise acquisition? (2)

4. AFTER MERGER EARNINGS

Firm XY is planning on merging with Firm YZ. Firm XY will pay Firm YZ's shareholders the current value of their shares in shares of Firm XY. Firm XY currently has 39 000 shares outstanding at a market price of R40 a share. Firm YZ has 22 000 shares outstanding at a price of R17 a share. The after-merger earnings will be R78 000.

What will the earnings per share be after the merger? (5)