Applying Relative, Asset Oriented, and Real Option Valuation Methods to

Mergers and Acquisitions

Applying Market-Based (Relative Valuation) Methods1

MVT = (MVC / IC) x IT

Where

MVC = Market value of the comparable company C

IC = Measure of value for comparable company C

IT = Measure of value for company T

(MVC/IC) = Market value multiple for the comparable company

1Comparable companies may include those with profitability, risk, and growth characteristics similar to the target firm.

Market-Based Methods: Comparable Company Example

Exhibit 8-1. Valuing Repsol YPF Using Comparable Integrated Oil Companies

Target Valuation Based on Following Multiples (MVC/VIC):

Comparable Company Trailing P/E1 Forward P/E2 Price/Sales Price/Book

Average

Col. 1 Col. 2 Col. 3 Col. 4 Col. 1-4

Exxon Mobil Corp (XOM) 11.25 8.73 1.17 3.71

British Petroleum (BP) 9.18 7.68 0.69 2.17

Chevron Corp (CVX) 10.79 8.05 0.91 2.54

Royal Dutch Shell (RDS-B) 7.36 8.35 0.61 1.86

ConocoPhillips (COP) 11.92 6.89 0.77 1.59

Total SA (TOT) 8.75 8.73 0.80 2.53

Eni SpA (E) 3.17 7.91 0.36 0.81

PetroChina Co. (PTR) 11.96 10.75 1.75 2.10

Average Multiple (MVC/VIC) Times 9.30 8.39 0.88 2.16

Repsol YPF Projections (VIT)3 $4.38 $3.27 $92.66 $26.49

Equals Estimated Value of Target $40.72 $27.42 $81.77 $57.32 $51.81

1Trailing 52 week average. 2Projected 52 week average. 3Billions of Dollars.

Market-Based Methods:Recent Transactions’ Method1

• Calculation similar to comparable companies’ method, except multiples used to estimate target’s value based on purchase prices of recently acquired comparable companies.

• Most accurate method whenever the transaction is truly comparable and very recent.

• Major limitation is that truly comparable recent transactions are rare.

1Also called precedent method.

Market-Based Methods:Same or Comparable Industry Method

• Multiply target’s earnings or revenues by market value to earnings or revenue ratios for the average firm in target’s industry or a comparable industry.

• Primary advantage is the ease of use and availability of data.

• Disadvantages include presumption industry multiples are actually comparable and analysts’ projections are unbiased.

PEG (Price to Earnings & Growth rate) Ratio• Used to adjust relative valuation methods for differences in growth rates

among comparable firms.• Helpful in determining which of a number of different firms in same

industry exhibiting different growth rates may be the most attractive.

(MVT/VIT) = A and

VITGR

MVT = A x VITGR x VIT

Where A = Market price to value indicator relative to the growth rate of value indicator (e.g., (P/E)/ EPS growth rate)

MVT = Market value of target

VIT = Value indicator for target (e.g., EPS)

VITGR = Projected growth rate in value indicator (e.g., EPS)

Applying the PEG Ratio

An analyst is asked to determine whether Basic Energy Service (BAS) or Composite Production Services (CPS) is more attractive as an acquisition target. Both firms provide engineering, construction, and specialty services to the oil, gas, refinery, and petrochemical industries.BES and CPS have projected annual earnings per share growth rates of 15 percent and 9 percent, respectively. BES’ and CPS’ current earnings per share are $2.05 and $3.15, respectively. The current share prices as of June 25, 2008 for BAS is $31.48 and for CPX is $26. The industry average price-to-earnings ratio and growth rate are 12.4 and 11 percent, respectively. Based on this information, which firm is a more attractive takeover target as of the point in time the firms are being compared?

Industry average PEG ratio:1 12.4/.11 = 112.73 BAS: Implied share price = 112.73 x .15 x $2.05 = $34.66CPX: Implied share price = 112.73 x .09 x $3.15 = $31.96Answer: The difference between the implied and actual share prices for BAS and CPX is $3.18 (i.e., $34.66 - $31.48) and $5.96 ($31.96 - $26.00), respectively. CPX is more undervalued than BAS at that moment in time.

1Solving MVT = A x VITGR x VIT using an individual firm’s PEG ratio provides the firm’s current or share price in period T, since this formula is an identity. An industry average PEG ratio may be used to provide an estimate of the firm’s intrinsic value. This implicitly assumes that both firms exhibit the same relationship between price-to-earnings ratios and earnings growth rates.

Asset-Based Methods:Tangible Book Value

• Tangible book value (TBV) = (total assets - total liabilities - goodwill)

• Target’s estimated value = Target’s TBV x [(industry average or comparable firm market value) / (industry or comparable firm TBV)].

• Often used for valuing – Financial services firms where tangible book

value is primarily cash or liquid assets– Distribution firms where current assets constitute

a large percentage of total assets

Asset-Based Methods: Liquidation Method

• Value assets as if sold in an “orderly” fashion (e.g., 9-12 months) and deduct value of liabilities and expenses associated with asset disposition.

• While varies with industry, – Receivables often sold for 80-90% of book value– Inventories might realize 80-90% of book book value

depending on degree of obsolescence and condition– Equipment values vary widely depending on age and

condition and purpose (e.g., special purpose)– Book value of land may understate market value– Prepaid assets such as insurance can be liquidated with

a portion of the premium recovered.

Asset-Based Method: Break-Up Value

• Target viewed as series of independent operating units, whose income, cash flow, and balance sheet statements reflect intra-company sales, fully-allocated costs, and operating liabilities specific to each unit

• After-tax cash flows are valued using market-based multiples or discounted cash flows analysis to determine operating unit’s current market value

• The unit’s equity value is determined by deducting operating liabilities from current market value

• Aggregate equity value of the business is determined by summing equity value of each operating unit less unallocated liabilities and break-up costs

Replacement Cost Method

• All target operating assets are assigned a value based on what it would cost to replace them.

• Each asset is treated as if no additional value is created by operating the assets as part of a going concern.

• Each asset’s value is summed to determine the aggregate value of the business.

• This approach is limited if the firm is highly profitable (suggesting a high going concern value) or if many of the firm’s assets are intangible.

Real Options as Applied to M&As

• Real options refer to management’s ability to adopt and later revise corporate investment decisions (e.g., acquisitions)

• Options to expand (i.e., accelerate investment)– Acquirer accelerates investment in target after acquisition completed

due to better than anticipated performance of the target • Options to delay (i.e., postpone timing of initial investment)

– Acquirer delays completion of acquisition until a patent pending receives approval

• Options to abandon (i.e., divest or liquidate initial investment)– Acquirer divests target firm due to underperformance and recovers a

portion of its initial investment

Things to Remember…• Alternatives to discounted cash flow analysis include the following:

– Market based methods• Comparable companies• Recent transactions• Same or comparable industries

– Asset based methods• Tangible book value• Liquidation value• Break-up value

– Replacement cost method– Weighted average method

• Firm value must be adjusted for both non-operating assets and liabilities.

• Real options should be considered in M&A valuation when clearly identifiable and when would add significantly to investment’s value