Mergers, Corporate Governance, and Control Topic 8

Two factors affecting EPS

1) due to risk 2) value of PVGO

What is the alternative to DCF valuation and NPV

Alternative is to essentially free ride of the wisdom of the market by doing valuation on multiples and comparables

Please tell me about the 6 waves of the US M&A activity

1893-1904 Horizontal mergers with the explicit objective of creating monopolies 1915-1929 Horizontal mergers of secondary firms resulting in oligopolies 1960-1970s Mostly conglomerate mergers -> buying companies in other industries. Here idea embedded is that managerial ability is transferable across industries 1980s Many gigantic mergers with more underlying business logic than the previous wave. <ergers were relatively hostile 1990s Megadeals fuelled by globalisation. Less Hostile more stock-financed purchases -> Cessation of cold-war breakdown of trade barriers conducive to M&A activity 2000 more buyouts due to the growth in private equity

Europe historical two waves

1984-1989 Mostly transatlantic acquisitions by US acquirers 1993-2001 A surge in intra-European transactions. A significant component of the activity involved cross-border acquisitions. The Euro and deregulation/privatisation played particularly important roles compared to corresponding US activity

Merger

2 firms combine to form a single firm Implies a marriage of equals -> 2 firms that are roughly = in size

Dubious sources of value

Acquiring Firm with Low E/P Ratio: The acquiring firm has a low earnings-to-price (E/P) ratio, which indicates either a high stock price relative to its earnings (high valuation) or low earnings relative to its stock price (potentially undervalued). Selling Firm with High E/P Ratio: The selling firm, or the firm being acquired, has a high E/P ratio. This typically indicates that it's priced lower relative to its earnings, often because the market has low growth expectations for the firm. Short-term EPS Rise After Merger: After the merger, the acquiring firm benefits from a short-term increase in EPS. This is because the total earnings post-merger reflect the earnings of both companies, but if the acquiring company paid a relatively low price for a high-earning company, its EPS—calculated as earnings divided by the number of shares outstanding—can rise. Long-term Slower EPS Growth Due to Share Dilution: In the long term, however, the EPS growth of the acquiring company may be slower than normal. This is due to the dilution of shares; if the acquisition was made by issuing new stock, there are now more shares over which the earnings must be spread. Over time, if the acquired company doesn't grow as quickly as the market expects, or if the costs of the merger outweigh the benefits, the EPS growth may not keep pace with expectations.

Asset-Based multiples

Asset-based Multiples: These multiples are based on the firm's assets rather than cash flows:MV of firm/BV of assets: This ratio compares the market value of the firm to the book value (BV) of its total assets, which reflects the accounting value of the assets.MV of equity/BV of equity: This compares the market value of the firm's equity to the book value of the equity, which is the difference between assets and liabilities as recorded on the balance sheet.

Why is the Combined returns of targets and Bidder closer to the latter than the former

Combined average is the size weighted average & given the bidder company has larger weight. The combined average return is closer to the bidder than the target.

How to calculate the cost of cash-financed merger

Cost = Cash paid - Vt Essentially, this calculates the acquisition premium and the point here is to pay acquisition cost large anough but not greater than the synergy benefit

Whys is cash financed mergers more desirable

Due to asymmetric information, optimistic managers prefer to finance mergers with cash. If you believe or know that your stock is underpriced as the perspective of acquirer you buy the target firm with cash rather than loosing on underpriced equity.

When does M&A make sense

Economically this makes sense to merge if two firms together are valued more than them valued separately.

What is Corporate governance

Ensure that everything is in the interest of shareholders. the threat of being acquired can lead to incumbent management being sacked

Cons

Forecast Reliability: The accuracy of a DCF/NPV valuation is only as good as the forecasts and assumptions it's based on, which can be uncertain. Omission Risk: There's a risk of omitting important cash flow components or failing to account for all relevant factors, which can skew the valuation. Managerial Predictions: Unless you have control over the company, you'll need to predict managerial decisions that could impact future cash flows, adding to the uncertainty. Discount Rate Challenges: Choosing the appropriate discount rate requires a model like the Capital Asset Pricing Model (CAPM), which may not always be accurate or may introduce additional estimation errors

Takeovers Friendly hostile

Friendly: The board of directors of two firms agreem to combine and seek shareholders approval for the combination genreally >50% Hostile in some cases the friendly takeover can be rejected Raider can make offer to board of directors A hostile takeover happens when one company (the "raider") wants to take over another company (the "target") without the target company's board agreeing to it. The raider can try to convince the target's board to agree to the takeover. If the board doesn't agree, the raider can go directly to the shareholders with a "Tender Offer," which is an offer to buy their shares at a specified price, usually higher than the market price, to gain control of the company. Sometimes, when a company is under threat of a hostile takeover, it may seek help from a "white knight" - another company that is more agreeable to merging or being bought. This white knight steps in to offer a better, friendlier deal to the target company, helping it avoid the hostile takeover.

How to calculate the gain from merger

Gain = Vat (AT) is the combined entity Acquirer and the Target Gain = Vat - (Va + Vt) the latter two terms are stand alone target and acquiring firms, either there is no upcoming merger or not expecting one. Vat hence the gain here Vat if there is is the synergy

Tell me the purpose of hedging and most common hedgers

Purpose of hedging is to minimise the volatility of CFs and most common hedgers are insurance and derivatives

Valuation by Multiples: Procedure

Hope: Firms in the same business have similar multiples (e.g. P/E) Step 1) Identify firms in the same bussiness as the firm you want to value. Step 2) calculate P/E ratio for comparables and come up with an estimate of P/E for the firm you want to value e.g., take the average of comparables' P/E. Step 3) Multiply the estimated P/E by the actual EPS of the firm you want to value

Types of Mergers

Horizontal mergers-> Firms that are in the same industry and in the same stage of production process. Vertical mergers -> Firms that are in the same industry but at different stages of the production process Usually where buyer buys out its supplier/distributor Shell for example is a vertically integrated firm Conglomerate Mergers- Example is general electric have health care division airplane engines so merged with lots of different industries

Dubious source of value of m&a

Increase Financial Slack (Get Cash): Rationale: By acquiring a company with substantial cash reserves, a company increases its own financial slack—the availability of liquid assets that can be used to fund new investments without the need to seek external financing. Pecking Order Theory: This theory suggests that managers prefer financing new investments internally to avoid the costs and scrutiny of external financing. Questionable Logic: The idea of acquiring a company just to access its cash can be puzzling because the cost of the acquisition (paying a premium over the market price for the target company) may negate the benefits of the cash obtained. In simpler terms, it's like spending a pound to obtain a pound, which doesn't inherently create value Diversification: combining several industries to lower total risk is diversification at the firm level. if casflows of the conglomerate are not correlated than there is diversification. Creating a conglomerate at corporate level is complicated & costly much costlier than individual buying portfolio stocks Investor Perspective: From an investor's point of view, this kind of diversification by the firm may not be necessary or beneficial. Investors have the ability to diversify their own investment portfolios across different industries and companies at a lower cost. This is because they can choose their own risk/return profile and are not limited by the strategic decisions of any one company. Efficiency Concerns: When a company diversifies across industries, it may also stretch its management too thin or invest in areas outside its core competencies. This can lead to inefficiencies and may actually destroy rather than create value.

Recent mergers and how do M&A compare to IPOs

M&A are very large transactions substantially larger than the IPO Transaction for M&A is about 1000x larger than the IPO. Since IB get a share of this deal flow they care about the M&A

In short what does M&A yield

M&A is when 2 firms become one

How to caluculate the NPV of the acquisition

NPV = Gain - Cost NPV amount of synergy left for acquirer shareholders

Valid source of value for M&A

Necessary Restructuring: If restructuring through mergers is cost effective, then it will add value. Obsolete Product: If a company's product is becoming outdated, merging with another company that has more current offerings can help it stay competitive. Increased Foreign Competition: Companies might face new challenges from international firms offering similar products, often at lower prices due to cheaper labor or materials. Mergers can help local companies combine their strengths to compete more effectively. Deregulation: In industries like banking and airlines, deregulation can remove barriers to competition and allow for market consolidation. Mergers can be a strategic response to the increased competition that deregulation often brings. Market Power: Eliminating Competition: If a company is unable to compete on price alone, acquiring a competitor can reduce competition, which might allow the merged entity to set higher prices. Monopoly Pricing: With fewer competitors in the market, the company has more power to control prices. This can lead to monopoly or oligopoly pricing, where the market is controlled by one or just a few companies. Impact on Stock Price: The anticipation of higher profits from reduced competition can lead to an increase in the company's stock price as investors anticipate better financial performance. Societal Impact: While the company may benefit from higher profits, consumers can suffer from higher prices and reduced choice, which is generally considered bad for society.

Takeover

One firm ("Acquirer") buys a sufficient number of shares or assets of another firm ('Target') to gain control Is the dominant firm buys dominant shares of the target -> Majority shares and the voting rights. Gets more complex where they have class A and class B shares Not a marriage of equals the management of the target is subordinate to that of the acquirer.

What theory explains why bidders offer an acquisition premium at all

One theory is the Free rider problem this means that acquisition of underperfoming management company should proceed as the raider will eliminate agency costs but becasue of free rider problem B Tyles chooses to stay away this is net loss fo economy only the raider can unlcok the extra value in target firm However the current shareholders will want to free -ride on raiders efforts. The free-rider problem explains why target prices jump ona. takeover announcement why most of the gains go to the initial shareholders and not the acquirer.

Dubious Sources of Value

Overconfidence of CEOs CEOs are often overconfident in their management abilities and might overstimate the potential gains. Roll Hubris hypothesis

What happens if the DCF valuations is way off from comparables

Perhaps, this tells us we went somewhere wrong with the assumptions of DCF valuation comparables gives a sense check to the DCF valuation. However, we do a mixture of valuation methods

Valuation by Multiples

Pros: Efficiently uses existing market data. -> incorporates a lot of info from other valuations in a simpler way Reflects the collective market view on growth and risk.-> Embodies market consensus about discount rate and growth rate -> Piggy banking from markets consensus Benefits from the market's collective wisdom. so free rides from it Ensures consistency with market valuations. Provides discipline to valuation process by ensuring that your valuation is in line with other valuations Cons: May not account for unique company characteristics. -> implicity assumes all companies are alike in growth rates, cost of capital, and business composition -> comparables may differ in value relevant ways Challenges in adjusting for company-specific changes. Differences in accounting practices can skew comparisons. Reliance on historical book values may not reflect current asset values. Assumes market-wide analysis is correct without independent verification. If everyone uses comparables, who actually does fundamentally analysis

Pros

Pros: Transparency: DCF/NPV involves creating a spreadsheet that lays out the expected free cash flows, making the valuation process transparent and based on clearly defined inputs. Detail-Oriented Forecasts: The cash flows come from detailed forecasts and specific assumptions about the business, such as sales growth, profit margins, and capital expenditure. Strategy Evaluation: You can see how changes in business strategies affect the valuation by adjusting the forecasts and assumptions in the model. Fundamentals-Based: The valuation is directly tied to the company's fundamental financial performance, which includes earnings, investments, and growth prospects.

Tell me about the estimation of merger gains

Start with the targets stand-alone market value VT and concentrate on the changes in cash flow that would result from the merger If the merger is financed by acquirer's stock, and sellers receive N shares in the merged company, the cost depends on the value of the shares in the new comapny Cost (N * Pat) - Vt

emperical evidence fo M&A

Stock versus Cash Offers: Market Preference: The market generally prefers cash offers over stock offers during acquisitions. Acquirer's Stock Price: Acquirers paying with their own stock tend to see a decline in their share price. This is believed to signal to the market that the acquirer's management might view their own stock as overvalued, hence preferring to use it for acquisitions rather than cash. Competition in Bidding: Impact on Sellers: When there are multiple bidders for a target company, it's usually good for the seller because competition can drive up the purchase price. Impact on Bidders: For bidders, competition is less favorable. On average, bidder returns decrease in competitive situations. Without competition, bidder returns average a decline of 1.2%, but with competition, this decline worsens to 5.1%. Relative Size and Division of Gains: Gains Distribution: The distribution of gains from an M&A deal often depends on the relative size of the target and the acquirer. Deception by Percentage: If the target is much smaller than the acquirer, a seemingly fair percentage split of the gains can be misleading because a small percentage of a large acquirer can be quite significant compared to a large percentage of a small target.

Valid Sources of Value

Synergies/Strategic Benefits and Economies of Scale/Scope (Higher cash flow, i.e. increase revenue, lower costs) - Transfer technology -Allows small firms to gain access to distribution and advertising -Easier to enter a new market Smaller firms often merge with larger ones to leverage their more extensive distribution and advertising networks. It is also easier for a company to enter a new market by merging with or acquiring a company that already operates in that space. Reduction in Taxes: While mergers themselves don't create tax shields, the use of debt financing in M&As can provide tax benefits due to the deductibility of interest payments. However, this only goes as high as its EBIT Companies can reorganize into trusts or partnerships or use other methods to take advantage of tax laws and reduce their tax liabilities. E.G Once you buy a irish company you incorporate comapny in the target country e.g Ireland that have lower taxes Realign Management's Incentives: Mergers can provide an opportunity to realign management incentives with shareholder interests, ensuring that managers are motivated to increase shareholder value. Replace Underperforming Managers: If a company has underperforming management, a merger or acquisition can be a way to bring in new management to improve performance.

Who benefits most from a M&A

Target shareholders capture most of the gains - they are the big winners no the acquirer shareholders. The price of target shareholders is positively associated with M&A. Simultaneously market reacts negatively when it comes to bidders' share price. Even though M&A creates value for most - most of the value is anchored to target shareholders, not the acquired

Tell me about the Cash-flow-based value multiples

These multiples compare the market value (MV) of a firm to its cash flows to gauge its overall value: MV of firm/ Earnings -> This multiple shows how much the market is willing to pay for a dollar of the firm's earnings. MV of firm/EBITDA: Earnings before interest, taxes, depreciation, and amortization (EBITDA) is used here. This multiple indicates the value the market places on the firm's profitability before these specific expenses. MV of firm/FCF: Free cash flow (FCF) represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. This multiple reflects the firm's value relative to the cash it can generate.

Cash-flow-based Price multiples

These multiples relate the stock price of a company to its cash flows, indicating how much investors are willing to pay for a share relative to the company's cash flow. generation:Price/Earnings (P/E): This is the ratio of the current share price to the earnings per share (EPS), showing investor willingness to pay for a dollar of earnings. Price/EBITDA: This ratio uses the share price and compares it to EBITDA on a per-share basis.Price/FCF: It compares the share price to the free cash flow per share, indicating the value investors place on the company's cash after investments.

Buyout

This often done with the help of lots of leverage A publicly traded firm or a division of a firm is bought and then taken private

What does doing valuation on multiples and comparables mean

Valuation by multiples and comparables is a method to estimate the firm's value by comparing it with similar publicly traded companies (comparables). For comparables, one component is an accounting value and the other component in the ratio =Mv -> Market Value.

Hence is a change in EPS a reliable indicator for acquisition

no, not necessarily because we do not if it is value creating or value destroying