3.1. Why valuation matters so much for M&As?

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Mergers and Acquisitions – The Relentless Pursuit of Synergy

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Moscow Institute of Physics and Technology

Mergers and Acquisitions – The Relentless Pursuit of Synergy

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Курс 4 из 5 — Specialization Understanding Modern Finance

The area of mergers and acquisitions (M&As) is special in finance. Incredible amounts of money are employed in such transactions. Deals draw a lot of public attention and dispute. Oftentimes, stories look more like fairy tales rather than financial reality. The key idea in any M&A transaction is to create value through a potentially synergetic activity. To this end, it is important to have a clear motive and implementation plan. Of special importance are the correct valuation, proper financing, and actual deal completion. But this is not the end – value mostly accrues from the post-merger integration. The understanding of the motives of various stakeholders is instrumental in the analysis of the potential creation of value. The learners will gain insight into the core value creating M&A strategies. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. Finally, the Course is very helpful in successful completion of the Specialization’s Final Project.

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Valuation of M&As

Week 3 is devoted to the central topic of the Course – M&A valuation. We start with the analysis of the importance of valuation in the potential value creation. Then we discuss and compare alternative approaches to valuation, paying special attention to free cash flow (FCF) valuation. We analyze major value drivers – profitability, growth, cost of capital etc. and derive general valuation formulas for special cases of no growth, constant and supernormal growth. Then we apply the formulas to analyze value gains/losses in M&A transactions on examples.

3.1. Why valuation matters so much for M&As?12:14

3.2. Alternative approaches to valuation16:59

3.3. Free cash flow (FCF) valuation10:55

3.4. The general formula8:08

3.5. Some methodology, or how to extract value drivers11:12

3.6. Cost of capital10:11

3.7. Value creation in M&As8:41

3.8. Calculating gains (losses)6:46

3.9. Valuation in the “new economy” – some comments8:56

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Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Welcome everyone to the third week or M&A course.

This week will be all devoted to valuation.

The key topic in the analysis of M&A transactions.

In the last part of the previous week we discussed the motives for

entering in a transaction.

And also we've identified some important obstacles in going ahead with it.

And we discussed how we can overcome them.

But then we ended the last week with the question how much to pay.

So in this first introductory episode we will discuss why valuation is so

important.

I'll put why valuation.

Well, you can say, you've been telling us that all the way through throughout

the courses of this specialization, this is a central topic, and so on and

so forth.

Now here, there is a very clear idea why this is so important.

Because these studies of M&A transactions, how they actually happened,

the empirical studies, they all attest to the following statement.

That paying too much is the number one reason,

or number one cause, of a failure of a transaction in the medium and long run.

So basically, regardless of how great a company you bought if you over paid,

you will never be able to enjoy the nice return on your investment.

So we said that this is #1 cause, Of a failure,

Is over paying.

Well, it takes various forms.

Let's say, It

may be multiple bidding.

If there is more that one bidder trying to buy this company,

then clearly there is an auction.

So they go, the winner is the one who pays more, but

we all know that here is the ideal winner's curse.

So, you might indeed be forced to pay so

much that you are on the brink of making any money.

The biggest example that is famous transaction of RJR Nabisco

that happened many years ago.

It was 1985, where there was the bidding counters between the outside

company that was KKR, and then the inside management.

And they started at one price.

And in the process of multiple bidding, they almost doubled.

And as a result and finally KKR won and then they got control of the company.

The resulting NPD of that happened to be although positive but very small.

So a little bit more and that would be a failing transaction.

Failing in terms of valuation.

So that’s just one example, on the other hand we can say that here we have to

discipline the view prints, which is close to that.

If I believe that I know the right way I will go ahead and

buy this company whatever it costs to me.

As soon as you start talking whatever, you're most likely to fail.

So, that is the first observation.

The next one I'll put it,

is that you need some valuation,

Framework.

And, well, we talked about that before, many a time.

And now, I would specify these things that we already talked about.

These are value drivers.

I'll call them VD in the future, so what kind of value drivers will we know?

Well, profitability.

Then let's say, growth And link to that investment opportunities.

Then also cost of capital.

There are some others, but I just mentioned a few to give you an idea.

Now an important thing is that when you do evaluation,

in general, there are two major areas.

One is the big picture, you try to have a rough understanding of what's going on and

the other is the more detailed thing.

Now, we cannot here, limit ourselves with just the big picture but

we, at the same time, cannot go in smaller details without seeing that big picture.

So the idea that we identify these value drivers is that those

are linked to the overall strategy.

And that's important, because if they are not,

then we may see all of the numbers in financial statements.

But between these numbers, we cannot see the core behind that.

And that is the key story.

So in what follows, we will go from really global

ideas, and monstrous views to some details.

Because unfortunately, like I said, in this case,

we cannot have only a vague idea that is all right to go ahead.

We also have to pinpoint here some number.

As soon as we arrive at relish we have to

remind us some of the problems on this spell.

So and here, those will be input quality.

Remember, we talked a lot.

There is, from garbage, there's only garbage.

So, if your inputs are bad, you cannot come up with any realistic evaluation.

So.

And when we talk about that we have to have first of all

overall understanding of our business.

And again we are valuing the target so this is the thing of their business.

Most often if corporate finance, we dealt with the analysis of investment options,

investment projects for our company.

Now we have to value someone else's company.

So it's not enough only to have their financial statements,

you have to understand what they're doing.

Now by the same token, we have to use historical data.

You can say well, there's no good in the historical data,

because everything may change in the future.

But often times, this is the only solid basis.

So if we understand how their business is developing, then we can

employ historical data and come up with not just arbitrary forecasts.

But something that is based on what the company has been doing.

Now, the next thing that I will, on the line is sensitivity.

So as soon as we perform evaluation,

we have to analyze its sensitivity with respect to changes in value drivers.

We can never have the inputs that will be those narrowly known.

Just because we're dealing with the future and with a forecast of the future.

So, then, we have to identify where our potential mistakes or

misjudging may be potentially most harmful.

And then, we have to try to narrow down these limits.

Well, I'm saying plain vanilla things in all approaches to valuation.

But when you talk about an M&A transactions, and

evaluating the target, these become really of key importance.

Now, there are some other things we have to see, relations to the market.

What do I mean by that?

Sometimes, let's say, we can make a forecast that we believe is right.

But maybe for some reason, the market right now is not well prepared for

any transactions of that kind.

And then the market values the company lower than that, or maybe higher.

So here, we have to find some benchmarks and try to employ them, as well.

We'll talk about that in some more detail in the next episode.

And then, let me give you an example of some,

let's say, key value drivers.

Let's say if you talk about valuation of an airline.

There are lots of parameters that affect the performance of an airline.

But there are only two that are key.

One is the occupancy rate so that means how many empty seats they have on flights.

And that is the main value driver for revenues.

And then the other is the cost of fuel.

This is the main value driver for the cost.

So basically, if fuel is expensive and

if your jets, they fly empty, then you're doomed.

If, however, your jets are always full, then you know how to,

well you cannot save much on the fuel, because fuel is a commodity.

But that is why low costers sometimes are doing so

great when they make sure that their flights.

They fly frequently and also they are all full.

And this way you just bump up the revenues.

So, this is basically the main idea here about input quality.

And then there's one other piece that I will put in red.

Better put because this is the good news for valuation.

And this is, Involvement,

Of stakeholders and then here you can see a less things like

short term myopia because here now the management

is a great stakeholder in the success of this transaction.

So when we're valuing the target in this case we are more likely to

see the situation when a lot of effort is being used here.

So, hopefully this process is supported by many

powerful stakeholders, that is why I put it as the good news.

Now, this is the overall view and hopefully right now we all understand how

important it is to arrive at a decent valuation, so we have a decent number.

Now in the next episode we will analyze general approaches that people

use in order to make this story, the story with a happy ending.

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