Exam 8: Relative, Asset-Oriented, and Real Option

Bristol-Myers Squibb Places a Big Bet on Inhibitex DCF valuation assumes implicitly that management has little decision-making flexibility once an investment decision is made. In practice, management may accelerate, delay, or abandon the original investment as new information is obtained. ______________________________________________________________________________________________________________ Pharmaceutical firms in the United States are facing major revenue declines during the next several years because of patent expirations for many drugs that account for a substantial portion of their annual revenue. The loss of patent protection will enable generic drug makers to sell similar drugs at much lower prices, thereby depressing selling prices for such drugs across the industry. In response, major pharmaceutical firms are inclined to buy smaller drug development companies whose research and developments efforts show promise in order to offset the expected decline in their future revenues as some “blockbuster” drugs lose patent protection. Aware that its top-selling blood thinner, Plavix, would lose patent protection in May 2012, Bristol-Myers Squibb (Bristol-Myers) moved aggressively to shed its infant formula and other noncore businesses to focus on pharmaceuticals. Such restructuring has reduced employment from 40,000 in 2008 to 26,000 in 2011. Bristol-Myers’ strategy has been either to acquire firms with promising drugs under development or to develop them internally. However, the firm faced an uphill struggle to offset the potential loss of $6.7 billion in annual Plavix revenue, which represented about one-third of the firm’s total annual revenue. In early January 2012, Bristol-Myers announced that it had reached an agreement to purchase hepatitis C drug developer Inhibitex Inc. for $2.5 billion. Inhibitex focuses on treatments for bacterial and viral infections. It had annual revenue of only $1.9 million and an operating loss of $22.7 million in 2011. The lofty purchase price reflected Bristol-Myers’ growth expectations for the firm’s hepatitis C treatment INX-189, based on very early phase one clinical testing trials, with larger trials scheduled for 2013. The all-cash deal for $26 per share represented a 164% premium to Inhibitex’s closing price on January 10, 2012. Bristol-Myers valued Inhibitex in terms of the expected cash flows resulting from the commercialization of hepatitis C treatment INX-189. Standard discounted cash flow analysis assumes implicitly that once Bristol-Myers makes an investment decision, it cannot change its mind. In reality, management has a series of so-called real options enabling them to make changes to their original investment decision contingent on certain future developments. These options include the decision to expand (i.e., accelerate investment at a later date), delay the initial investment, or abandon an investment. With respect to Bristol-Myers’ acquisition of Inhibitex, the major uncertainties deal with the actual timing and amount of the projected cash flows. In practice, Bristol-Myers’ management could expand or accelerate investment in the new Inhibitex drug, contingent on the results of subsequent trials. The firm could also delay additional investment until more promising results are obtained. Finally, if the test results suggest that the firm is not likely to realize the originally anticipated developments, it could abandon or exit the business by spinning-off or divesting Inhibitex or by shutting it down. The bottom line is that management has considerably greater decision-making flexibility than is implicit in traditional discounted cash flow analysis. Google Buys YouTube: Valuing a Firm Without Cash Flows YouTube ranks as one of the most heavily utilized sites on the Internet, with one billion views per day, 20 hours of new video uploaded every minute, and 300 million users worldwide. Despite the explosion in usage, Google continues to struggle to “monetize” the traffic on the site five years after having acquired the video sharing business. 2010 marked the first time the business turned marginally profitable. Whether the transaction is viewed as successful depends on whether it is evaluated on a stand-alone basis or as part of a larger strategy designed to steer additional traffic to Google sites and promote the brand. This case study illustrates how a value driver approach to valuation could have been used by Google to estimate the potential value of YouTube by collecting publicly available data for a comparable business. Note the importance of clearly identifying key assumptions underlying the valuation. The credibility of the valuation ultimately depends on the credibility of the assumptions. Google acquired YouTube in late 2006 for $1.65 billion in stock. At that time, the business had been in existence only for 14 months, consisted of 65 employees, and had no significant revenues. However, what it lacked in size it made up in global recognition and a rapidly escalating number of site visitors. Under pressure to continue to fuel its own meteoric 77 percent annual revenue growth rate, Google moved aggressively to acquire YouTube in an attempt to assume center stage in the rapidly growing online video market. With no debt, $9 billion in cash, and a net profit margin of about 25 percent, Google was in remarkable financial health for a firm growing so rapidly. The acquisition was by far the most expensive acquisition by Google in its relatively short eight-year history. In 2005, Google spent $130.5 million in acquiring 15 small firms. Google seemed to be placing a big bet that YouTube would become a huge marketing hub as its increasing number of viewers attracts advertisers interested in moving from television to the Internet. Started in February 2005 in the garage of one of the founders, YouTube displayed in 2006 more than 100 million videos daily and had an estimated 72 million visitors from around the world each month, of which 34 million were unique. As part of Google, YouTube retained its name and current headquarters in San Bruno, California. In addition to receiving funding from Google, YouTube was able to tap into Google's substantial technological and advertising expertise. To determine if Google would be likely to earn its cost of equity on its investment in YouTube, we have to establish a base-year free cash-flow estimate for YouTube. This may be done by examining the performance of a similar but more mature website, such as about.com. Acquired by The New York Times in February 2005 for $410 million, about.com is a website offering consumer information and advice and is believed to be one of the biggest and most profitable websites on the Internet, with estimated 2006 revenues of almost $100 million. With a monthly average number of unique visitors worldwide of 42.6 million, about.com's revenue per unique visitor was estimated to be about $0.15, based on monthly revenues of $6.4 million. By assuming these numbers could be duplicated by YouTube within the first full year of ownership by Google, YouTube could potentially achieve monthly revenue of $5.1 million (i.e., $0.15 per unique visitor × 34 million unique YouTube visitors) by the end of year. Assuming net profit margins comparable to Google's 25 percent, YouTube could generate about $1.28 million in after-tax profits on those sales. If that monthly level of sales and profits could be sustained for the full year, YouTube could achieve annual sales in the second year of $61.2 million (i.e., $5.1 × 12) and profit of $15.4 million ($1.28 × 12). Assuming optimistically that capital spending and depreciation grow at the same rate and that the annual change in working capital is minimal, YouTube's free cash flow would equal after-tax profits. Recall that a firm earns its cost of equity on an investment whenever the net present value of the investment is zero. Assuming a risk-free rate of return of 5.5 percent, a beta of 0.82 (per Yahoo! Finance), and an equity premium of 5.5 percent, Google's cost of equity would be 10 percent. For Google to earn its cost of equity on its investment in YouTube, YouTube would have to generate future cash flows whose present value would be at least $1.65 billion (i.e., equal to its purchase price). To achieve this result, YouTube's free cash flow to equity would have to grow at a compound annual average growth rate of 225 percent for the next 15 years, and then 5 percent per year thereafter. Note that the present value of the cash flows during the initial 15-year period would be $605 million and the present value of the terminal period cash flows would be $1,005 million. Using a higher revenue per unique visitor assumption would result in a slower required annual growth rate in cash flows to earn the 10 percent cost of equity. However, a higher discount rate might be appropriate to reflect YouTube's higher investment risk. Using a higher discount rate would require revenue growth to be even faster to achieve an NPV equal to zero. Google could easily have paid cash, assuming that the YouTube owners would prefer cash to Google stock. Perhaps Google saw its stock as overvalued and decided to use it now to minimize the number of new shares that it would have had to issue to acquire YouTube, or perhaps YouTube shareholders simply viewed Google stock as more attractive than cash. With YouTube having achieved marginal profitability in 2010, it would appear that the valuation assumptions implicit in Google's initial valuation of YouTube may, indeed, have been highly optimistic. While YouTube continues to be wildly successful in terms of the number of site visits, with unique monthly visits having increased almost six fold from their 2006 level, it appears to be disappointing at this juncture in terms of profitability and cash flow. The traffic continues to grow as a result of integration with social networks such as Facebook and initiatives such as the ability to send clips to friends as well as to rate and comment on videos. Moreover, YouTube is showing some progress in improving profitability by continuing to expand its index of professionally produced premium content. Nevertheless, on a stand-alone basis, it is problematic that YouTube will earn Google’s cost of equity. However, as part of a broader Google strategy involving multiple acquisitions to attract additional traffic to Google and to promote the brand, the purchase may indeed make sense. -What method of accounting would Merrill use to show its investment in BlackRock?

The enterprise value to EBITDA method is useful because more firms are likely to have negative earnings than negative EBITDA.

Investment decisions, including M&As, often contain certain "embedded options" such as the ability to accelerate growth by adding to the initial investment (i.e., expand), to delay the timing of the initial investment (i.e., delay), or to walk away from the project (i.e., abandon).

Break-up value assumes that individual businesses can be sold quickly without any material loss of value.

The comparable companies' method and recent transactions methods of valuation are conceptually similar.

The PEG ratio can be helpful in evaluating the potential market values of a number of different firms in the same industry in selecting which may be the most attractive acquisition target.

A higher P/E ratio for a firm may be justified if its earnings are expected to grow significantly faster than firm's future earnings.

The comparable companies' transactions valuation method is generally considered the most accurate of all the valuation methods.

Real options include the right to buy land, commercial property, and equipment. Such assets can be valued as call options if its current value exceeds the difference between the asset's current value and some predetermined level.

Scenario analysis involves valuing businesses based on different sets assumptions about the future. What are the advantages and disadvantages of applying this methodology in determining an appropriate purchase price using relative valuation methods to estimate firm value?

Give examples of pre- and post-closing real options.

Tangible book value is widely used for valuing financial services companies, where tangible book value is primarily cash or liquid assets.

Book values are maligned as measures of value, because they represent historical rather than current market values.

Titanic Corporation has reached agreement with its creditors to liquidate voluntarily its assets and to use the proceeds to pay off as much of its liabilities as possible. The firm anticipates that it will be able to sell off its assets in an orderly fashion, realizing as much as 70% of the book value of its receivables, 40% of its inventory, and 25% of its net fixed assets (excluding land). However, the firm believes that the land on which it is located can be sold for 120% of book value. The firm has legal and professional expenses associated with the liquidation process of $2,900,000. The firm has only common stock outstanding. Estimate the amount of cash that would remain for the firm's common shareholders once all assets have been liquidated. Balance Sheet Item Bank Value of Atsets Liquidetion Value Cash \ 10 Accaunts Receivable \ 20 Invertary \ 15 Net Fixed Assets Excluding Land \ 8 Land \ 6 Total Assets \ 59 Tatal Linbilities \ 35 Shareholders Equity \ 24

Liquidation value provides an estimate of the minimum value of the target firm.

Based on the information given in the case, how would you estimate the value of Twitter at the time of the IPO based on a simple average of comparable firm revenue multiples based on projected 2014 revenue?

The replacement cost approach to valuation of a target firm ignores value created by operating the assets in combination as a going concern.

Investors may be willing to pay considerably more for a stock whose PEG ratio is greater than one if they believe the increase in earnings will result in future financial returns that significantly exceed the firm's cost of equity.

An investor group has the opportunity to purchase a firm whose primary asset is ownership of the exclusive rights to develop a parcel of undeveloped land sometime during the next 5 years. Without considering the value of the option to develop the property, the investor group believes the net present value of the firm is $(10) million. However, to convert the property to commercial use (i.e., exercise the option), the investors will have to invest $60 million immediately in infrastructure improvements. The primary uncertainty associated with the property is how rapidly the surrounding area will grow. Based on their experience with similar properties, the investors estimated that the variance of the projected cash flows is 5% of the NPV, which is $55 million, of developing the property. Assume the risk-free rate of return is 4 percent. What is the value of the call option the investor group would obtain by buying the firm? Is it sufficient to justify the acquisition of the firm?

The capitalization rate is equivalent to the discount rate when the firm's revenues are not expected to grow.