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

Liquidation value is the projected sale value of a firm's assets.

The replacement cost approach to valuation estimates what it would cost to replace the target firm's assets at current market prices using professional appraisers less the present value of the firm's liabilities.

The NPV of an acquisition of a manufacturer operating at full capacity may have a lower value than if the NPV is adjusted for a decision made at a later date to expand capacity. If the additional capacity is fully utilized, the resulting higher level of future cash flows may increase the acquisition's NPV. In this instance, the value of the real option to expand is the difference between the NPV with and without expansion.

Which of the following represent advantages of the comparable companies' valuation method?

The weighted average valuation approach involves the use of a number of different valuation methods, weighted by the relative importance the appraiser attributes to each method.

Analysts have increasingly used the relationship between enterprise value to earnings before interest and taxes, depreciation, and amortization to value firms.

Since real options provide flexibility that can greatly change the value of a project, it should be considered in capital budgeting methodology.

In constructing the enterprise value, the market value of the firm's common equity value is added to the market value of the firm's long-term debt and the market value of preferred stock.

In determining the purchase price for an acquisition target, which one of the following valuation methods does not require the addition of a purchase price premium?

Which one of the following factors is not considered calculating a firm's PEG ratio?

If the P/E ratio for the comparable firm is equal to 10 and the after-tax earnings of the target firm are $2 million, the market value of the target firm would be $5 million.

If the tangible book value of a firm significantly exceeds its market value for an extended period of time, it can become an attractive takeover target.

Is Texas Instruments Overpaying for National Semiconductor? As Always, It depends. Valuation is far more an art than a science, and understanding the limitations of individual valuation methods is critical. Averaging multiple valuation methods is often the most reliable means of valuing a firm. Evaluating success of an individual acquisition is best viewed in the context of an acquirer’s overall business strategy. Value is in the eye of the beholder. Various indicators often provide a wide range of estimates. No single method seems to provide consistently accurate valuation estimates. Which method the analyst ultimately selects often depends on the availability of data and on the analyst’s own biases. Whether a specific acquisition should be viewed as successful depends on the extent to which it helps the acquirer realize a successful business strategy. At $25 per share in cash, Texas Instruments (TI) announced on March 5, 2011, that it had reached an agreement to acquire National Semiconductor (NS). The resulting 78% premium over NS’s closing share price the day prior to the announcement raised eyebrows. After showing little activity in the days immediately prior to the announcement, NS’s share price soared by 71% and TI’s share price rose by 2.25% immediately following the announcement. While it is normal for the target’s share price to rise sharply to reflect the magnitude of the premium, the acquirer’s share price sometimes remains unchanged or even declines. The increase in TI’s share price seems to suggest agreement among investors that the acquisition made sense. However, within days, analysts began to ask the question that bedevils so many takeovers. Did Texas Instruments overpay for National Semiconductor? Whether TI overpaid depends on how you measure value and how you interpret the results. Looking at recent semiconductor industry transactions, the magnitude of the premium is almost twice the average paid on 196 acquisitions in the semiconductor industry during the last several years. Based on price-to-earnings ratio analysis, TI paid 19.1 times NS’s 2012 estimated earnings, as compared to 14.3 times industry average earnings for the same year. This implied that TI was willing to pay $19.10 per share for each dollar of the next year’s earnings per NS share. In contrast, investors were generally willing to pay on average on $14.30 for each dollar of 2012 earnings for the average firm in the semiconductor industry. Using a ratio of market capitalization (market price) to sales, it also appears that TI’s premium is excessive. TI paid four times NS’s current annual sales, well above other key competitors. such as Maxim Integrated Products and Intersil, which traded at 3.2 and 1.8 times sales, respectively. The enterprise-value-to-sales ratio compares the value of a firm to its revenue and gives investors an idea of how much it costs to buy the company’s sales. Some analysts believe that it is a more useful indicator than a market-capitalization-to-sales ratio, which considers only how equity investors value each dollar of sales, since the market-cap-to-sales ratio ignores that the firm’s current debt must be repaid. By this measure, TI is willing to pay $4.40 for each dollar of revenue, as compared to $3.80 per dollar of sales for the average semiconductor firm. Another useful valuation ratio, the price-to-earnings ratio divided by the earnings growth rate (PEG ratio), also suggested that TI might have overpaid. The PEG ratio relates what investors are willing to pay for a firm per dollar of earnings to the growth rate of earnings. At 1.28 prior to the TI takeover, NS was trading at a premium to its growth rate according to this measure. After the acquisition, the PEG ratio jumped to 2.09. While suggesting strongly that TI overpaid, these measures may be seriously biased. A large percentage of TI’s and NS’s revenue comes from the production and sale of analog chips, a rapidly growing segment of the semiconductor industry. Part of the growth in analog chips is expected to come from the explosive growth of smartphones and tablets, where their use in regulating electricity consumption is crucial to longer battery life. Consequently, many of the previous acquisitions in the semiconductor industry are of firms that do not compete in the analog chip market; as such, they are not entirely comparable. Moreover, many of these acquisitions came amidst a sluggish economic recovery and were made at “fire-sale” prices. With the exception of comparisons with recent comparable transactions, all of these valuation measures do not consider directly the value of synergy. There was little overlap between TI’s and NS’s product offering. TI believes that they can increase substantially NS’s sales by selling their products through TI’s much larger sales force. Furthermore, TI added 12,000 new analog chip products, bringing its combined offering to more than 30,000 products. TI also gets access to a number of analog engineers, who are highly specialized and relatively rare. Finally, in the highly fragmented semiconductor industry, consolidation among competitors may lead to higher average selling prices than would have been realized otherwise. The acquisition of NS by TI should be viewed in the context of a longer-term strategy in which TI is seeking an ever-increasing share of the $42 billion analog chip market, which many analysts expect to outgrow the overall semiconductor market during the next three to five years. Following the financial crisis in 2008, TI acquired analog chip manufacturing facilities at “fire-sale” prices to boost the firm’s capacity. The NS acquisition will give TI a 17% share of this rapidly growing market segment. -Scenario analysis involves valuing businesses based of different sets assumptions about the future. What are the advantages and disadvantages of applying this methodology in determining an appropriate purchase price?

The so-called PEG ratio is calculated by dividing the firm's price-to-earning ratio by the expected growth rate in the firm's share price.

Valuations of target firms based on the comparable companies and recent transactions methods must be adjusted to reflect control premiums.

If the market leader in an industry has a $300 million market value and a 30% market share, the market is valuing each percentage point of market share at $10 million. If a target company in the same industry has a 20% market share, the market value of the target company is $200 million.

Which of the following statements about the comparable companies' valuation method is not true?

Disadvantages of the comparable industry method of valuation include the presumption that industry multiples are actually comparable and that analysts' earnings projections are unbiased.

Is Texas Instruments Overpaying for National Semiconductor? As Always, It depends. Valuation is far more an art than a science, and understanding the limitations of individual valuation methods is critical. Averaging multiple valuation methods is often the most reliable means of valuing a firm. Evaluating success of an individual acquisition is best viewed in the context of an acquirer’s overall business strategy. Value is in the eye of the beholder. Various indicators often provide a wide range of estimates. No single method seems to provide consistently accurate valuation estimates. Which method the analyst ultimately selects often depends on the availability of data and on the analyst’s own biases. Whether a specific acquisition should be viewed as successful depends on the extent to which it helps the acquirer realize a successful business strategy. At $25 per share in cash, Texas Instruments (TI) announced on March 5, 2011, that it had reached an agreement to acquire National Semiconductor (NS). The resulting 78% premium over NS’s closing share price the day prior to the announcement raised eyebrows. After showing little activity in the days immediately prior to the announcement, NS’s share price soared by 71% and TI’s share price rose by 2.25% immediately following the announcement. While it is normal for the target’s share price to rise sharply to reflect the magnitude of the premium, the acquirer’s share price sometimes remains unchanged or even declines. The increase in TI’s share price seems to suggest agreement among investors that the acquisition made sense. However, within days, analysts began to ask the question that bedevils so many takeovers. Did Texas Instruments overpay for National Semiconductor? Whether TI overpaid depends on how you measure value and how you interpret the results. Looking at recent semiconductor industry transactions, the magnitude of the premium is almost twice the average paid on 196 acquisitions in the semiconductor industry during the last several years. Based on price-to-earnings ratio analysis, TI paid 19.1 times NS’s 2012 estimated earnings, as compared to 14.3 times industry average earnings for the same year. This implied that TI was willing to pay $19.10 per share for each dollar of the next year’s earnings per NS share. In contrast, investors were generally willing to pay on average on $14.30 for each dollar of 2012 earnings for the average firm in the semiconductor industry. Using a ratio of market capitalization (market price) to sales, it also appears that TI’s premium is excessive. TI paid four times NS’s current annual sales, well above other key competitors. such as Maxim Integrated Products and Intersil, which traded at 3.2 and 1.8 times sales, respectively. The enterprise-value-to-sales ratio compares the value of a firm to its revenue and gives investors an idea of how much it costs to buy the company’s sales. Some analysts believe that it is a more useful indicator than a market-capitalization-to-sales ratio, which considers only how equity investors value each dollar of sales, since the market-cap-to-sales ratio ignores that the firm’s current debt must be repaid. By this measure, TI is willing to pay $4.40 for each dollar of revenue, as compared to $3.80 per dollar of sales for the average semiconductor firm. Another useful valuation ratio, the price-to-earnings ratio divided by the earnings growth rate (PEG ratio), also suggested that TI might have overpaid. The PEG ratio relates what investors are willing to pay for a firm per dollar of earnings to the growth rate of earnings. At 1.28 prior to the TI takeover, NS was trading at a premium to its growth rate according to this measure. After the acquisition, the PEG ratio jumped to 2.09. While suggesting strongly that TI overpaid, these measures may be seriously biased. A large percentage of TI’s and NS’s revenue comes from the production and sale of analog chips, a rapidly growing segment of the semiconductor industry. Part of the growth in analog chips is expected to come from the explosive growth of smartphones and tablets, where their use in regulating electricity consumption is crucial to longer battery life. Consequently, many of the previous acquisitions in the semiconductor industry are of firms that do not compete in the analog chip market; as such, they are not entirely comparable. Moreover, many of these acquisitions came amidst a sluggish economic recovery and were made at “fire-sale” prices. With the exception of comparisons with recent comparable transactions, all of these valuation measures do not consider directly the value of synergy. There was little overlap between TI’s and NS’s product offering. TI believes that they can increase substantially NS’s sales by selling their products through TI’s much larger sales force. Furthermore, TI added 12,000 new analog chip products, bringing its combined offering to more than 30,000 products. TI also gets access to a number of analog engineers, who are highly specialized and relatively rare. Finally, in the highly fragmented semiconductor industry, consolidation among competitors may lead to higher average selling prices than would have been realized otherwise. The acquisition of NS by TI should be viewed in the context of a longer-term strategy in which TI is seeking an ever-increasing share of the $42 billion analog chip market, which many analysts expect to outgrow the overall semiconductor market during the next three to five years. Following the financial crisis in 2008, TI acquired analog chip manufacturing facilities at “fire-sale” prices to boost the firm’s capacity. The NS acquisition will give TI a 17% share of this rapidly growing market segment. -Despite their limitations, why is the judicious application of the various valuation methods critical to the acquirer in determining an appropriate purchase price?

It is critical for the analyst to remember that high growth rates by themselves are likely to increase multiples such as a firm's price to earnings ratio even without any improvement in financial returns.