The Ten-Day MBA 4th Ed. Page 22
Improve Sales and Earnings
Procter & Gamble, the leader in soaps, detergents, and paper products, decided to expand sales and earnings by buying Wella, Richardson-Vicks, Noxell, and Gillette. Their brand-management expertise served them well in enhancing the values of these acquisitions.
Purchase an Undervalued Company
Based on market conditions, corporations can sometimes buy companies at a bargain. Companies may also be a bargain if investors do not recognize the potential of valuable assets on the books. Ted Turner bought MGM/United Artists in 1986 because MGM had an extensive movie library of classics that Turner felt was undervalued and not fully exploited. Real estate, timber, patents, copyrights, and other value could be overlooked or misjudged by the market.
Lower Operating Costs
When companies merge, many cost savings are possible. With the absorption of a company, some of the acquired company’s corporate overhead expenses can be cut. In manufacturing mergers, factories can produce larger quantities more efficiently.
In the 1990s, many companies were formed to consolidate fragmented industries by “rolling up” many mom-and-pop outfits, in hopes of achieving efficiencies. Office supply businesses, veterinary practices, and car dealerships were rolled up.
TYPES OF ACQUISITIONS
If two companies decide to join forces to become one company, this is called a merger. When Sperry and Burroughs merged in 1986, the merged entity was named Unisys.
If one company buys another company, it is called an acquisition. If both parties agree to the purchase, it is called a friendly acquisition; if not, it is called a hostile takeover.
Smaller companies that are attractive takeover candidates often agree to be purchased in friendly takeovers. In 1989 Procter & Gamble made a friendly purchase of Noxell, the maker of Cover Girl and Clarion cosmetics. Both saw the advantages of the two marketing companies joining forces. In 2005, P&G bought the much larger Gillette under the same friendly circumstances.
In other cases, the purchase can be nasty. In 1984, T. Boone Pickens tried to buy Phillips Petroleum in an unsuccessful hostile takeover. The management of Phillips was so opposed to the idea that in 1985 it borrowed $4.5 billion to buy back 47 percent of its common stock. This thwarted Pickens’s efforts because it borrowed against the same assets that he was planning to mortgage.
The fourth type of acquisition that I have mentioned several times already in this chapter is the leveraged buyout (LBO). In the 1980s, many lenders were willing to loan money to takeover artists. In the same way that a mortgage company makes a loan to a home buyer for a down payment of only 5 percent, banks, insurance companies, and bond investors lent money to these financiers to buy companies. The company that emerges from a leveraged buyout carries a high level of debt on which it must pay interest and principal.
THE VALUATION PROCESS
To engage in M&A, you must assess the value of the targets. Cash flow is the main consideration. A business’s cash flows are the result of operations, investing, and financing activities (the same activities that the accountant’s statement of cash flows describes). In the accounting chapter, I used the example of tiny Bob’s Market. By adding a few zeros to the numbers, it could be Safeway or Kroger. Because you are already familiar with Bob’s Market, this section will continue with that example.
The total value of a company is called its enterprise value (EV). It is the present value of its projected cash flows. A company’s EV is equal to its equity value (total outstanding shares × current market price) owned by shareholders, plus interest-bearing debt held by debt holders, less its surplus cash and marketable investments held beyond the firm’s operating needs. Conversely, the equity would be equal to the company’s EV less its debt plus its surplus cash and marketable investments.
Think of the enterprise value as the theoretical total takeover price. In the event of a buyout, an acquirer would have to pay shareholders for their equity and take on the company’s debt. The market value of the equity may be different from an analyst’s calculation of value based on cash flows projections, but that is how investors find opportunities.
Five steps are involved in calculating and evaluating a business’s cash flows:
1. Analyze operating activities.
Forecast the income statement; sales, cost of goods sold, selling, general, and administration expenses.
2. Analyze the investments necessary to replace and to buy new property, plant, and equipment.
3. Analyze the capital requirements of the firm.
Determine the corporate working capital requirements.
4. Project the annual operating cash flows and terminal value of the firm.
5. Calculate the NPV of those cash flows to calculate the firm’s value.
MBAs use many techniques or approaches to value firms. With all the flair a marketer displays in putting together a marketing strategy, finance jocks show their stuff in M&A valuations. The table below is one popular simplified method used by many in the financial community.
1. Analyze operating activities and the firm’s capital spending requirements.
The first thing is to forecast sales and calculate the gross margins on sales and other operating expenses. But financial analysts must do more than just look at numbers. They must also review the industry, the competition, the markets for raw materials, and management’s plans to run and grow the business. All these factors will affect the cash flow of business.
Discussions with Bob, his accountant, and his assistant manager revealed that the business is healthy and they expect sales to grow by 10 percent a year over a four-year period and then stabilize. They are confident that they will maintain a gross margin of 25 percent or a variable 75 percent cost of sales. They also believe that their SG&A expenses will remain a steady variable 24 percent of sales. The depreciation for equipment, which does not cost cash, can be added back, but Bob believes that he will be upgrading the store each year by reinvesting the $3,000 in new store fixtures. With that information, the cash flow forecast would look as shown below.
BOB’S MARKET, INCOME STATEMENT FOR THE YEAR ENDING DECEMBER 31, 2012
(IN THOUSANDS)
2. Analyze the investments necessary to replace and to buy new property, plant, and equipment.
Don’t be shy. Consult with the engineers, purchasing department, and the accountants to get a good estimate of costs and useful lives.
3. Determine the working capital needs of the business.
Businesses need cash to operate. The level of working capital is most often a function of the volume of sales. The more sales that are generated, the greater the cash needs for making change at the cash registers and purchasing inventory. This need is balanced somewhat by the credit that vendors increasingly extend as the market’s purchases from them grow in volume. This is an important part of the process; failing to consider the working capital needs could result in a cash squeeze.
CASH FLOW PROJECTIONS (IN THOUSANDS)
When we look back at the balance sheet of Bob’s Market, we see that Bob had $115,000 in current assets and $87,000 in current liabilities. That is a net working capital position of $28,000 (115 − 87).
Bob says that every week he needs 28 cents for every dollar of sales ($28,000/[$5,200,000 annual sales/52 weeks per year]). That covers his cash needs for inventory and register money offset by the additional financing extended by his grocery vendors. Added to the valuation calculation, the cash flow projection would look as follows:
CASH FLOW PROJECTION (IN THOUSANDS)
4. Determine the terminal value of the firm.
A business is presumed to be a going concern that will continue to operate indefinitely into the future. By valuing the cash flow to a certain point in time, you are ignoring ongoing value. That is why at the end of the financial projection, a terminal value must be calculated and added to the cash flow valuation.
At Bob’s Market the fourth year’s cash flow was $50,000. If that cash i
s forecasted to be the same year after year, you could use the same valuation method that is used to value a perpetuity.
The proper discount factor to use in this case is the weighted average cost of capital (WACC). We use WACC because the free cash flow of the company is available to pay interest on debt and to pay dividends to equity holders. Therefore the proper discount factor takes into account the firm’s entire capital structure, its debt and equity.
Bob’s Market’s capital structure is conservative. Its balance sheet lists only $10,000 of debt and $45,000 of equity. Its debt carries an interest rate of 10 percent. The cost of equity can be calculated using the Capital Asset Pricing Model. Using a historical long-term risk-free Treasury rate of 8 percent, the risk premium of 7.4 percent, and a .85 beta representing the lower risk of a low-debt grocery store, the cost of equity is 14.3 percent.
Ke = Rf + (Km − Rf) Beta
14.3% = 8% + (7.4%) .85
Plugging the cost of equity into the WACC equation, the firm’s weighted average cost of capital is 13 percent.
Putting it all together in a valuation, the terminal value cash flow calculation would be:
5. Calculate the NPV of those cash flows to calculate the firm’s value.
Add the terminal value to the present value of the first three years’ projected cash flows, and the entire value of the firm can be calculated as follows:
NET PRESENT VALUATION OF FREE CASH FLOWS (IN THOUSANDS)
That’s it! The grocery store’s enterprise value is $332,000. The $5,000 in cash held by the store is not surplus cash; Bob needs it in the registers and to operate. (Cash is an asset on Bob’s balance sheet shown in the accounting chapter.) To find Bob’s equity value, take the enterprise value of $332,000 less the outstanding bank debt of $10,000 (also on his balance sheet), and that equals $322,000. That is what a takeover artist would expect to pay Bob for his store and assume its debt. That is how MBAs value companies large and small. Yes, it’s a bit tedious, but mathematically not difficult to calculate. By keeping M&A a mysterious process, MBAs can charge more for their M&A services. Now you have the inside story.
ADDITIONAL THINGS MBAS INCLUDE IN THEIR VALUATIONS
The valuation of Bob’s Market assumes that the grocery store will be operated as Bob said it would. MBAs sometimes have different ideas. Companies being analyzed for potential acquisition are just like meat in a butcher shop—cut, sliced, and ground up as necessary. Analysts investigate the company from all angles. MBAs look at any opportunity to improve operations, lower expenses, and increase cash flow. They consider the sale of assets. The process is colored by the type of acquisition it is: merger, friendly, hostile, or leveraged. If the company is being taken over by a new management, then many changes are possible and likely. If the purchase is made with a great deal of debt, the new owners will want to increase cash flow and sell assets as soon as possible to pay off the debt incurred in purchasing the company. A sampling of things new owners will look for in these situations are:
Wage Concessions, Break Labor Unions
Layoffs
Lower Production Costs
Reduce Working Capital Needs
Lower Inventory
Lower Receivables
Increase Payables
Gain Access to Employees’ Pension Money
Sell Real Estate
Sell Patents and Rights
Sell Divisions, Subsidiaries, Product Lines
Sell Unnecessary Luxuries for Executives (jets, company apartments)
“GOOD NEWS!
IT’S NOT A TAKEOVER, MERELY SOMEONE TAKING THE COMPANY FOR A JOYRIDE.”
The MBA Touch: Asking “What If?” All the steps outlined can be investigated and plugged into mathematical formulas and spreadsheets. Analysts have to make many informed guesses. The real contribution an MBA can make to the process is not only an accurate evaluation of specific company information, but an experienced evaluation of the external factors that may affect the cash flows forecasted. How would a change in product costs affect the forecasted cash flows? How could the competitive environment in the industry affect sales? What if?
A proper MBA forecast of cash flows includes variations or “sensitivities” of key assumptions, so that decision makers can assess the risk inherent in the cash flows they are forecasting. The use of a spreadsheet is imperative and its “Data-Table” function is the MBA tool to perform variation analysis. If you’re not familiar with it, consider yourself computer illiterate.
In the airline industry, for instance, fuel prices, fares, and passenger load factors can produce swings in cash flows. Variations in key assumptions such as these three items dramatically change valuations and cash flows. In a leveraged buyout, owners are counting on projected cash flows to pay interest on the debt they carry. If they are caught short of cash, companies go into bankruptcy.
MAKING A BID
MBA calculations and forecasts are fine and dandy, but they are often ignored. Sometimes the thrill of the hunt overcomes buyers, and they act like bidders in the heat of an art auction. Instead of a net-present-value cash-flow valuation, bidders use simpler rule-of-thumb methods, a multiple of earnings, multiple of EBITDA, or multiple of sales. In leveraged buyouts, the bid often simply represents the maximum amount of financing the acquisitor can obtain, or the maximum debt the targeted company’s cash flow can carry. People differ, and accordingly, they have different motivations and methods in their M&A quests.
FINANCIAL OVERVIEW
Simply stated, there are two main functions in the financial world: buying and selling. Businesses require funding; therefore, they either sell equity shares in their companies (stocks), or fixed-interest-payments securities (bonds). The investment community values these securities and buys and sells them.
The theoretical basis for financial analysis is the risk/reward equation, in which higher risks are associated with higher returns. Returns are calculated by determining the amount and the timing of cash flows.
The guiding principle of financial management is to maximize the firm’s value by financing cash needs at the least cost possible, at a level of risk that management can live with.
KEY FINANCE TAKEAWAYS
Present Value—The value of a dollar received in the future is less than a dollar on hand today. There is a time value of money.
Beta—A measure of risk inherent in a security or a portfolio of securities as it reacts to general market movements
The Efficient Frontier—The graph depicting the highest portfolio returns for a given risk level
The Capital Asset Pricing Model—Ke = Rf + (Km − Rf) Beta
Duration—The time it takes for a bond to pay back half of an investor’s investment
Bond Value Fluctuations—If market interest rates go up, bond values go down, and vice versa.
The Dividend Growth Model—Value = D/(K − g)
Call Option—The right to purchase an asset at a fixed price for a limited amount of time
Put Option—The right to sell an asset at a fixed price for a limited amount of time
The After-Tax Cost of Borrowing—After-Tax Rate = Borrowing Rate × (1 − tax rate)
Capital Structure—The mix of debt and equity of a company
FRICTO—Flexibility, Risk, Income, Control, Timing, and Other matters, the checklist to be considered in making capital structure decisions
The Optimal Capital Structure—One that minimizes the weighted average cost of capital and maximizes the value of the firm
Enterprise Value (EV)—The total value of a company
Day 7
OPERATIONS
Operations Topics
The History of Operations Research
The Problem Solving Framework
Flow Diagrams
Linear Programming
Gantt Charts
Critical Path Method
Queuing Theory
Inventories
Economic Order Quantities
Material Requi
rements Planning
Quality
Information Technology
Operations is the only MBA subject that concerns itself with actually making products and providing services—the ultimate purpose of business. That is the line Production and Operations Management (POM) professors deliver each year to incoming MBAs. It must fall on deaf ears, since most MBAs go into finance, marketing, and consulting. It may be that recruiters feel MBAs are not sufficiently trained to be worth the high salaries paid in their plants and factories. They may also believe that MBAs are best kept at headquarters with their iPads, cigars, and HP calculators. From my interviews with recruiters and students, lack of interest on both sides is responsible for the lack of operational-bound MBAs.
Operational subjects are not all engineering and numbers. POM classes also have a humanistic side. The technical or quantitative approach presents students with a variety of mathematical tools with which to attack operational problems in a clinical fashion. The humanistic approach teaches students to look at operational problems from a worker’s perspective as well. Clearly many business solutions lie in employee motivation.
THE OPERATIONS HISTORY LESSON
Studies on methods to improve the production of goods and services have been conducted since the beginning of the twentieth century. Academics believed that if they only researched closely enough how businesses worked, they would stumble on that magic formula that would result in total efficiency. Much of that pioneering research was done on the factory floor. Because their names and theories are frequently mentioned in articles and MBA conversation, you had better add them to your business vocabulary.