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274 Merger and Acquisition Valuation Case Study were adequately similar to Cardinal to determine value based on the price paid for alternative investments in the public markets. The guideline public company method employs the invested capital model where returns to debt and equity include EBIT, EBITDA, and revenues. These returns are compared to the mar- ket value of invested capital (MVIC), rather than the equity price per share, because the returns are to debt and equity. Based on re- search and analysis of the guideline companies, considering their performance and strategic strengths and weaknesses, along with industry conditions and trends, they were compared to Cardinal based on various operational performance measures. The follow- ing ratios were computed for each of the guideline companies, in- cluding the mean and median for each ratio: MVIC to EBIT MVIC to EBITDA MVIC to Revenues To begin the search for guideline companies we selected the following criteria: Public Guideline Companies Industry SIC 2841: Printing and Publishing Size Annual sales between $7.5 million and $750 million (within a factor of 10 times the size of Cardinal) Time Transactions as of the valuation date Type Minority interest transactions Exhibit 16-11 Stand-Alone Fair Market Value: Implied Multiple of Adjusted EBIT/EBITDA (in thousands) Implied Implied Year 5 EBIT Multiple EBITDA Multiple Normalized EBIT for Year 5 $7,650 4.67 Normalized EBITDA for Year 5 $9,250 3.86 Computation of the Stand-Alone Fair Market Value 275 Status Profitable companies, financially solvent and reasonably leveraged, that are freely and actively traded Growth Companies whose recent historical growth rates and forecasted growth rates are reasonably similar Domicile U.S. corporations The guideline companies that were selected are: Guideline Companies Latest Latest Fiscal Name Fiscal Year Year Sales CRP Publications 12/31/Year 5 144,496,402 Night Rider, Inc. 9/30/Year 5 66,851,000 Industry Trends 6/30/Year 5 597,165,000 Hanover Media 3/31/Year 5 361,822,000 Leisure Living 12/31/Year 5 662,501,000 The following is a brief description of each company. • CRP Publications: a diversified media company that produces nine journals that cover emerging technology industries. It also provides market research services. • Night Rider, Inc.: operates through three subsidiaries, which publish special-interest magazines relating to the motorcycle, trucking, and tattoo industries. • Industry Trends: publishes 21 industry-specific journals and newsletters, which it markets through affiliations with industry trade associations. • Hanover Media: publishes, produces, and distributes Christian-oriented magazines, online services, and books, and markets a line of religious gift and stationery products. • Leisure Living: markets resorts and time-sharing resort properties as well as three consumer magazines that cover the travel and leisure industry. From available public sources, extensive information about the five public guideline companies was gathered, including their annual reports, U.S. Security and Exchange Commission’s Forms 276 Merger and Acquisition Valuation Case Study 10-K, and information from various stock reporting services and industry analysts’ reports. The operating performance, financial position, and cash flow of each company was analyzed. Their com- petitive advantages and disadvantages were considered in light of industry and economic conditions. From this data, the informa- tion in Exhibit 16-12, about the companies’ operating perform- ance, is summarized. From the data in Exhibit 16-12, operating multiples that com- pare the market value of invested capital to EBIT, EBITDA, and revenue per share are computed and presented in Exhibit 16-13, along with the resulting mean and median multiples of each op- erating measure. These multiples reflect investor consensus of the value of these five companies in this industry and present a basis for selection of appropriate multiples for Cardinal based on these alternative investment choices. Exhibit 16-12 Guideline Company Operating Performance Per Share MVIC/ EBIT/ EBITDA/ Revenue/ Share Share Share Share CRP $19.85 $1.12 $1.32 $15.27 Night $ 5.32 $1.62 $2.83 $17.73 Industry $61.05 $9.63 $11.70 $88.48 Hanover $13.69 $1.58 $1.93 $11.80 Leisure $28.03 $4.92 $5.73 $63.70 Exhibit 16-13 Guideline Company Operating Multiples Per Share MVIC/EBIT MVIC/EBITDA MVIC/Revenue CRP 17.66 15.07 1.30 Night 3.29 1.88 .30 Industry 6.34 5.22 .69 Hanover 8.67 7.10 1.16 Leisure 5.70 4.89 .44 Mean 8.33 6.83 .78 Median 6.34 5.22 .69 Computation of the Stand-Alone Fair Market Value 277 Exhibit 16-14 Comparison of Cardinal With Guideline Companies Comparison to the Guideline Discussion Companies Liquidity Asset Management Financial Leverage Profitability Growth Cardinal’s current ratio and quick ratio are both just above the industry average shown in Exhibit 16-6. Cardinal’s cash position has declined while its current liabilities have increased in the last year. Cardinal’s total assets, accounts receivable, inventory, and fixed assets are all carried at substantially higher levels relative to the company’s sales than any of the guideline public companies. This reflects substantial inefficiency in the utilization of all of these assets and sharply reduces the cash flow to capital providers. Cardinal’s debt, though decreasing steadily over the last five years as a percentage of total assets, is higher than four of the five guideline companies. Cardinal’s stronger profit margins compensate somewhat for the company’s weaker asset utilization to generate profits similar to the guideline companies. Cardinal’s 15% annual compound growth rate over the last five years is less than three of the five guideline companies, but its projected long-term growth is similar to that of the guideline companies and the industry. Slightly weaker Much weaker Weaker Average Average Cardinal’s strategic position and operating performance is compared to the guideline companies considering the various risk factors previously discussed, including Cardinal’s limited manage- ment, heavy debt, strong customer loyalty, and larger, stronger competitors. Comparison of Cardinal with the guidelines on spe- cific financial measures is presented in Exhibit 16-14. 278 Merger and Acquisition Valuation Case Study Based on this comparison of Cardinal with the guideline public companies, the following value multiples shown in Exhibit 16-15 were selected as appropriate for Cardinal when compared to the guide- line companies considering Cardinal’s performance and risk profile. Estimate of Equity Value of Guideline Company Method The market value of the company’s long-term debt is subtracted in Exhibit 16-16 from the previously determined value of invested capital, to obtain an equity value, which for the market approach is rounded to $21 million. Merger and Acquisition Method Computation of Stand-Alone Fair Market Value In the search for market data, one strategic acquisition was identi- fied that was considered for comparative purposes. In this trans- action, which occurred in the first quarter of Year 5, Granite Pub- lishing purchased Western Media, which was a chain of six local Exhibit 16-15 Calculation of Invested Capital Value of Cardinal Based on the Guideline Company Approach Normalized Operating Value Estimated Invested Procedure Results for Year 5 ϫ Multiple ϭ Capital Value MVIC/EBIT 7,650 ϫ 5.00 ϭ 38,250 MVIC/EBITDA 9,250 ϫ 4.00 ϭ 37,000 MVIC/Revenue 75,200 ϫ .50 ϭ 37,600 Exhibit 16-16 Calculation of Equity Value of Cardinal Based on the Guideline Company Approach Estimated Invested Market Value of Estimated Procedure Capital Value Ϫ Long-Term Debt ϭ Equity Value MVIC/EBIT 38,250 Ϫ 16,300 ϭ 21,950 MVIC/EBITDA 37,000 Ϫ 16,300 ϭ 20,700 MVIC/Revenue 37,600 Ϫ 16,300 ϭ 21,300 Computation of the Stand-Alone Fair Market Value 279 newspapers and electronic reporting services located in the south- western United States. Western was traded on the NASDAQ stock exchange, and, in that transaction, Granite paid a 72% premium over Western’s preacquisition stock price. This transaction, which was paid for in Granite’s stock, reflected a multiple of nine times Western’s forecasted EBITDA. Over the last 10 years, Granite has made numerous such acquisitions of local and regional newspaper chains, which is part of a long-term trend of consolidation in the newspaper industry. Further analysis of this transaction and others made by Granite led to the conclusion that the price paid and the resulting multiples from this transaction reflect synergies unique to Granite and do not provide a reliable basis for determination of Cardinal’s value. In general, it is inappropriate to attempt to es- tablish “the market” based on the results of a single transaction. Rejection of the Adjusted Book Value Method To consider the fair market value on a stand-alone basis of Cardi- nal from the perspective of the value of the assets owned by the company, an adjusted book value computation could be per- formed. This method, which assumes value is derived from a hy- pothetical sale of the specific tangible and intangible assets of the company, does not specifically recognize general intangible value that may exist as a result of the company’s technology, customer base, reputation, and other general goodwill factors. While gen- eral goodwill value can be computed through a computation known as the excess earnings method, this is generally not done in val- uations for merger and acquisition. This is a method that is ap- plied usually only in the valuation of very small businesses, such as professional practices, so it will not be used to appraise Cardinal. Summary and Conclusion of Stand-Alone Fair Market Value The results of the valuation procedures employed to compute the fair market value of Cardinal’s equity are summarized in Ex- hibit 16-17. After employing the various reconciliation method- ologies explained in Chapter 13, the fair market value of equity is determined to be $20.1 million, including Cardinal’s nonop- erating assets. 280 Exhibit 16-17 Reconciliation of Indicated Stand-Alone Values and Application of Discounts/Premiums Appropriate to the Final Opinion of Value Indicated by Method Adjustments for (Preadjustments) Differences in Degree of Adjusted Valuation Interest Value Basis Control Marketability Value Basis Weight Weighted Method Being Component Valued Value Capitalization 100% $19,434,000 As if 0% 7% a $18,074,000 Control 60% $10,844,000 of Net Income freely marketable to Invested traded Capital Guideline 100% $21,000,000 As if 0% 7% a $19,530,000 Control 40% $7,812,000 Public freely marketable Company traded Fair Market Value of a 100% Closely Held Interest on an Operating Control, Marketable Basis $18,656,000 Plus: Nonoperating Assets $1,400,000 Fair Market Value of a 100% Closely Held Interest on a Control, Marketable Basis $20,056,000 Divided by Number of Issued and Outstanding Shares 1,000,000 Per Share Fair Market Value of a Closely Held Share on a Control, Marketable Basis $20.06 a The discount for this lack of marketability is estimated to be 7%, which approximates the transaction costs required to sell th e company. Computation of Investment Value 281 COMPUTATION OF INVESTMENT VALUE This computation of investment value will use the multiple-period discounting method and will recognize the synergies that can be achieved through this acquisition. Risk and Value Drivers To develop the discount rate for equity and the weighted average cost of capital (WACC) to be used by Omni in its evaluation of Cardinal, adjustments, shown in Exhibit 16-18, have to be made to the rates developed previously in Exhibits 16-8 and 16-9 for Cardinal. Omni is a midcap-size publicly traded company, so the size adjustment for Omni is substantially less than for Cardinal. In addition, most of the specific company risk factors for Cardi- nal can be eliminated when it operates as a division of Omni. In developing the specific company risk premium for Omni, the ad- ditional risk created by the presence of competitors much larger than Cardinal is eliminated by Omni’s size and market strength. However, because Omni does not possess substantial expertise or experience in the rural market served by Cardinal, it imposed a 1% risk premium to reflect its movement into a less certain mar- ket. Omni’s financial strength eliminates the financial and man- agement risk factors that exist with Cardinal as a stand-alone business. While some doubt exists as to whether Cardinal’s strong cus- tomer loyalty can be maintained when the company operates as a division of a conglomerate, Omni management is attracted to the very high untapped sales potential of this customer base. While Cardinal lacks the expertise and resources to take advantage of this sales potential, Omni sees this as a substantial synergistic ad- vantage that reduces the riskiness of this acquisition. The discount rate to equity of 14.5% from Exhibit 16-18 is combined with Omni’s cost of debt at the prime rate of 9%, based on the market value of Omni’s debt and equity shown in Exhibit 16-19 to yield the WACC discount rate of 12.23% and the WACC cap rate of 8.23%. It should be obvious from a comparison of Omni’s WACC dis- count of 12.23% in Exhibit 16-19 versus Cardinal’s of 17.97% from 282 Merger and Acquisition Valuation Case Study Exhibit 16-18 Rates of Return (Discount Rate) Applicable to Net Cash Flow to Equity (As of the Appraisal Date) Symbol Component Increment Rate Long-Term Treasury Bond Yield a 6.00% ϩ Equity Risk Premium (R m Ϫ R f ) b 7.50% ϭ Average Market Return for Large-Cap Stock 13.50% ϩ Risk Premium for Size c 1.00% ϭ Average Market Return Adjusted for Size to Mid Cap-Size Firm 14.50% Specific Company Risk Premium Adjustments d : ϩ Industry Risk 1.00 ϩ Financial Risk 0.00 ϩ Management Risk 0.00 ϩ Customer Base (sales potential) (1.00) 0.00 ϭ Rate of Return for Net Cash Flow to Equity e 14.50% a This is the 20-year U.S. Treasury Bond. b The Equity Risk Premium is applied to recognize the additional risk associated with in- vesting in publicly traded common stock (equities) instead of the risk-free 20-year U.S. Bond. c Empirical evidence indicates Omni’s size will still justify a size premium of approximately 1%. d Omni’s lack of experience or expertise in this market raises its overall risk profile. Part of the synergy of Omni acquiring Cardinal is that the following risk drivers will be either elim- inated or reduced: thin management and Cardinal’s premerger heavy debt. Omni con- cludes that the sales potential of the underserved customer base reduces risk. e This is a rate of return or discount rate directly applicable to net cash flow as it is based on the return to investors, net of income tax to their corporations. Computation of Investment Value 283 Exhibit 16-19 Weighted Average Cost of Capital (WACC) and Capitalization Rate Applicable to Net Cash Flow to Invested Capital Applicable Rates: Rate of Return Applicable to Forecasted Net Cash Flow (Exhibit 16-8) a 14.50% Cost of Debt (Prime Rate) 9.00% Tax Bracket 40.00% Capital Structure (based on Omni’s Market Value b ): Debt 25% Equity 75% Computation of WACC and Conversion to Cap Rate Component Net Rate Ratio c Contribution to WACC Debt @ Borrowing Rate (1Ϫt) d 5.40% .25 1.35% Equity 14.50% .75 10.88% WACC Discount Rate for Net Cash Flow to Invested Capital 12.23% Less: Long-Term Sustainable Growth e Ϫ4.00% Capitalization Rate for Net Cash Flow to Invested Capital f 8.23% a The discount rate applicable to forecasted net cash flow is from Exhibit 16-18. b Omni’s debt-equity mix is derived from Omni’s market values of debt and equity. c The ratio is the equity-debt split (see note b). d Omni borrows at prime. e The long-term sustainable growth rate was provided in the case narrative. f The WACC capitalization rate is applicable to net cash flow to invested capital, that is, the net cash flow inclusive of the returns to debt and equity. [...]... Adjustment Issues Exhibit 16-20 shows the normalization adjustments and computation of net cash flow to invested capital forecasted for Omni’s acquisition of Cardinal Lou Bertin’s Compensation Bertin’s estimated above-market compensation of $750,000 annually will be adjusted the same as it was in the valuation of the company on a stand-alone basis Omni concluded that Cardinal’s management was thin enough... enhancements, 78–79 Revenue Ruling, 59–60, 4 Revenues (of target-company), 68 Risk, 14, 18 and interest rates, 120 macroenvironmental, 36 management of, 97 104 measurement of, 19 Monte Carlo simulation for managing, 99 100 real option analysis for managing, 100 104 specific company, 35–41 in SWOT analysis, 27 systematic, 124 traditional statistical tools for managing, 98 Risk analysis, inadequate, 50 Risk drivers,... but a suitable replacement would be paid his salary Market Research Market research information is of continuing critical importance to Omni, particularly since the acquirer believes that they can make better use of the untapped sales potential in this market No adjustment is required Computation of Investment Value 285 Operating Assets There remains no adjustment required to the company’s return for. .. Costs Omni management estimates that $800,000 in severance costs will be incurred in each of the first two years after the acquisition related to terminated employees Transaction Costs Omni management estimates that legal, tax, and intermediary costs related to the acquisition of Cardinal will total $1.8 million and will be incurred at the time of the acquisition Revenue Enhancements Taking advantage... that they are prepared to negotiate the sale or purchase of Cardinal based on the information presented, we encourage them to consider the following questions: • Have you carefully read each of Cardinal’s magazines and carefully compared them to their major competitors? • Are you confident that you understand the rapid transformation occurring in this industry as “publication” companies transform into...284 Merger and Acquisition Valuation Case Study Exhibit 16-9 that Cardinal’s operations are substantially safer when located within the size and depth of Omni than when operating as a stand-alone company Thus, the first factor contributing to the increase in Cardinal’s investment value to Omni over its standalone fair market value is the reduction in risk Normalization, Synergy, and Net Cash Flow Adjustment... $50, 110 Less: Market Value of Interest-Bearing Debt $Ϫ16,300 Investment Value of Equity $33, 810 Less: Market Value of Cardinal’s Operating Equity Premerger (Exhibit 16-17) $Ϫ18,656 Implied Increase in Value of Cardinal’s Postmerger Operating Equity (maximum investment value) $15,154 288 Merger and Acquisition Valuation Case Study SUGGESTED CONSIDERATIONS TO CASE CONCLUSION After studying this case,... premium, 128 and risk-free rate, 127–128 and small-company risk premium, 128 and specific-company risk premium, 128–132 291 292 Index Business combinations, 63–65 Buyer(s): in asset transactions, 224–225 and fair market value, 5–6 and investment value, 6–8, 11–12 motivations of, 47–48 in stock transactions, 221–222 Capital: access to, 129 cost of, see Cost of capital Capital asset pricing model (CAPM),... year thereafter After this, Cardinal’s growth should approximate the industry average annual rate of 4% Economies in Cost of Sales Once capital expenditure improvements have been implemented in Year 6, cost of sales is expected to decline, as forecasted in Exhibit 16-20 Once again, in a real valuation situation, these forecasted changes would be supported by substantial detail and analysis 286 Merger... method 298 Index Trapped -in gains, discount for, 196 Turnarounds, 68 U.S Food and Drug Administration (FDA), 237 U.S Securities and Exchange Commission (SEC), 160, 186, 190, 227, 236, 246 Valuation: approaches to, 85–87 asset approach to, see Asset approach income approach to, see Income approach market approach to, see Market approach and return on investment, 14–15 Value: acquisitions and shareholder, . adjusted the same as it was in the valuation of the com- pany on a stand-alone basis. Omni concluded that Cardinal’s man- agement was thin enough that market-level compensation for a chief executive. appropriate for Cardinal when compared to the guide- line companies considering Cardinal’s performance and risk profile. Estimate of Equity Value of Guideline Company Method The market value of. 16-20 Maximum Investment Value of Cardinal Invested Capital Basis (000) Line Item Year 6 Year 7 Year 8 Year 9 Terminal Year Normalized Pretax Income $7,956 $8,274 $8,605 $8,949 $9,307 to I/C increasing