-------- Chapter 10 --------

Increasing the Value of the

Organization
 Multiple Approaches to
Valuation are Illustrated by
Case Examples
• Mergers in oil industry in the 1980s
(Chevron-Gulf)
• Mergers in oil industry of the 1990s
(Exxon-Mobil)
• Firm valuation through the stages in the
life cycle
• Valuations in the Internet industry
Oil Mergers of the Early 1980s
(Chevron/Gulf)
• Transaction terms
– Chevron won auction in March 1984
– Cash bid of $80 per share
– Pretakeover activity price of Gulf was $39
– Premium was $41 or 105%
– Gulf had 165.3 million shares, total price was
$13.2 billion — a gain of $6.8 billion
– Transaction was taxable and treated as a
purchase
• Event returns
– Chevron had a positive event return of $2
billion for the period between February
1984 and May 1984
– Gulf positive event return gain was about
$6.8 billion
– Total positive event return was $8.8 billion
• Comparable transaction analysis
– In five prior oil company acquisitions the
weighted average ratios were calculated
• Transaction value to book equity 2.35
• Transaction value to EBITDA 3.05
• Transaction value to revenues 0.75
• Transaction value to market equity 1.34
• Application of the multiples gave an
average value of Gulf of $16.1 billion
– This benchmark indicates that the $13.2
billion price was fair
– Further analysis is required
• The Value of Gulf, 1983
– Formula method
• The value drivers for Gulf were:
– Actual tax rate (T) = 50%
– Marginal cost of capital (k) = 13.1%
• Risk free rate = 8.0%
• Market price of risk = 7.5%
• Yield to maturity (YTM) of AA-rated debt = 10%
• Leverage ratio = 30%
– Initial EBIT (1983) (X0) = $2,990 m
• Gulf's EBIT had been flat at $2.99 billion for previous
10 years — assume no growth company
• Valuing Gulf as a no growth company gives $11.5
billion
• Finding costs analysis
– The returns from Gulf's exploration and
development (E&D) programs in the early
1980s were negative
– By stopping E&D programs, Gulf could have
avoided losses with a capitalized value of
$50.36/share based on a cost of capital of
17%.
– Added to the then current market value of
common stock at $39 gives a total of $89 per
share, supporting the $80 per share price paid
by Chevron.
– Calculations based on a cost of capital of 13%
resulted in a loss per barrel of $42.10 from
E&D program. Added to the market value of
common stock gives a total of $81 per share.
• Other approaches to the valuation of Gulf
– Chevron purchased Gulf's reserves of 2,313
million barrels equivalent
– Price of oil fluctuated between $10 and $31.75
per barrel
– Using $10 per barrel, Gulf's reserves were
worth $23.13 billion — far above the $13.2
billion Chevron paid.
• The different valuation approaches indicate
that Chevron's purchase of Gulf at $13.2
billion was a positive NPV investment
 Valuation and Merger
Analysis General Framework
• Nature of the industry
• Industry characteristics that drive
mergers and potential synergies
• Historical value drivers
• Business economic analysis of the
future for the industry and firms
• Projections of the value drivers for
valuation firms
• Effects of the merger or rival
competitive structure and strategies
• Antitrust and other regulatory aspects
• Implementation
 Exxon-Mobil Merger
• Characteristics of the oil industry
– Basic characteristics
• Oil is a global market
• Strategically important for industrial, political,
and military reasons
• Large costs required for environmental
protection
• Impact of OPEC
• High degree of price instability
– Setting for oil industry mergers in 1997-
1999
• Price fluctuations — from $25 per barrel in 1996
to $9 per barrel by early 1999 to $24 per barrel
in September 1999; $35 in early 2000; $26 in
May 2000
• Restructuring, investment in technology, and
cost reduction
– Oil industry characterized by cash flows in excess of
positive NPV investment opportunities
– Oil companies tried diversification in 1980s which
resulted in declines in shareholder values
– Companies restructured by selling off unrelated
businesses in early 1990s
– Invested in improved technologies — increased oil field
recovery by more than 50%
– Finding costs for 20 largest companies dropped from
over $20 per barrel of oil equivalent in 1979-1981 to less
than $5 by 1993-1995
– Lifting costs including taxes dropped to $4.60 per barrel
for onshore activity and $4.19 for foreign activity by
1997
– Production costs dropped from $7.20 per barrel in the
mid-1980s to $4.10 by 1990
– Gains from cost reductions helped oil companies
achieve profitability at oil prices in the $16 to $18 per
barrel range but gains leveled off in the 1990s
• Uneven market adjusted returns to shareholders
– Net market adjusted shareholder returns were positive
for BP and Exxon in the five- and three-year periods
prior to 1999
– Returns were negative for other major oil companies
– Mobil, ARCO, and Amoco significantly underperformed
the benchmark
– Oil group underperformed the broader market index
– Statistically significant relationship between revenues
and shareholders returns - largest companies were the
lowest cost producers
• M&A activities were an effort by oil companies to
increase efficiencies, to reduce costs, to invest in
new technologies, and to seek new profitable
investment opportunities
• Reasons for the Exxon-Mobil merger
– Would extend presence in regions of the
world with highest potential for future oil and
gas discoveries and production
– Stronger position to invest in large outlay
programs with high prospective returns and
risk
– Complementary exploration and production
operations in South America, Russia, Eastern
Canada, Asia, and Africa
– Near-term operating synergies in the amount
of $2.8 billion
• Valuation analysis of the Exxon-Mobil
merger
– Premerger market value — Exxon: $175 billion, Mobil:
$58.7 billion
– Premerger price per share — Exxon $72; Mobil $75.25
– Terms of 1.32 Exxon shares for each share of Mobil;
(1.32)($72) = $95.04
– $95.04 x 780 million Mobil shares = $74.13 billion paid
or ($74.13/$58.7) = 26.3% premium over Mobil
premerger market cap
– Premerger, Exxon shares represented 75% of
combined market value
– Postmerger, Exxon shares represented 70% of
combined market value
• Cost of capital for Exxon and Mobil
– Cost of equity
• Betas
– Value Line estimates — Exxon: 0.85, Mobil: 0.75
– Beta below 1.0 — oil companies are greatly influenced
by policies of OPEC nations as well as returns on the
market
• Long-term treasuries: 6% range
• Market equity risk premium: 5%
• Cost of equity capital
– Exxon = 6% + (5%)(0.85) = 10.25%
– Mobil = 6% + (5%)(0.75) = 9.75%
• Cost of debt
– Exxon
• AAA bond rating
• Yield to maturity (YTM): 120 basis points (bp)
above treasuries
• Before-tax cost of debt = 7.2%
– Mobil
• AA bond rating
• YTM: 20 to 30 bp over AAAs
• Before-tax cost of debt = 7.5%
• Debt to total firm value = 30%, Equity to
total firm value = 70%
• Cash tax rates: Exxon = 35%, Mobil =
40%
• Weighted cost of capital
– Exxon = (7.2%)(1 - 30%)(30%) + (10.25%)
(70%) = 8.6%
– Mobil = (7.5%)(1 - 30%)(30%) + (9.75%)
(70%) = 8.2%
– Combined firm in range of 8.3% to 8.5%
– Company risks reduced
• Premium recovery
– Dilution/accretion analysis
• No synergies
– Exxon: dilution of 6.2% of share price
– Mobil: accretion of 18.5% of share price
• Estimated synergies between $3 to $6 billion per
year
– Exxon experiences accretion between 8.1% and 22.5%
– Mobil experiences accretion between 36.6% and 54.7%
– Exxon experiences accretion if synergies are over $2
billion
• Value driver analysis
n
(1  g ) t R0 (1  g ) n  m(1  T )
V0  R0  m(1  T )(1  b)  
t 1 (1  k ) t
k (1  k ) n

– Value drivers
• Next year revenues — Exxon: $150 billion, Mobil:
$75 billion
• Revenues growth rate — Exxon: 10%, Mobil: 10%
• Net operating margin — Exxon: 7.9%, Mobil: 5.9%
• Actual cash basis tax rates — Exxon: 35%, Mobil:
40%
• Cost of capital — Exxon: 8.6%, Mobil: 8.2%
• Competitive advantage period = 15 years
• Stand-alone firms
– Exxon
• Estimated value per share = $73.25
• Actual premerger price = $72
– Mobil
• Estimated value per share = $70.66
• Actual premerger price = $75.25

• Combined firms
– Net operating income margin (m) = 8.1%
– Weighted (by revenues) average m = 7.2%
– Add estimated synergy gains of $2 billion or 0.9% of
revenues
– Estimated combined equity value = $281 billion or $80.82 per
share
• Sensitivity analysis
– Elasticities of response in value drivers
• Positive — initial level of revenues, growth rate in
revenues, net operating income margin, and
period of competitive advantage
• Negative — tax rate, cost of capital, and
investment requirements
– Role of sensitivity analysis
• Enables decision maker to identify relative power
of value drivers on the firm valuation
• Provides a planning framework for improving firm
performance related to value drivers
• Test of merger performance
– Value of combined company = $281 billion
– Amount paid to Mobil = $74 billion
– Remainder = $207 billion
– Exxon premerger value = $175 billion
– Gain from merger = $32 billion
– Gain allocation
• Exxon shareholders own 70% of combined company or
$22.4 billion of the merger gains
• Mobil shareholders own 30% of combined company or
$9.6 billion of merger gains plus premium received of $15
billion for a total $24.6 billion of value added to their
shares
• Comparison of premium paid with
expected target improvement
– Rappaport (1998)
• Calculates value of Duracell as a stand-alone company and
its change in value resulting from combination with Gillette
• Improvement in value results from operating synergies
– Critique
• Potential synergies can also involve interdependencies
between target and acquirer
• Improvement analysis should consider combined companies
rather than target alone
• Large premiums paid may appear impossible to overcome if
one considers only value increases for the target alone
• Event analysis
– Event date 0 was announcement date on
12/1/98
– Excess returns with respect to AMEX Oil Index
– CAR for event window [-10,0]
• Mobil = 16.2%
• Exxon = 0.97%
– CAR for event window [-10,+10]
• Mobil = 23.7%
• Exxon = 6.3%
– Positive CARs consistent with calculation of
$32 billion added value from the merger
• Antitrust issues
– Herfindahl-Hirschman Index (H Index) measure
• H index for petroleum industry
– 1975, H index = 410
– 1979, H index = 416
– 1984, H index = 377
– 1990, H index = 362
– 1995, H index = 407
– 1996, H index = 415
• H index well under critical 1,000 level specified in
regulatory Guidelines
– Effects of major oil mergers on H index
• Major oil combinations
– Total/Petrofina: increase index by 6.13 points to 395.48
– Total Fina/Elf Aquitane: increase index by 22.01 points to
417.49
– BP/Amoco: increase index by 29.18 points to 446.67
– Exxon/Mobil: increase index by 83.07 points to 529.74
– BP Amoco/ARCO: increase index by 51.1 points to
580.84
– If a Chevron/Texaco took place: increase index by 17.94
points to 598.78
• Six mergers among top 23 petroleum companies in
the world would result in a rise of H index from 389
to 599, well short of 1,000 critical level
– Overall industry concentration measures are
far below 1,000 threshold
– Antitrust issues are not raised from an
aggregate industry standpoint
– Although individual oil companies are large,
oil industry is also large ($1.5 trillion
revenues)
– Federal Trade Commission required Exxon-
Mobil to sell off some wholesale distribution
and retail marketing entities
• Emerging competitive forms in the oil
industry
– Integrated oil firms compete in traditional
areas of oil and gas exploration and
production, refining, and marketing
– Integrated oil firms have significant
penetration in chemical industry
– Competitive pressures on firms in energy
industry
• Lower cost structures of megafirms
• New low-priced supply quantities from improvement
in technology and cost structures
• Convergence of markets
• Deregulation
• Divestitures resulting from tighter focus
– Competitive responses
• Relationships, alliances, joint ventures, focus
• Specialization
• Other mergers
Valuation in the Framework of
Product Life Cycles
• Industry product life cycle
Stage Example Revenues Profits Financing
I Strategic Vision Internet Beachhead Losses Supplier
revenues financing
II Innovation Biotech Accelerating Some net Increased
revenues income external
financing
III Super Growth New Telecom High level of Strong profits Ample external
revenue market financing
IV Growth Food Revenue Profit margins Most financing
growth peaks level off with internal
cash flows
V Maturity Automobile Revenue Profit margins Surplus cash
growth slows narrow
VI Decline Steel Revenues flat or Negative profit Investment
declining reductions
VII Renewal and Oil Revenue Modest profit No external
Restructuring improves recovery financing
required
• Value drivers
– Growth rates (g)
• Highest for Stage I
• Decline as the industry progresses through the product
life cycle
• Could become negligible, zero, or negative for industries
in decline
– Net operating income (NOI/Revenue)
• Small or negative for the first stage
• Profit rates rise sharply as industry moves into a volume
of revenues that demonstrate a solid future
• Profit rates decline as industry matures
• NOI margin becomes zero or negative for industry in
decline
– Investment requirement (I)
• In Stage I, external investment requirements are
low because of heavy reliance on supplier
financing
• At the stage at which some firms in the industry
are well launched, external financing
requirements will be high
• As the industry matures, investment requirements
decline
• Investment requirements may become negligible
or zero in declining industries
– Number of years of competitive advantage (N)
• Expected competitive advantage for firms with
sound strategic basis, launched in Stage I, has
potential to be sustained for a long period of time
• As industry matures, competitive advantage
declines and the expected number of years
shortens
• Competitive advantage is negligible or non-existent
in industries in decline
– Cost of capital (k)
• Companies in early stages experience high
cost of capital because of high uncertainties in
the industry
• Cost of capital declines with each successive
stage
• In later stages VI and VII, cost of capital may
increase as uncertainty increases again as
decline and renewal or restructuring are
experienced
– (r - k)
• r = marginal profitability rate
• k = cost of capital
• Larger positive difference between r and k implies:
– Greater ratio of market value of an investment (firm as a
whole) and investment cost
– Greater market to book ratio
– Greater q-ratio
• Spread by which r exceeds k highest in Stage II and
declines in successive stages, becoming zero or
negative as the stage of decline is reached
– Marginal investment requirements (b)
• Investment requirements (opportunities)
normalized by after tax cash flows
• Gives a measure of amount by which
investment requirements will have to be
financed from sources other than current year
cash flows
• Pattern similar to investment requirement value
driver
– Product of marginal profitability rate (r) and
marginal investment requirement rate (b) is
always equal to the growth rate (g)
– Measure of incremental value creation
= (r - k) I
– Comments
• Stages of industry's development have a major
influence on value drivers of prospective merger
partners but not deterministic
• Industry product life cycle perspective provides first
step for understanding of valuations in industries in
different stages of their life cycles
• Variations are present among firms in the same
industry
 The Internet and Online
Technologies

• Background
– Revolutionary distribution vehicle
– Global market
– High growth rates
– Financial characteristics
• High volatility in stock prices
• High stock prices relative to revenues because of
high prospective growth rates
• Internet retailers can earn returns on invested
capital comparable to traditional retailers with gross
operating margins in the 5 to 10% range vs. 20 to
30% because of lower investment requirements
– Use of M&As
• Proceeds and stocks from new Internet IPOs used
for rapid series of acquisitions
• Aim is to achieve critical mass, market leadership,
and name recognition
• Valuation approaches
– Comparable companies approach
• Ratio of market to EBITDA may not work
because of low or negative EBITDAs
• Ratio of market to book may be distorted
because losses depress size of book values
• Ratio most widely used is market to revenues
– DCF valuation
• Standard DCF methodology with multiple stages
of revenue growth can explain valuation
relationships observed for Internet companies
• Illustration of a 4-stage DCF valuation model
– Stage 1
• Losses in early years
• High revenue growth rate above 50%
• Negative operating margins
• Zero tax rate
• High cost of capital of 15%, reflecting high beta
risks
– Stage 2
• Company has matured sufficiently to achieve profitability
• Period of favorable growth and high margins
• Growth rate drops to around 33%
• Operating margins rise to 30%
• Tax rate around 20% to reflect benefit of carryforward of tax
losses in Stage 1
• Cost of capital remains relatively high
– Stage 3
• Revenue growth decays until it reaches 3%
• Operating margin declines to 15%
• Combined corporate tax (federal and state) of 40%
• Cost of capital remains relatively high
 – Stage 4
• Constant or no growth rate
• Operating margins decline further to 10%
• Tax rate and cost of capital at same level as in Stage 3
• Variations in the value drivers can be made to reflect
different scenarios
• High multiples of market to revenues observed in
Internet companies reflect high growth and high profit
margins achievable in early stages of new industries
 Calculating Growth Rates
• Discrete compound annual growth rate (d)
– Geometric average based on the end points of the time
series
– Found by dividing the final year number (Xn) by the
initial year figure (X1), then taking the n-th root (for n
number of years between initial and final number)
1/ n
 Xn 
d     1
 X1 
– May be seriously flawed if end values are not
representative of fluctuations in the time series of the
variable
• Continuously compounded growth rate (c)
– Estimated from regression
ln(Xt) = a + bt where
ln(Xt) = natural log of variable X
t = time in annual periods
– Continuous compounded growth rate, c, for
variable X
c = b' = estimated slope coefficient of regression
– Regression method considers fluctuations; takes into
account all data points
• Relation between discrete and
continuously compounded rate
d = ec - 1 where e = the base of the natural
system of logarithms
= 2.71828

c = ln(1+d)