Evaluation
What you'll learn
- LOS 16.eEvaluate corporate investment actions, including equity investments, joint ventures, and acquisitions.
- LOS 16.fEvaluate corporate divestment actions, including sales and spin offs.
- LOS 16.gEvaluate cost and balance sheet restructurings.
We will illustrate the process of evaluating corporate investment actions using an equity investment as an example. (Similar processes can be used for other corporate actions.)
Alpha, Inc., a large movie studio, is a mature business that is concerned about new competition eroding its market share. Beta LLC is a digital distribution company that provides proprietary entertainment content to its subscriber base. Beta has had high organic growth over the past three years, but needs an infusion of capital to fund continued growth.
Beta has zero debt and one class of common shares. Selected financials of the two companies for the past year (trailing 12 months) are shown here.
Selected Financial Data for 20X1 (TTM) for Alpha and Beta (USD millions)
Alpha makes a $1 billion cash investment to acquire 25% of the equity in Beta. Alpha finances the equity investment by issuing senior unsecured debentures. The two companies enter into an agreement to distribute the content library of Alpha based on 50/50 revenue sharing.
An analyst gathers the following information related to the peers of Beta LLC:
Comparable Company Analysis for Beta (USD millions)
Evaluate the implied valuation of Beta and the transaction’s effects on Alpha’s solvency.
Solution
Let’s think about some of the questions that an analyst might want to consider:
1. What other corporate actions could Alpha have undertaken?
Alpha alternatively could have secured a controlling interest in Beta (i.e., an acquisition). Alpha could also have entered into an agreement to set up a third separate company as a joint venture; however, because Beta needs an infusion of cash, Beta is more motivated to find an investor than to commit to a new investment.
2. What are the primary motivations for the two companies to enter into the announced transaction?
Alpha will obtain entry into a fast growing business segment, as well as gain a mechanism to monetize its assets (i.e., its content library). Beta will obtain the necessary infusion of cash to finance its growth.
3. Evaluate the valuation of Beta implied by the transaction.
Given that Alpha acquired a 25% stake for $1 billion, Beta’s implied market cap is estimated at $4 billion. Given that Beta has no debt, Beta’s implied enterprise value is also $4 billion.
The following table shows the EV/revenue multiples for the comparables as well as the mean and median multiples.
Using the mean EV/revenue multiple of 5.925, the EV of Beta would be estimated to be 720 × 5.925 = $4.27 billion. Using the median multiple, the EV of Beta would be estimated to be 720 × 5 = $3.6 billion. The median multiple may be more representative because the mean is significantly skewed by Comparable Q, which appears to be an outlier.
At a justified value of $3.6 billion, the $4 billion purchase price appears to be at a premium of 11%.
Other things to take into account are risk and growth rate differences among the peer companies.
4. What is the impact of the investment on Alpha’s debt to net income ratio, assuming no change in the financials for the two companies over the next year?
Alpha’s current debt to net income = 8,671 / 680 = 12.75x.
Alpha’s 25% stake in Beta would increase Alpha’s net income by 25% of the net income of Beta (this will be shown as “income from associates” in Alpha’s income statement).
Alpha’s new net income = 680 + (0.25 × 45) = 691
Alpha’s new debt = 8,671 + 1,000 = 9,671
Alpha’s new debt to net income = 9,671/691 = 14x.
Thus, one impact of the investment in Beta is that Alpha’s debt to net income ratio will increase from 12.75x to 14x.
Joint Ventures
The process of evaluating a joint venture announcement is similar. Questions to consider include: What are the gains to the two firms involved? What impact will the transaction have on the various ratios of the two companies?
The accounting for a joint venture is similar to that of equity investments. The two partners in the joint venture will report their stake in the venture using the equity method, reporting their share of income from the venture in their respective income statements. Any capital raised by the two partners will be accounted for in their own financial statements (e.g., debt used to finance the investment in the joint venture would increase the debt level of the investor company).
Acquisitions
We cover acquisition accounting in detail in the Financial Statement Analysis topic area. The acquisition method calls for line by line consolidation of the investor’s financial statements with the financial statement of the subsidiary, with a recognition of non controlling interest in the consolidated financial statements.
Evaluating an acquisition should include determining the impact of estimated synergies on the profitability ratios. The impact of consolidation on leverage ratios (debt to equity or debt to EBITDA) should also be analyzed, to determine the potential for a change in the parent company’s debt ratings (and hence, in its cost of capital). The evaluation should consider the impact of the transaction on the diluted EPS of the parent and whether the transaction price appears to be reasonable, using comparable transaction analysis and the premium paid analysis discussed earlier.
Evaluation of divestment actions typically involves:
1. Valuation of business segments.
2. Impact on ratios.
For the sale of a business segment, analysts should form an opinion on whether the valuation of the segment is reasonable. One approach is to use a multiple such as EV to EBITDA or EV to sales to value the various segments of a business. The sum of the values of these individual segments is then compared to the “conglomerate” EV to determine if the market is properly valuing the sum of the parts.
When preparing pro forma financial statements, the proceeds from the sale (i.e., cash or stock of the purchaser and/or assumption of debt) should be accounted for properly. Ratios such as debt to EBITDA can then be prepared to evaluate the impact of the sale on the company’s debt ratings.
Unlike sales, spin offs do not generate sale proceeds, and hence are easier to model.
Many external factors can be responsible for the initiation of a corporate restructuring, for example, the actions of an activist shareholder, a failed acquisition, etc.
The evaluation of a restructuring announcement involves preparing pro forma financial statements that reflect our expectations about cost savings, as well as assessing the likelihood of success in achieving the intended restructuring goals. Given a starting set of financial statements, you should be able to apply the given assumptions to generate pro forma values. These can then be used to calculate the relevant ratio(s).