Session 12: Acquisition Ornaments: Synergy, control & complexity

Valuing a Business: Synergy, Control, and Complexity

In this session, the speaker discusses three additional components that might show up in a valuation of a business - synergy, control, and complexity. The speaker explains what these components are and how to value them.

Synergy

• Synergy is often used in the context of acquisitions where two companies come together and they're able to do something that they could not have done as individual companies.

• Synergy can take one of two forms - operating synergy or financial synergy.

• Operating synergy can take two sub-forms - cost controls (economies of scale) or growth synergies (higher returns on combined projects).

• Financial synergy can take one of three forms - tax benefits, increased debt capacity, or lower cost of capital.

Control

• Control often shows up in the context of acquisitions where many companies pay a controlled premium (20-25% above market price) to reflect the value of control.

• The speaker explains what control is and why it's worth what it is.

Complexity

• Some companies are more difficult to value than others due to their complexity. When valuing such companies, you have to wonder whether the value should be discounted for that complexity.

• The speaker lays out a framework for answering this question over the course of the next few minutes.

Valuation Scenarios

• In this section, the speaker looks at a specific scenario in valuation - valuing a company for an acquisition.

• The speaker addresses three issues that might arise when valuing such a company - synergy, control, and complexity.

Financial Benefits of Mergers and Acquisitions

In this section, the speaker discusses the potential financial benefits of mergers and acquisitions.

Synergy Benefit

• Debt ratio goes up, cost of capital goes down, tax benefit increases value.

• Diversification may be a synergy benefit for two private businesses.

• Value synergy by adding values of target company and acquiring company together.

• Value combined company with all benefits thrown in to get value of synergy.

Valuation of Synergy

• Best-case valuation example: Procter & Gamble bought Gillette for $25 billion premium.

• Standalone valuation: $221 billion for Procter & Gamble, $59 billion for Gillette.

• Best-case valuation: assumed everything managers said they would do happened instantaneously. Got a value $17 billion higher for combined company.

• Problem with best-case valuation is that it takes time to collect benefits.

Control Benefit

• Two valuations needed: one with existing management running the company and one with you running the company.

• Value control comes from thinking you can run a company better than existing management.

• Difference between two values is value of control.

• Likelihood that you can change way the company is run determines value control.

Valuation Example

• Example valuation done on Croatian tobacco company called Adris Grupa.

Revaluing a Company with Debt Ratio

In this section, the speaker discusses how to revalue a company by using a slightly higher debt ratio and reinvesting only in projects that are on their cost of capital.

Revaluing a Company

• The speaker suggests revaluing the company with somebody else running it.

• A slightly higher debt ratio can be used to revalue the company.

• Only reinvest in projects that are on their cost of capital.

Value of Control

In this section, the speaker talks about the value of control and how it can be calculated.

Calculating Value of Control

• The difference between status quo value and optimal value is the value of control.

• If there is no difference between status quo value and optimal value, then there is no value of control.

• Voting shares often trade at premiums over non-voting shares because they offer an expected value of control.

• Non-voting shares' values can be calculated by dividing status quo value by total number of outstanding voting and non-voting shares.

Complexity in Valuation

In this section, the speaker discusses complexity in valuation and how it affects investors' perception of companies.

Measuring Complexity

• Simple companies are valued more highly than complex companies because investors worry about what they don't know.

• One way to measure complexity is by counting the number of pages in 10K or annual reports. Companies with hundreds of pages tend to be more complex.

• Another way to measure complexity is through multiple questions that assess different aspects such as holding structure, accounting transparency, etc.

Incorporating Complexity into Valuation

• For discounted cash flow valuation, complexity can be incorporated by lowering cash flows, increasing discount rate, or lowering growth rate.

• For relative valuation using multiples, a lower multiple of earnings or book value can be used for more complex companies.

• Regression analysis shows that every hundred additional pages in the 10K knocks down price-to-book ratio by about 0.3.

Final Thoughts on Acquisition

In this section, the speaker concludes the session with final thoughts on acquisition.

Complexity and Multinational Companies

• Companies need to factor in complexity as they go multinational and multiverse.

• There is a price to be paid for complexity.

• Investors should consider the value of control when acquiring companies.