Valuing a company

1. Valuing a company Suppose company A wants to buy company B. What should they pay? If you were able to buy all the outstanding shares at the current market price, what would that be? "market cap" (market capitalization) Market cap = shares outstanding X price per share This is a regular part of the corporate reports in the Wall Street Journal (or any other investment report).

2. Bloomberg web site, but many other stock charting services also give market cap.

3. Can you buy for market cap? As you start buying shares, the price will go up. So you'll have to pay a premium. Can you buy 51% of the shares, and then approve a merger in which the remaining 49% of the shares are sold for almost nothing? No. The law requires you to treat minority shareholders fairly. Sometimes, you make an offer to purchase at some price above the current market price. Then the existing shareholders decide whether or not to sell to you. As the purchase is under discussion, the price goes up. More often, you make a bargain with the existing management.

4. Arbitrageurs There are people called "arbitrageurs" or arbs. Traditional arbitrage is based on the price difference of a commodity in different markets. If wheat is selling for $1/bushel in Chicago and $.90 in Kansas City and the railway rate to ship wheat from Kansas City to Chicago is $.05/bushel, you can make a nickel a bushel buying wheat in Missouri and sending it to Chicago. People in that business traditionally handle enormous dollar volumes on tiny margins, and they keep prices consistent. Note that traditional arbitrage has no risk.

5. Market arbitrage Something similar operates in stock market takeover offers. Suppose there is a guaranteed, unconditional offer from company X to buy company Y stock at 2:1 (that is two shares of company Y will become one share of company X). Then if company Y stock is now $25 and company X stock is now $48, you can make $1/share buying Y and turning it into X. Since stock prices go up and down, this is risk free only if you can do the transaction instantaneously. More seriously, offers to purchase are usually NOT unconditional. They usually say the purchase will go through only if 50% of the shares are "tendered" (presented for exchange).

6. Risk Arbitrageurs Suppose you offer, conditionally, $50/share for a company now selling at $35. The price will go up immediately, but probably not to $50. Why not? If the offer is not approved, the stock will presumably go down to $35 again. So there is some risk in assuming the shares are now worth $50 because there is a conditional offer to purchase them. Risk arbitrageurs are in business to guess whether the merger is going to succeed. Suppose they estimate the chance of approval at 2/3. Then a fair price for the shares is $45. If the stock is below that, they will buy it. Others may think that a better estimate of success is 1/3, which would imply a fair price of $40 and if they see a price of $45 they may sell short. The "arbs" make their money guessing right about the deal outcome.

7. Remember the movie "Wall Street?" The character Gordon Gekko in that movie was patterned on the most famous risk arbitrageur, Ivan Boesky. The best known quote from the movie is "Greed is good". (A slightly simpler version of what you read in the Wall Street Journal every day about the merits of the "invisible hand", Adam Smith's claim that if each individual tries to maximize his or her own profit, the result will be the greatest good for society). In fact, risk arbitage has declined greatly since the 1980s, partly because of increased law enforcement against insider trading and more because of increased corporate structures that make contested takeovers less common (“poison pill” devices).

8. L: Michael Douglas as Gordon Gekko; R: Ivan Boesky

9. Most companies bid for will die. If you work for a company that somebody wants to take over, once the offer is made the company is probably dead. Even if the current management tries to oppose the takeover, it's hard to stay independent. Suppose your stock price was $35. It may be doubtful whether the offering company will get half the shareholders to tender at $50. But if the arbs are offering even $40, why would anyone not planning to tender for $50 turn down the $40? So all your shares wind up in the hands of the arbs. And they don't want the company long-term: they want to sell to somebody. So the only real hope for independence is a "white knight" purchaser: another company which offers $51 but which is friendly to current management.

10. Poison pills Corporations (since the 1980s) have protected themselves against hostile takeovers with “poison pill” defenses that suddenly raise the price of the acquisition. For example, the company may provide that in the event of a takeover, existing shareholders will be eligible to buy additional shares at a very low price. They may also provide for boards of directors with staggered terms so that it will take several years for a majority of the shareholders to acquire control of the board of directors. As a result, the kinds of takeovers which produced mass mailings to shareholders urging one or another action are largely gone; instead the CEOs are given incentives to cooperate with the takeover, so it can be an agreed-on merger. For example, Carly Fiorina just walked away from HP with $21M after getting a $65M bonus to join HP (plus the cost of shipping her yacht to California).

11. What else besides market cap? What should be the rate of return? If a company is yielding $100M in profit each year, that would be a 5% return on $2B. Right now 10-year treasuries are yielding 4% and the prime rate is 5.5%. Does that mean 5% is a reasonable return? This depends on risk. A top-rated corporate utility bond might only yield 4.5% for ten years (today), but a typical stock investment should be done hoping for better. Typically, one looks at price/earnings.

12. Some recent big deals Proctor & Gamble just bought Gillette for $57B Gillette has 993M shares at $52: market cap $49.19B A week earlier Gilette was at $44. SBC bought AT&T for $16B AT&T has 795M shares, at $19+/share, market cap $15.42B A week earlier was $18. Verizon bought MCI for $6.7B MCI market cap was $6.35B. So buying Gillette required paying a higher premium (amount paid above the current price) than was needed for AT&T or MCI. Why? Look at past performance: neither AT&T nor MCI was doing well.

16. Typical price/earnings ratios Bloomberg.com, or other sources, will spit these out. Consolidated Edison: 16.8 General Motors: 6 Amazon: 36 Pepsico: 23 Genentech: 54

17. These tend to go by industry General Motors: 6 Ford: 6.2 Daimler Chrysler: 13.4 Extreme values tend to represent oddball cases - a company which has almost no earnings will have an enormous P/E ratio (and a company which is making a loss has no P/E ratio). So: pick a comparable company look at its P/E ratio take your target company profit estimate its cost

18. Consulting companies Service companies which rent people are generally less profitable than those which sell products. It’s harder for them to grow. A service company might sell for about one year’s revenue (eg SPSS, Inc. has a market cap of $291M on yearly sales of $208M). A manufacturing company might sell for well over a year’s revenue: Gillette, just sold for $57B, on total revenue of $10B. But Gillette has $400K revenue per employee. Trading companies are worth less than one year’s sales: they handle a great deal of money but don’t keep it. Albertson’s (supermarkets) has a market cap of $8.47B, on total sales of $35.4B.

19. Taking a specific example SAIC has just agreed to sell Telcordia for $1.35B; why is that reasonable? Telcordia made $160-200M in each of the last few years. CSC is selling at 15 P/E. ADC Telecommunications is selling at 24 P/E Companies like IBM, Nortel, and Lucent also sell at >10 P/E. So why is Telcordia being sold at a P/E of about 8? Look at the last few years, and forecast.

20. Telcordia is not a listed company It’s a subsidiary of SAIC, which is an employee-owned company. Nevertheless, it has to file 10-K forms with the SEC. (Under its full name: Science Applications International Corp). It does have products, but an awful lot of their product line is custom software.

22. SAIC 10-K form detail of segments

23. Telcordia revenue history Revenues, $M, year ending Jan 31…

24. Telcordia profits a bit better Operating income, $M, year ending Jan 31…

25. Telcordia employees

26. Reality? At some point it helps to know what’s really going on. Telcordia’s primary business is selling software to analog wireline carriers (i.e. Verizon, SBC, BellSouth, Qwest, AT&T). But the world is moving to wireless and VoIP. And, worse yet:

27. Legacy telecom is a bad world Verizon local services revenue 2001: $21.438B 2002: $20.271B 2003: $19.454B The number of “land lines” in the US telephone network is actually decreasing. This is the first time this has happened since the Great Depression. So if most of your customers are in this business, it’s bad news.

29. On the other hand The VoIP and wireless businesses are growing rapidly. Telcordia has staff and skills to sell to that market. Do you believe that with new management they can do better? “We have been changing so much over the last couple of years that this only allows us to continue changing even faster,” Desch said. “It's not a matter of what's different, but what can continue to be different.” (Matt Deutsch is the CEO of Telcordia. I don’t know what this statement means either).

30. Summary Stock price & shares outstanding: any stock information source History of earnings and revenues: SEC filings Future prospects: industry reports The company’s annual report will tell you why things are good. Newspaper stories may suggest bad news More profitable might be to look in annual reports of competitors and see what is lacking in the company you’re examining. There are overall evaluations in the business reports areas for big enough companies.