The illustrative buyout scenario of Microsoft is modified and continued at rcmfinancial.com. There will be a new update coming soon. The next installment shall discuss the value driver model and how it can predict the markets reaction in terms of share price to the proposed takeover. This update reviews book income, free cash flows, EVA, MVA, EBITDA, the related tax shields and discounted cash flows. The New Media Financial Enterprise model consists of 16 modules, of which we will review about seven. The following is an excerpt from the latest scenario (it has been revised to overemphasize the effect of accounting earnings on valuation):
As an illustration, RCM Financial Group will acquire the
Microsoft corporation in a slightly leveraged buyout (MSFT is
flush with cash, so we will pay the debt back immediately).
Before we go on, review the assumptions used in the model. Of
particular importance is the capitalization structure. It proposes a
leverage buyout using 60% common equity and 5% preferred with
the balance split between relatively high quality senior, sub-senior,
and junior/zero coupon bonds. Therefore, RCM will need a larger
suite of credit worthy backers in order to keep expenses down.
Next, we proceed to the Income Statement.
Revenues/sales are projected with present growth rate and
the plethora of new products expected to be released over
the next 3 years, encroaching upon the UNIX market and
capitalizing on new media ventures and Internet commerce.
Cost of revenues assume the current software cost
structure with the incremental inclusion of the additional
costs of new media revenue production.
Sales & marketing will be increased over the nest three
years (see Valuation Primer part I)
General and administrative expenses are to increase
gradually as the mix of software and other products
changes.
R&D and upfront marketing are to be just short of
excessive (see Valuation Primer part I). They will be
amortized over a five (depending on the individual project)
year period, with each 20% depreciation charge to offset
any income produced by the R&D for that year. This is the
proper way to do it. Accrual accounting measures, such as
in Annual Reports, allow R&D and upfront marketing costs
to be lumped up front and considered an expense, when
they are really an intermediate to long term investment. As
you can note they are a significant amount of our new
companies growth.
EBITDA = earnings before interest, taxes, depreciation and
amortization. This is a useful number for it gives earnings
before many (but not all) of the accrual accounting tricks
that can be played.
Amortization of Goodwill - as you can see this is a
significant expense that robs from the accounting earnings
and gives to the???; nobody really knows where it goes. It
is a pure ACCOUNTING term, and has no business in a
valuation process. If you notice it does not show up in the
cash flow, DCF, or EVA analyses. Goodwill is the
premium paid over the book value of a company (see
Valuation Primer part I). It is amortized to account for that
premium when it should be added to invested capital, as an
additional hurdle for the New companies investments to
overcome.
Amortization of Intangibles - includes R&D and upfront
marketing investments.
Preferred dividends - presently yielding 5% with dividends
accruing for five years (see assumptions).
Net Income Available to Common - notice that the new
Microsoft has negative earnings for the first three years of
its existence. Uh, Oh!!! Plunging share prices!!!
Management in shareholder lawsuits!!! More like
management in Armani suits!!! Let's take a look at cash
flows and net values. Remember, we get special gifts from
the IRS when we use these accrual rules to say we don't
make money. All we have to do is put our cash in ongoing
investments (which tend to make more money and create
value) and not on our income statement.
Before we go on, please read about the 1 billion dollars to be
found in Microsoft's annual report foot notes.
How do the results add up according to traditional book
accounting rules? Look at the Book Accounting Summary. It
summarizes the anticipated debt paydown time in years, EBITDA,
EBITDA margin, book return on equity, and related debt ratios
among other statistics. According to the Book Return on Equity,
things don't look very well. Compare this outlook to the Free
(Unlevered) Cash Flow Statement, which adds back the vast
majority of accrual charges such as goodwill. You see, goodwill
was (for illustrative purposes) amortized over five years instead of
forty, which has the effect of significantly reducing accounting
earnings without affecting cash flow. The tax shield incurred
through the use of debt, has sloughed off significant income taxe
payable.
Now, compare the Book Return on Equity results to the
Economic Value Added Table. Even though earnings are negative,
value is actually being created at a break neck clip. EVA is the
NOPAT (Net Operating Profits After Tax), contrived from Free
Cash flow with the appropriate non-cash accrual accounting
charges added back in (ex. amortiztion, goodwill, deferred taxes,
LIFO reserves, etc.).
To calculate market value, you add EVA and Free Cash Flow up
over the years in question and discount it to the present value
using the propsective cost of capital. Discounted EVA yields
Market Value added, and discounted free cash flow yields DCF.
Both of the aforementioned discounting scenarios account for
varying rates of growth and varying rates of capital cost. |
