Question

End of chapter case study: investors question abbott labs' valuation of st. jude medical Case Study Objectives: To Illustrate • The application of relative valuation methods • The limitations of such methods How to approximate the value of synergy • The role key assumptions play in establishing the credibility of any valuation Abbott Lab's market value plunged more than $5 billion or 6% in a single day following the announcement of the firm's acquisition of St. Jude Medical (St. Jude) on April 26, 2016, as investors expressed their disapproval. Their concern was that Abbot was overpaying and would be unable to earn financial returns demanded by investors. The $25-billion deal included a $6.5-billion premium, 37% above St. Jude's closing price on April 25, 2016. St. Jude's shares soared by more than 27% boosting the firm's market capitalization to $24.1 billion from its level of $17.59 billion the prior day. In announcing the transaction, Abbott said the primary motive for the takeover was to expand its heart device business. Abbott, the industry leader in manufacturing coronary stents and heart valves, wanted to combine with St. Jude, a maker of pacemakers and other devices for failing hearts. The aging population makes the "failing heart" market likely to show considerable growth in the coming years. Medical equipment makers are under pressure to offer a wider portfolio of products to their hospital customers, which have been through a wave of mergers that have increased their power to negotiate pricing. With combined revenue of $8.7 billion, Abbott said its deal would help it compete more effectively against larger rivals Medtronic Plc, Boston Scientific Corp., and

3. What are the key limitations of the comparable companies valuation methodology? Be specific.

4. In estimating the value of anticipated cost savings, should an analyst use St. Jude’s marginal tax rate of 40% or its effective tax rate of 22%? Explain your answer.

5. What is the PV of the $500-million pretax annual cost savings expected to start in 2020? Assume the appropriate cost of capital is 10% and that the savings will continue in perpetuity. Show your work.

Answer 1

3. Limitations:

• comparable companies valuation methodology derives the valuation of a company on the basis of the valuation ascribed by the market to other comparable companies. Market may not always remain perfect. And hence the market distortions can lead to the distortion in the valuation of the comparable companies and hence in the valuation of the company in hand.
• Finding the right peer set or comparable firms can be very difficult.
• Trading multiples can go up and down on daily basis and may also get impacted due to non fundamental factor. The valuation of the company in hand will suffer on account of this.
• This method may ignore the impact of qualitative factors like management, control, quality of governance in the valuation.

4. The analyst should use St. Jude’s marginal tax rate of 40%. Anticipated cost savings will be incremental cash flows for the firm and hence will be subjected to the incremental or marginal tax rate an not the average of effective tax rate.

5. PV of the savings in perpetuity = Post tax savings / discount rate = $ 500 x (1 - 40%) / 10% = $ 3,000 million