I’ve not felt compelled to write in a while but the Mondelez offer for Hershey depicts an interesting phenomenon. The offer is $23B and this may seem a ridiculous premium to pay but actually is right in line with a standard DCF. Using a discount rate of about 5.5% and growth of just under 2%, you get a valuation of $23B. So it appears the M&A sector is still using good ole DCF analysis to value a firm. My recently graduated students will be happy to hear. So one might ask then what could possibly have drawn me out of the woodwork to talk about something that looks perfectly normal?
Well the problem is that the P/E on this valuation is 28x. Now I believe people often lose sight of what that means exactly. Take an extreme scenario like AMZN for example, with a P/E of 294x. We know this is high and we know it suggests investors are anticipating massive growth, for if they weren’t, they would need to expect to break even in about 300 years on their investment. Fortunately AMZN does present a high probability for massive growth and so shareholders will likely not have to wait 300 years to get their money back. But a 28x P/E suggests the same; if there is no growth investors can expect to break even in 28 years. The difference with HSY is that there is essentially no growth occurring and so investors may very well have to wait the full 28 years to get their money out.
And so herein lies the conundrum. The DCF is providing a valuation but that valuation is generating a price multiple way beyond what the estimated growth would support. Why? Well because as firms take on higher and higher debt