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Unit 4fi
Unit 4fi
Unit 4 Valuation
Structure
4.1 Introduction
Objectives
4.2 Meaning and Valuation Approaches
4.3 Basis of valuation
Self Assessment Questions
4.4 Valuation Methods
Relative Valuation
Discounted cash flow valuation
Market Multiple Analysis
Self Assessment Questions
Earning Analysis
Self Assessment Questions
Valuing Operating and Financial Synergy
Valuing corporate control
Valuing LBO
4.5 Summary
4.6 Terminal Questions
4.7 Answers to SAQs and TQs
4.1 Introduction
This unit presents a comprehensive approach to corporate valuation. It
provides a unique combination of practical valuation techniques with the
most current thinking to provide an up-to-date synthesis of valuation theory,
as it applies to mergers, buyouts and restructuring. The unit will provide the
understanding and the answers to the problems encountered in valuation
practice, including detailed treatments of free cash flow valuation; financial
and valuation of leveraged buyouts.
Objectives
After studying this unit, you should be able to:
Define the concept of Valuation of corporate merger and acquisition
Discuss the valuation in relation to merger and acquisition activity
Discuss the valuation of operation and financial synergy
Discuss the valuation of LBO
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Mergers and Acquisitions Unit 4
earnings of the firm etc) are relevant. Therefore, the focus of determining
the firm’s value is on several quantitative variables. There are several
bases of valuation as listed below:
Asset Value
The business is taken as going concern and realizable value of assets is
considered which include both tangible and intangible assets. The value of
goodwill is added to the value of the tangible assets which gives value of the
company as a going concern. Goodwill represents the company’s excess
earning power capitalized on the basis of certain number of year’s
purchases.
Capitalized earnings
This is the predetermined rate of return expected by an investor. In other
words, this is simple rate of return on capital employed. Under this method,
the expected profit will be divided by the expected rate of return to calculate
the value of the acquisition.
Market Value of listed stocks
Market value is the value quoted for the stocks of listed company at stock
exchanges. The market price reflects investor’s anticipation of future
earnings, dividend payout ratio, confidence in management of company,
operational efficiency etc. The temporary factors causing volatility are
eliminated by averaging the quotations over a period of time to arrive at a
fair market value. The acquirer pays only market value in hostile takeover.
The market value approach is one of the most widely used in determining
value, especially of large listed firms. The market value provides a close
approximation of the true value of a firm.
Earnings Per Share
The value of a prospective acquisition is considered to be a function of the
impact of the merger on the earnings per share. The analysis could focus
on whether the acquisition will have a positive impact on the EPS after the
merger or if it will have the effect of diluting the EPS. The future EPS will
affect the firm’s share prices, which is the function of price-earning (P/E)
ratio and EPS.
Investment value
Investment value is the cost incurred (original investment plus the interest
accrued thereon) to establish an enterprise. This determines the sale price
of the target company which the acquirer may be asked to pay for the
negotiated merger.
Book Value
Book value represents the total worth of the assets after depreciation but
with revaluation. Book value is the audited written down money worth of the
total net tangible assets owned by a company. The total net assets are
composed of gross working capital plus fixed assets minus outside liabilities.
The book value, as the basis of determining a firm’s value, suffers from a
serious limitation as it is based on the historical costs of the assets of the
firm. Historical costs do not bear a relationship either to the value of the firm
or to its ability to generate earnings. However, it is relevant to the
determination of a firm’s value for the following reasons:
i) It can be used as a starting point to be compared and complemented by
other analyses.
ii) The ability to generate earnings requires large investments in fixed
assets and working capital and study of these factors is particularly
appropriate and necessary in mergers
Cost basis valuation
Cost of the assets less depreciation becomes the basis under this method.
This method ignores intangible assets like goodwill. It does not give weight
to changes in price level.
Reproduction Cost
Reproduction cost method is based on assessing the current cost of
duplicating the properties or constructing similar enterprise in design and
material. It does not take into account the intangible assets for valuation
purpose.
Substitution cost
Substitution cost is the estimate of the cost of construction of the
undertaking or enterprise in the same utility and capacity.
Out of the above nine methods of valuation, the important methods are:
assets based valuation, earning based valuation and market price valuation.
NCF = EBIT
1 T ) DEP NWC CAPEX
Where,
NCF means net cash flows;
EBIT means earnings before interest and tax;
T means Tax Rate;
DEP means depreciation;
Delta NWC means changes in working capital; and
Delta CAPEX means changes in capital expenditure.
Here it should be noted that the discount rate should be average cost of
capital.
2. Terminal Value
Terminal value is the value of cash flows after the horizon period. It is
difficult to estimate the terminal value of the firm as the firm is normally
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Mergers and Acquisitions Unit 4
acquired as going concern. The terminal value is the present value of free
cash flow after the forecast period. Its value can be determined under three
different situations as below:
When terminal value is likely to be constant till infinity:
TV = FCFt-1 / Ko
When terminal value is likely to grow at a constant rate
TV = FCFt-1 (1+g)/(Ko-g)
When terminal value is likely to decline at a constant rate
TV = FCFt-1(1-g)/(Ko+g)
Where, FCFt-1 refers to the expected cash flow in first year after the horizon
period, Ko refers average cost of capital.
Example
ABC Company Limited targeted to acquire XYZ Company Ltd. The
Projected Post Merger Cash Flow Statements for the XYZ Company Ltd is
given below:
(Rs. in millions)
Year 1 Year 2 Year 3 Year 4 Year 5
Net Sales Rs. 105 Rs. 126 Rs. 151 Rs. 174 Rs. 191
Cost of goods sold 80 94 111 127 136
Selling and administration
Expenses 10 12 13 15 16
Depreciation 8 8 9 9 10
EBIT 7 12 18 23 29
Interest* 3 4 5 6 7
EBT 4 8 13 17 22
Taxes (40%) $ 1.6 3.2 5.2 6.8 8.8
Net Income 2.4 4.8 7.8 10.2 13.2
Add Depreciation 8 8 9 9 10
Free Cash Flows 10.4 12.8 16.8 19.2 23.2
Less retention needed for growth
# 4 4 7 9 12
Add Terminal Value @ 126.3
Net Cash Flows** 6.4 8.8 9.8 10.2 137.5
* Interest payments are estimated based on XYZ Co’s existing debt, plus
additional debt required to finance growth
$ The taxes are the full corporate taxes attributable to XYZ’s operation
# Some of the cash flows generated by the XYZ after the merger must be
retained to finance asset replacements and growth, while some will be
transferred to ABC to pay dividends on its stock or for redeployment within the
company. These retentions are net of any additional debt used to help finance
growth.
@ XYZ’s available cash flows are expected to grow at a constant 6% rate after
Year 5.
The value of all post- Year 5 cash flows as on December 31, Year 5 is
estimated by use of the constant growth model to be Rs. 126.3 million:
TV(Year 5) = FCF(Year 6)/(k-g)
= {Rs.23.2 – Rs.12.0)(1.06)}/(0.154 -0.06)
= Rs. 126.3 million
The Rs. 126.3 million is the present value at the end of Year 5 of the stream
of cash flows for Year 6 and thereafter. Here, it estimated 15.4 per cent as
cost of capital.
** These are the net cash flows projected to be available to ABC by virtue of
the acquisition. The cash flows could be used for dividend payments to
ABC share holders, finance asset expansion in ABC’s other divisions and
subsidiaries and so on.
The current value of XYZ to ABC’s shareholders is the present value of the
cash flows expected from XYZ discounted at 15.4% :
cash flows. If there had been financial synergies, the analysis would have
to be modified to reflect this added value.
4.4.3 Market Multiple Analysis
The another method of valuing a target company is market multiple analysis,
which applies a market-determined multiple to net income, earnings per
share, sales, and book value or number of subscribers (in case of cable TV
or cellular telephone systems). While DCF method applies valuation concept
in a precise manner, focusing on expected cash flows, market multiple
analysis is more judgmental.
This method uses sample ratios from comparable peer groups for
determining the current value of a company. The specific ratio to be used
depends on the objective of the valuation. The valuation could be designed
to estimate the value of the operation of the business or the value of the
equity of the business.
To explain the concept, note that XYZ company’s projected net income is
Rs. 2.4 million in Year 1 and it rises to Rs. 13.2 million in Year 5, for an
average of Rs.7.7 million over five year projected period. The average P/E
ratio for publicly traded companies similar to XYZ is 12. To estimate XYZ’s
value using the market P/E multiple approach, simply multiply its Rs. 7.7
million average net income by market multiple of 12 to obtain the value
(Rs.7.7 x 12) Rs. 92.4 million. This is the equity or the ownership value of
the firm. It can be noted here that we used the average net income over the
coming five years to value XYZ. The market P/E multiple of 12 is based on
the current year’s income of comparable companies, but XYZ’s current
income does not reflect synergistic effects or managerial changes that will
be made. By averaging future net income, we are attempting to capture the
value added by ABC to XYZ’s operations.
EBITDA is another commonly used measure in the market multiple
approach. When calculating the value of the operation, the most commonly
used ratio is the EBITDA multiple, which is the ratio of EBITDA (Earnings
before Interest Taxes Depreciation and Amortization) to the Enterprise
Value (Equity Value plus Debt Value). This multiple is based on total value,
since EBITDA measures the entire firm’s performance. Multiplying the
Target Company’s EBITDA by the market multiple gives an estimate of the
targets’ total value. To find the target’s estimated stock price per share,
subtract debt from total and then divide by the number of equity shares.
II. Self Assessment Questions
1. What are the basic pieces of information required for DCF technique?
_________________________________________________________
_________________________________________________________
2. List the five-step process for evaluating a company's cash flow.
_________________________________________________________
_________________________________________________________
_________________________________________________________
3. What is terminal value?
_________________________________________________________
_________________________________________________________
4.4.4 Earnings Analysis
When valuing the equity of a company, the most widely used multiple is the
Price Earnings Ratio (P/E Ratio) of stocks in a similar industry, which is the
ratio of Stock price to Earnings per Share of any public company. Earning
per share (EPS) is the earning attributable to share holders which are
reflected in the market price of the shares. Using the sum of multiple P/E
Ratio’s improves reliability but it can still be necessary to correct the P/E
Ratio for current market conditions. A reciprocal of this ratio (EPS/P)
depicts yield. Share price (P) can be determined as P = EPS x P/E Ratio.
While planning for takeover, P/E ratio plays significant role in decision
making for the acquirer in the following ways:
Target Company’s P/E ratio is exit ratio and higher the ratio means the
acquirer has to pay more. In such cases, merger will lead to dilution in
EPS and adversely affect share prices. If the exit ratio of Target
Company is less than the acquirer, then shareholders of both companies
benefit.
A company can increase its EPS by acquiring another company with a
P/E ratio lower than its own, if business is acquired by exchange of
shares.
Example
ABC Company Ltd takes over XYZ Company Ltd. The merger is not
expected to yield in economies of scale and operating synergy. The
relevant data for two companies are as follows:
3. Tax benefits can arise either from the acquisition taking advantage of tax
laws or from the use of net operating losses to shelter income. Thus, a
profitable firm that acquires a money-losing firm may be able to use the
net operating losses of the latter to reduce its tax burden. Alternatively, a
firm that is able to increase its depreciation charges after an acquisition
will save in taxes, and increase its value.
Clearly, there is potential for synergy in many mergers. The more important
issues are whether that synergy can be valued and, if so, how to value it.
3. Valuing Operating Synergy
There is a potential for operating synergy, in one form or the other, in many
takeovers. Synergy can be valued by answering two fundamental questions:
1. What form is the synergy expected to take?
Will it reduce costs as a percentage of sales and increase profit
margins (e.g., when there are economies of scale)?
Will it increase future growth (e.g., when there is increased market
power) or the length of the growth period?
Synergy, to have an effect on value, has to influence one of the four
inputs into the valuation process:
o cash flows from existing assets,
o higher expected growth rates (market power, higher growth
potential)
o a longer growth period (from increased competitive advantages)
o a lower cost of capital (higher debt capacity)
2. When will the synergy start affecting cash flows?
Synergies can show up instantaneously, but they are more likely to
show up over the time. Since the value of synergy is the present
value of the cash flows created by it, the longer it takes for it to show
up, the lesser its value.
Once we answer these questions, we can estimate the value of synergy
using an extension of discounted cash flow techniques.
First, we value the firms involved in the merger independently, by
discounting expected cash flows to each firm at the weighted average
cost of capital for that firm.
Second, we estimate the value of the combined firm, with no synergy, by
adding the values obtained for each firm in the first step.
Third, we build in the effects of synergy into expected growth rates and
cash flows, and we value the combined firm with synergy.
The difference between the value of the combined firm with synergy and
the value of the combined firm without synergy provides a value for
synergy.
4.4.6 Value Creation through Synergy
Synergy is a stated motive in many mergers and acquisitions. If synergy is
perceived to exist in a takeover, the value of the combined firm should be
greater than the sum of the values of the bidding and target firms, operating
independently.
V(PQ) > V(P) + V(Q)
Where,
V(PQ) = Value of a firm created by combining P and Q (Synergy)
V(P) = Value of firm P, operating independently
V(Q) = Value of firm Q, operating independently
Merger will create an economic advantage (EA) through synergy when the
combined present value of the merger firms is greater than the sum of their
individual present values as separate entities. If firm P and firm Q merge,
and they are separately worth VP and VQ respectively, and worth VPQ in
combination then the economic advantage will occur if:
VPQ VP VQ
EA =
VPQ VP VQ
NEA =
V PQ VP VQ CashPaid VQ
VPQ VP VQ represent the benefit results from operating efficiency and
synergy when two firms merge. If the acquiring firm pays cash equal to the
value of the acquired firm, then the entire advantage of merger will accrue to
the shareholders of acquired firm. In practice, the acquiring and the acquired
firm may share the economic advantage between themselves.
4.4.7 Valuing Corporate Control
If the motive for the merger is control, the target firm will be a poorly
managed firm in an industry where there is potential for excess returns. In
addition, its stock holdings will be widely dispersed (making it easier to carry
out the hostile acquisition) and the current market price will be based on the
presumption that incumbent management will continue to run the firm.
Many hostile takeovers are justified on the basis of the existence of a
market for corporate control. Investors and firms are willing to pay large
premiums over the market price to control the management of firms,
especially those that they perceive to be poorly run.
The value of wresting control of a firm from incumbent management is
inversely proportional to the perceived quality of that management and its
capacity to maximize firm value. In general, the value of control will be much
greater for a poorly managed firm that operates at below optimum capacity
than for a well managed firm. The value of controlling a firm comes from
changes made to existing management policy that can increase the firm
value. Assets can be acquired or liquidated, the financing mix can be
changed and the dividend policy re-evaluated, and the firm can be
restructured to maximize value. If we can identify the changes that we
would make to the target firm, we can value control. The value of control can
then be written as:
Value of Control = Value of firm,
Optimally managed - Value of firm with current management
The value of control is negligible for firms that are operating at or close to
their optimal value, since a restructuring will yield little additional value. It
can be substantial for firms operating at well below optimal, since a
restructuring can lead to a significant increase in value.
4.5 Summary
Merger should be undertaken when the acquiring company’s gain exceeds
the cost. The cost is the premium that the acquiring company pays for the
target company over its value as a separate entity. Merger benefits may
result from economies of scale, increased efficiency, tax shield or shared
resources. Discounted cash flow technique can be used to determine the
value of the target company to the acquiring company. This unit described
different techniques for the valuation of target companies on the basis of
various parameters.
TQs
1. Refer to Section 4.4.2-2
2. Refer to Section 4.4.3
3. Refer to Section 4.4.5-1
4. Refer to Section 4.4.5-2
5. Refer to Section 4.4.7