Merger Valuation Methods PDF

Valuation of Businesses for Mergers & Acquisitions  Need for valuing shares (or business) As far as unlisted companies are concerned, the price of shares of such companies is not readily available, so we need to determine the value of shares of such companies, but this is not the case with the...

Valuation of Businesses for Mergers & Acquisitions  Need for valuing shares (or business) As far as unlisted companies are concerned, the price of shares of such companies is not readily available, so we need to determine the value of shares of such companies, but this is not the case with the listed companies. The price per share of a listed company is already available on the stock market. Then why do we need to calculate the value of shares or businesses separately? The reasons are: The market price may not represent fair value. There is no guarantee that the market price is not rigged or manipulated. Methods of Valuation  Asset based valuation  Earnings or dividend-based valuation  CAPM based valuation  Valuation based on Present Value of free cash flows Assets Based Valuation  The book value of a firm is based on the balance sheet value of owner's equity or in other words Assets minus liabilities. For assets value to be useful, the target company should have followed a regular depreciation, replacement and revaluation policy. The reasons for using this method are  It can be used as a starting point to be compared and complemented by other analysis  Where large investment in fixed assets is required to generate earnings, the book value could be a critical factor especially where plant and equipment are relatively new.  The study of firm's working capital is also necessary.  However, this method suffers from certain disadvantages:  It is based on historical cost of the asset which do not bear a relationship either to value of the firm or its ability to generate earnings.  Some entities may wish to sell only part of their business. In such case book value may fall flat.  Based on the values in the revalued balance sheet in line with the fair market value: Total assets: $107 billion Total liabilities: $60 billion Value: Total assets – Total liabilities = $107 – $60 = $47 billion  Consider another asset-based valuation example where the book value of assets is $50,000 (current assets, fixed assets, and other assets like investment in subsidiaries); the corresponding total derived after adding the fair market value of each item in the asset list is $76,000. The fair market value of intangible assets is $10,000. So, the value of the total assets is $86,000. The book value or fair market value of current and long-term liabilities is $33,000. In the next step, add $7,000 as the value of contingent liabilities; the total liabilities are $40,000. Finally, the total owner’s equity is derived by Pros and Cons  Pros It is the most preferred method in a critical context like liquidation and M&A. It follows simple mathematical formulas. Consider off-balance-sheet items.  Cons Having innumerable assets does not point to the profitability of the business. Valuing the intangible assets requires attention to detail and making the overall process complex. The method does not include the earnings of the company. Requires revaluation to derive the fair market value. Earnings based Valuation There are two methods here. Capitalization of earnings and PE based value. Capitalization of Earnings  Example:  Profit available for equity shareholders(Rs) 225000  No. of equity share 10000  Earning Per share (Rs/share) 22.5  Normal Return on investment 16%  Value per share (22 5/16%) share Rs 140 625 per share PE based valuation  The market value of an equity share is the product of "earnings per share (EPS)" and the "price-earnings ratio.". According to this approach, the value of the prospective acquisition depends on the impact of the merger on the EPS. There could either be a positive impact or a dilutive impact. Prima facie, dilution of the EPS of the acquiring firm should be avoided. However, the fact that the merger immediately dilutes the current EPS does not necessarily make the transaction undesirable. However, the prevailing PE in the market may not always be feasible. Some aspects that will influence the valuer's choice of PE ratio include:  Size of the target company  In case of unlisted companies, there would be restricted marketability and the PE multiple will tend to be lower than listed company  Gearing level  Reliability of past profit records, nature of assets, liquidity etc. Earnings Based model-ROCE driven  A modified method of estimating value of the firm based on earnings is to use the market-return on assets as a benchmark. The steps are as follows:  Compute the current Return on Capital Employed (ROCE) (a) Assign weights to the past capital employed to arrive at weighted average capital employed (b) Assign weights to the past profits to arrive at the weighted average profit after tax. (c) Average return on capital employed is then computed by dividing (b) by (a)  Compute the latest capital employed.  Compute the Return by multiplying latest capital employed with ROCE.  Compute the Return by multiplying latest capital employed with ROCE  Capitalize the value from above step at the market ROI to arrive at value of the firm. It should be remembered that the ROCE is meaningful only when expressed in current cost figures. ROCE computed on current cost basis is more meaningful than historical cost basis. Dividend Based Valuation  Quite often, the amount of dividend paid is taken as the base for deriving the value of a share. The value on the basis of the dividend can be calculated as No growth in Dividends  S=D1/Ke  where  S- Current share price  D1- Dividend  Ke- cost of equity Constant Growth in Dividends  S = [Do(1+g)] / (Ke-g) where,  Do - Dividend of last year  g- Expected growth rate CAPM based valuation  The Capital Asset pricing model can be used to value the shares. This method is useful when we need to estimate the price for initial listing in the stock exchange. The crux of this model is to arrive at the cost of the equity and then use it as the capitalization of dividend or earning to arrive at the value of share.  The formula is:  ke = Rf + beta of the firm (Rm-Rf)  where,  Rf – Risk free rate of return  Ke- cost of equity  Rm – market rate of return  Free cash flow model  The free cash flow model facilitates estimating the maximum worthwhile price that one may pay for a business. Free cash flow analysis utilizes the financial statements of the target business to determine the distributable cash surpluses and takes into account not merely the additional investments required to maintain growth but also the tie-up of funds needed to meet incremental working capital requirements. Under this model, the value of the firm is estimated by a three-step procedure:  Determine flows: the free future cash Net operating income + Depreciation- incremental investment in capital or current asset for each year separately.  Determine terminal cash flows, on the assumption that there would be constant growth, or no growth.  Present values these cash flows can then be compared with the price that we would pay for the acquisition. However, while estimating future cash flows, the sensitivity of cash flows to various factors should also be considered. Fair Value  Instead of placing reliance on a single method, it is preferable to base our valuation on the average of the results of two or three types discussed above. Normally, fair value is ascertained as the average of net asset value (NAV) per share and the capitalized value of earnings per share (EPS). This particular method is also known as the Berliner method.