The Valuation of Acquisitions and Mergers
1 Introduction
In this chapter we will consider the various approaches to calculating the value of a business. Do appreciate that there is never one ‘correct’ valuation – if we are acquiring a business then we will look at a range of values when deciding how much to offer.
In the exam you may be told specifically which method to use, or alternatively you may be asked to write a report suggesting a value in which case you will need to look at several methods depending on the information available in the question.
All of the arithmetical techniques discussed in this chapter have been covered already in early chapters of these notes.
2 Asset based valuation methods
An asset-based valuation takes the value of the firm’s assets less its liabilities.
The asset values used can be:
book values – using the values in the Statement of Financial Position. However book values are unlikely to represent the true value of the assets
realisable values – valuing the assets at the value at which they could be sold individually. This is likely to be the absolute minimum that the sellers would accept and therefore the absolute minimum worth offering
replacement values – the cost of buying the assets individually. This would perhaps be the maximum that the acquirer would be prepared to pay except for the fact that there is almost certainly going to be some goodwill that can only be acquired if the whole business is purchased.
3 Cash based valuation methods
There are two main cash based methods to be aware of:
Free cash flow to firm
and
Free cash flow to equity
3.1 The free cash flow to firm method
Here we take the expected future cash flows from the business and discount at the relevant cost of capital (which will be discussed separately).
The present value of the future cash flows will be the total value of the business. To arrive at a value for the equity we then subtract the market value of the debt.
A company has prepared a forecast of the future cash flows. The cash flows are expected to be $4.5M in the first year, $8.1M in the second year, $11.7M in the third year, and thereafter to increase at the rate of 4% per year.
The company has debt with a market value of $50M, and the relevant cost of capital is 10%.
Calculate the value of the firm and the value of the equity.
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3.2 Calculating the free cash flows
There are two ways in which you could be given the information needed to be able to arrive at the free cash flows.
One way is to be given details of the revenues and expenses in which case the free cash flows is calculated in exactly the same way as the net cash flow for a project.
The other way is to be given accounting information, in which case the free cash flow is arrived at as follows:
EBIT | X |
Less: Taxation | (X) |
Add: Depreciation | X |
Operating cash flow | X |
Less: Amounts needed to replace non-current assets | (X) |
(unless told otherwise, assume equal to the level of depreciation) | |
Less: Any additional non-current asset expenditure | (X) |
Less: Incremental working capital expenditure | (X) |
Free cash flow | X |
Calculate the free cash flow given the following information:
Operating profit (EBIT | 720 |
Depreciation | 288 |
Increase in working capital | 120 |
Cost of new non-current assets | 36 |
Interest paid | 12 |
Loans repaid | 48 |
Tax paid | 336 |
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3.3 What discount rate to apply?
The relevant discount rate depends on the business risk in the company being acquired and in the way in which the acquisition is to be financed (the gearing). The effect of changes in either or both of the business risk and the gearing risk have been discussed in earlier chapters (which you may need to revisit to remind yourself), but are summarised as follows:
If the business risk of the company being acquired is the same as that of the acquiring company, and there is little or no change in the existing gearing of the acquiring company after the acquisition:
In this (unlikely) situation, then we discount at the current WACC of the acquiring company.
If the business risk of the company being acquired is different from that of the acquiring company, but there is little or no change in the existing gearing of the acquiring company after the acquisition:
calculate the asset beta for the company being acquired. (This will probably mean ungearing the equity beta of a company having a similar type of business, using the gearing of the similar company).
calculate an equity beta by gearing up the asset beta just calculated, using the gearing of the acquiring company
calculate a cost of equity using the equity beta just calculated
calculate a WACC (using this cost of equity and the gearing of the acquiring company) and use this to discount the free cash flows
A plc is company with a gearing ratio (debt to equity) of 0.4. Shares in A plc have a β of 1.48. .
They are considering acquiring another company - B plc. Shares in B plc have a β of 1.8 and B plc has a gearing ratio (debt to equity) of 0.2. A plc is raising more debt in order to partly finance the acquisition of B plc, but their overall gearing ratio is not expected to change substantially. A plc has a cost of debt of 7%.
The market return is 15% and the risk free rate is 8%.
Corporation tax is 25%
Calculate the discount rate that should be applied to the free cash flows of B plc in order to arrive at a value of B plc.
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If the business risk of the company being acquired is different from that of the acquiring company, and there is a substantial change in the existing gearing of the acquiring company after the acquisition (i.e. a leveraged buyout where substantial debt is being issued to help finance the acquisition)
Take an adjusted present value approach (APV).
Calculate the ungeared equity beta for the company being acquired (which will be the same as the asset beta for the company)
Calculate a cost of equity using this beta
Discount the free cash flows at this cost of equity
Add the tax benefit on the debt raised to arrive at the APV
3.4 Synergy benefits?
All of the above ignore the fact that there may well be synergy benefits from the acquisition of the other company and that as a result the total free cash flow may be higher than the sum of the current cash flows in the individual companies.
In this situation, instead of valuing separately the company being acquired, we should value the new ‘enlarged’ company (using the free cash flows of the ‘enlarged’ company) and subtract the current value of the acquiring company to arrive at an estimate of the amount worth paying for the acquisition.
Before adding a synergy, read what kind of figure it is. An annual saving or extra cash flow belongs in the enlarged company's yearly cash flows or earnings, so it is discounted, or multiplied by the P/E ratio, along with them; a one-off amount is added once; and a figure already given as a present value is added as it stands, not spread over the years again. Then finish the working: the enlarged company's value less the acquirer's current value is the most worth paying, and whatever is paid below that is the gain left for the acquirer's shareholders.
3.5 The free cash flow to equity method.
In the previous section we were using the free cash flow of the firm to arrive at a total market value of the business as a whole. To get a market value of the equity we then subtracted the market value of the debt.
The alternative is to calculate the market value of the equity directly by calculating the free cash flows to equity and discounting them at the cost of equity.
The free cash flow to equity is arrived at as follows:
EBIT | X |
Less: Taxation | (X) |
Add: Depreciation | X |
Operating cash flow | X |
Less: Amounts needed to replace non-current assets | (X) |
(unless told otherwise, assume equal to the level of depreciation) | |
Less: Any additional non-current asset expenditure | (X) |
Less: Incremental working capital expenditure | (X) |
Free cash flow | X |
Less: Debt interest and repayments | (X) |
Add: Cash raised from debt issues | X |
Free cash flow to equity | X |
Using the information in example 2, calculate the free cash flow to equity,
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4 Market based valuation methods
4.1 Market value on the stock exchange
If the company being acquired is quoted on the stock exchange, then the market value is clearly the minimum that the shareholders in the company would be prepared to accept (and that therefore there is any point in the acquiring company offering).
If, however, the acquiring company is buying a controlling interest then one would normally expect they would have to pay a premium over the current market value.
4.2 The Price-Earnings Ratio method
This is the most common market based method in practice - especially when valuing an unquoted company(and you should be familiar with it from your Paper F9 studies).
We take the PE ratio of a similar quoted company (or the average PE for the industry) and apply this to the earnings available for shareholders (i.e. profits after tax) of the company being valued.
If we are valuing an unquoted company then we would reduce the PE ratio (and thus arrive at a lower value) to reflect the fact that the shares are not currently marketable. There is no fixed reduction - you would simply need to make the point were it relevant in the exam.
4.3 The earnings yield approach
Whereas the PE ratio is Market value / EPS, the earnings yield is simply the inverse of the PE ratio and is EPS / Market value.
So just as with the PE approach, we take the earning yield of a similar quoted company and apply this to the company that we are valuing.
5 Using the Black-Scholes option pricing model for business valuation
Holding shares in a company is similar to holding a call option because if the debt in the company exceeds the asset value then the shareholders can walk away (due to limited liability) whereas if the assets exceed the debts then the shareholders will continue in the business in order to get the surplus.
Therefore Black-Scholes may be used to value this ‘option’. We would use the formula as normal, with
Pa = the fair value of the firms assets
Pe = the amount owing to lenders
r = the risk free rate of interest
t = the time until the debt is redeemed
s = the standard deviation of the value of the assets
6 Over-valuation
Here we are referring to the situation where a market value of a share on the stock exchange is higher than it reasonably should be.
This can occur for two main reasons:
the market does not fully understand the business and is over-estimating the expected future returns, or
the management of the company are conveying misleading information about the business
7 High growth, start-up businesses
Be aware of the problems that exist in attempting to value a new business, especially one with high- growth potential.
there are likely to be losses in the early years
there are no past results on which to base estimates of expected returns in the future
management is often inexperienced
these businesses are often unlike existing businesses due to the nature of the product or service, and so it is difficult to find comparable companies.
These problems make it very difficult to come up with any reliable valuation, using any of the methods detailed earlier in this chapter.