Education Course Notes [Session 5 & 6]
Chapter 8 Valuation of Acquisitions and Mergers
LEARNING OBJECTIVES1. Discuss the problem of overvaluation.
2. Estimate the potential near-term and continuing growth levels of a corporation’s earnings using both internal and external measures.
3. Assess the impact of an acquisition or merger upon the risk profile of the acquirer distinguishing:
(a) Type I acquisitions that do not disturb the acquirer’s exposure to financial or business risk.
(b) Type II acquisitions that impact upon the acquirer’s exposure to financial risk.
(c) Type III acquisitions that impact upon the acquirer’s exposure to both financial and business risk.
4. Advise on the valuation of a type I acquisition of both quoted and unquoted entities using:
(a) Book value-plus models
(b) Market based models
(c) Cash flow models, including EVA, MVA
5. Advise on the valuation of type II acquisitions using the APV value model.
6. Advise on the valuation of type III acquisitions using iterative revaluation procedures.
7. Demonstrate an understanding of the procedure for valuing high growth start-ups.
1. The Overvaluation Problem
1.1 Market efficiency
1.1.1 Empirical evidence suggests that stock markets are semi-strong efficient, i.e. equity prices reflect all publicly available information. However, this does not necessarily mean that the shares will be fairly valued.
1.1.2 If the market does not fully understand the information available – as was the case in the late 1990s and early 2000s with some high-tech, telecommunications, and internet ventures – it tends to overestimate the potential returns and so overvalue the equity.
1.1.3 The price of overvalued equity may not be corrected by the market if:
(a) the data provided by managers is deliberately misleading;
(b) there is collusion by gatekeepers including investment and commercial banks, and audit and law firms.
1.2 Management responses to overvaluation
1.2.1 Managers may be reluctant to correct the markets’ mistaken perceptions. This can lead to :
(a) the use of creative accounting to produce the results the city is expecting.
(b) poor business decisions aimed at giving the impression of success.
(c) poor acquisitions made using inflated equity to finance the purchase.
1.3 The impact of overvaluation on reported earnings
1.3.1 Since managers may manipulate reported earnings to produce more favourable results, the financial data they supply should be treated with caution. When valuing a company the financial statements should first be analysed and adjusted as necessary.
2. Estimation of the Growth Levels of a Firm’s Earnings
2.1 The growth rate of a company’s earnings is the most important factor in the value of the company.
2.2 There are three ways to estimate the growth rate of earnings of a company.
(a) By extrapolating past values
(b) By relying on analysts’ forecasts – Analysts regularly produced forecasts on the growth of a company and these estimates can be the base for forming a view of the possible growth prospects for the company.
(c) Looking at the fundamentals of the company – it can be estimated by earnings retention model (refer to Chapter 4).
Example 1 – By extrapolating past valuesYear / EPS
$
2014 / 0.53
2013 / 0.43
2012 / 0.37
2011 / 0.26
2010 / 0.25
2009 / 0.18
The average growth rate, g, may be calculated as follows.
0.18 × (1 + g)5 = 0.53
g = 0.241 or 24.1%
There are some problems associated with historical estimates:
(a) A decision needs to be made regarding the length of the estimation period. Too long a period may reflect conditions that are no longer relevant for the future.
(b) Even if the same conditions prevail, the average value estimated may not be relevant for the near term especially if growth rates are volatile. An average value may be close to the expected future growth rate over the medium terms.
3. Valuation of a Type I Acquisition of Both Quoted and Unquoted Entities
3.1 Introduction
3.1.1 A type I acquisition does not affect the acquiring company’s exposure to business or financial risk.
3.1.2 Type I acquisitions may be valued using one of the following valuation methods:
(a) Book value-plus models
(b) Market relative models
(c) Cash flow models, including EVA, MVA
3.2 Book value-plus models (asset-based methods)
(Jun 15)
3.2.1 Book value or asset-based methods of company valuation use the statement of financial position as the starting point in the valuation process.
Example 1The summary statement of financial position of ABC Co is as follows.
Non-current assets / $ / $
Land and buildings / 160,000
Plant and machinery / 80,000
Motor vehicles / 20,000
260,000
Goodwill / 20,000
Current assets
Inventory / 80,000
Receivables / 60,000
Short-term investments / 15,000
Cash / 5,000 / 160,000
Total assets / 440,000
Equity and liabilities
Equity
Ordinary shares of $1 / 80,000
Reserves / 140,000
4.9% preference shares of $1 / 50,000
270,000
Non-current liabilities
12% loan notes / 60,000
Deferred taxation / 10,000 / 70,000
Current liabilities
Payables / 60,000
Taxation / 20,000
Proposed ordinary dividend / 20,000 / 100,000
440,000
What is the value of an ordinary share using the net assets basis of valuation?
Solution:
If the figures given for asset values are not questioned, the valuation would be as follows.
$ / $
Total value of assets less current liabilities / 340,000
Less: Intangible asset (goodwill) / 20,000
Total value of assets less current liabilities / 320,000
Less: Preference shares / 50,000
Loan notes / 60,000
Deferred taxation / 10,000 / 120,000
Net asset value of equity / 200,000
No. of ordinary shares / 80,000
Value per share / $2.50
3.3 Market value models (P/E ratio)
(Jun 12, Jun 14, Dec 15)
3.3.1 The P/E method is a very simple method of valuation. It is the most commonly used method in practice.
3.3.2 Value of company = Total post-tax earnings × P/E ratio
Value per share = EPS × P/E ratio
3.4 Market to book ratio – based on Tobin’s Q ratio
3.4.1 / Tobin’s market to book ratioMarket value of target company = Market to book ratio × book value of target company’s asset
Where market to book ratio = Market capitalization / Book value of assets for a comparator company (or take industry average)
3.4.2 This method assumes a constant relationship between market value of the equity and the book value of the firm.
Example 2The industry sector average Market to Book ratio for the industry of X plc is 4.024.
The book value of X plc is $3,706m and it has 1,500m shares in issue.
Required:
Calculate the predicted share price.
Solution:
Predicted value of X plc = $3,706 × 4.024 = $14,912.94m
Predicted share price = $14,912.94m / 1,500m = 994.2c
3.5 Free cash flow models
(Jun 11, Jun 12, Dec 13, Jun 14, Dec 15)
3.5.1 The free cash flow approach has been explained in detail in Chapter 5. The procedure for valuing a target company on the basis of its predicted cash flow is the same.
Free cash flow = / EBIT– Tax on EBIT
+ Non cash charges (e.g. depreciation)
– Capital expenditure
– Net working capital increases
+ Net working capital decreases
+ Salvage value received
Free cash flow to equity = / Free cash flow ± net borrowing – net interest paid
3.5.2 There are two approaches to valuing a company using the free cash flow basis.
Approach 1 / Approach 21 Identify the free cash flows of the target company (before interest) / 1 Identify the free cash flow to equity of the target company (after interest)
2 Discount FCF at WACC to obtain NPV / 2 Discount FCFE at cost of equity (Ke) to obtain NPV
3 Value of target = NPV of company – debt / 3 Value of target = NPV
Example 3
ABC Inc is planning on making a bid to take over BBC Inc which is in the same industry. Both companies have similar gearing level of 18%.
ABC Inc has estimated that the takeover will increase its annual cash flows over the next few years by the following amounts.
Year / After-tax (but before interest) cash flows
$m
2011 / 14.00
2012 / 18.50
2013 / 20.75
2014 onwards / 30.25
BBC Inc has 6.5% irredeemable debentures of $37.5 million trading at par.
The risk-free rate is 6.5% and the market rate is 12%. ABC Inc’s equity beta is 2.450 and the corporation tax rate is 28%.
Required:
If ABC Inc was prepared to bid $100 million for the entire share capital of BBC Inc, would the acquisition increase shareholder wealth? Use both approaches given above to illustrate your answer.
Solution:
Ke (using CAPM) = 6.5% + 2.45 × (12% – 6.5%) = 19.98% (say 20%)
Kd =
WACC = 20% × 0.82 + 4.68% × 0.18 = 17.2%, say 17%
Approach 1
Approach 2
Under both approaches, as value of equity > the proposed bid, the shareholders’ wealth would increase if the target was acquired.
3.6 EVA approach
(Dec 07, Dec 09, Jun 13, Dec 14)
3.6.1 EVA is an estimate of economic profit. It can be used as a means of measuring managerial performance, by addressing the NPV of revenues (profits) less resources used (capital employed).
3.6.2 EVA is calculated as follows:
EVA = Net operating profit after tax (NOPAT) – (WACC × book value of capital employed)3.6.3 Note that NOPAT cannot simply be lifted from the financial statements. There are numerous adjustments that may have to be made such as:
(a) Intangibles (for example, advertising, research and development, training). These are viewed as investments and are added to the statement of financial position.
(b) Goodwill written off and accounting depreciation. These are replaced by economic depreciation, which is a measure of the actual decline in the market value of the assets.
(c) Net interest on debt capital – debt is included in capital employed and the cost of debt is included in the WACC.
Example 4ABC plc has a NOPAT as adjusted for EVA purposes of $562.98 million. It currently has invested capital of $5,609.48 million and a WACC of 7.25%. The company has total debt of $1,500 million.
Find the EVA for ABC plc, the value of the firm and the value of the firm’s equity.
Solution:
EVA = NOPAT – (WACC × Capital employed)
EVA = $562.98m – (7.25% × $5,609.48) = $156.30m
Firm value = Capital employed + EVA / WACC
Firm value = $5,609.48 + $156.30m / 7.25% = $7,765.34m
Equity = Firm value – value of debt
Equity = $7,765.34m – $1,500m = $6,265.34m
3.7 Market value added approach
3.7.1 The market value added (MVA) of a company is defined as:
MVA = Market value of debt + Market value of equity – Book value of equity – Book value of debt3.7.2 The MVA shows how much the management of a company has added to the value of the capital contributed by the capital providers.
3.7.3 The MVA is related to EVA because MVA is simply the PV of the future EVA of the company. In terms of the notation used in the previous section:
MVA = PV of EVA3.7.4 If the market value and the book value of debt is the same, then the MVA simply measures the difference between the market value of common stock and the equity capital of the firm.
3.8 Dividend valuation basis
(Jun 08, Jun 15)
3.8.1 / Dividend Valuation ModelThe dividend valuation model is based on the theory that an equilibrium price for any share on a stock market is:
(a) The future expected stream of income from the security.
(b) Discounted at a suitable cost of capital.
Equilibrium market price is thus a present value of a future expected income stream. The annual income stream for a share is the expected dividend every year in perpetuity.
The basic dividend-based formula for the market value of shares is expressed in the DVM (assume no growth) as follows:
Market value (ex div)
If the dividend has constant growth, dividend growth model can be applied:
Where: D0 = Current year’s dividend
g = Growth rate in earnings and dividends
D0(1+g) = D1 = Expected dividend in one year’s time
Ke = Shareholders’ required rate of return
P0 = Market value excluding any dividend currently payable
4. Valuation of Type II Acquisitions Using the APV Model
4.1 A type II acquisition affect the acquiring company’s exposure to financial risk only – it does not affect exposure to business risk.
4.2 The theory behind the APV has been explained in Chapter 4. An acquisition is valued by discounting free cash flows to the firm by the ungeared cost of equity and then adding the PV of the tax shield.
4.3 The approach used in valuation can be summarized as follows:
Step 1 / Calculate the NPV as if ungeared – that is, KeStep 2 / Add the PV of the tax saved as a result of the debt used in the project
Step 3 / Deduct the debt of the target company to obtain the value of equity and then deduct the proposed cost of the acquisition
Example 5
ABC Co is considering the acquisition of BBC Co, an unquoted company. The shareholders of BBC Co are hoping to receive $75 million for the sale of their shares.
The ungeared (asset) beta factor for BBC Co is 1.20, the risk free rate of interest is 3% and the market risk premium is 5.8%.
Forecast free cash flows for BBC Co are as follows:
Year / 1 / 2 / 3 / 4
$m / $m / $m / $m
Free cash flow / 10.3 / 11.5 / 13.8 / 14.9
Annual cash flows after year 4 are expected to stay constant into perpetuity.
BBC Co has $50 million of 6% debt, repayable in 4 years. The tax rate is 30%.
Required:
Using the APV method of valuation, calculate whether ABC Co should be prepared to pay the $75 million required by the shareholders of BBC Co.
Solution:
Ungeared cost of equity = 3% + 1.2 × 5.8% = 9.96%, say 10%
PV of tax relief on debt interest:
$m
Debt amount / 50.0
Annual tax relief (50m × 6% × 30%) / 0.9
Annuity factor (6%) for 4 years / × 3.465
PV of tax shield / 3.12
APV calculation
$m
Base case NPV / 141.12
Add: PV of tax shield / 3.12
144.24
Less: Debt / (50.00)
Equity value / 94.24
This is significantly more than the $75 million that the shareholders are hoping fro, so ABC Co should pay the $75 million and take over BBC Co.
5. Valuation of Type III Acquisitions Using Iterative Revaluation Procedures