Valuation Mergers and acquisition

8/13/2019 Valuation Mergers and acquisition

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MODULE V

VALUATION


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VALUATION In finance, valuation is the process of

estimating what something is worth. Itemsthat are usually valued are a financialasset or liability. Valuations can be doneon assets (for example, investments in

marketable securities such as stocks,options, business enterprises, or intangibleassets such as patents and trademarks) oron liabilities (e.g., bonds issued by a

company). Valuations are needed formany reasons such as investment analysis,capital budgeting, merger and acquisitiontransactions, financial reporting,


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PRINCIPLES OF VALUATION Book Value

Depreciated value of assets minus outstanding

liabilities Liquidation Value

Amount that would be raised if all assets were soldindependently

Market Value (P) Value according to market price of outstanding stock

Intrinsic Value (V)

NPV of future cash flows (discounted at investors

required rate of return)

Appraisal Value

- it is the value acquired from the independent appraisal

agency. This value is normally based on there lacement cost of assets.


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INTRINSIC VALUATION PROCEDURE

1

1

n

t

t

t

k

CFV


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MERGER AS A CAPITAL BUDGETING

DECISION

Capital Budgeting involves acquiring fixed orlong-term assets

Discounted Cash Flow Approach is used

determine the profitability of an asset or viabilityof a Project

M&A involves acquiring the target firmcomprising a large number of assets and liabilities

It is a very long-term investment

Valuation of the target firm is done in the light ofadditional cash flows generated additionally by

the acquisition


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MERGER AS A CAPITAL BUDGETING

DECISIONSTEPS:-

Determination of Incremental projected Free

cash flows to the firm(FCFF).

Determination of Terminal value Determination of Appropriate discount rate/

cost of capital.

Determination of present value of FCFF Determination of cost of Acquisition


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Methods of Valuation

Asset based valuation Earnings or dividend based

valuation CAPM based valuation

Valuation based on Present Valueof free cash flows


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Assets Based Valuation

The book value of a firm is based on the balance sheet value ofowner's equity or in other words Assets minus liabilities. For assetsvalue to be useful, the target company should have followed aregular depreciation, replacement and revaluation policy. Thereasons 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 whereplant 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 generateearnings.

Some entities may wish to sell only part of their business. In suchcase book value may fall flat.


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Example For example:

Balance sheet of A Ltd

Liabilities Amt Assets Amt

Equity share capital of 100000 Goodwill 20000

Rs 10 each Plant and machinery 100000

General reserve 50000 Stock 40000

Creditors 60000 Debtors 50000

Tax payable 30000 Cash at bank 30000

Total 240000 Total 240000

Goodwill is worth nothing. Plant and machinery is valued at Rs 85000. Sundry debtors declared insolvent owed Rs5000. Compute value per share.

Solution: Calculation of net worth

Goodwill -

Plant and machinery 85000

Stock 40000

Debtors 45000

Cash at bank 30000

Less:

Creditors (60000) Tax payable (30000)

Net worth (Rs.) 110000

No. of shares 10000

Value per share (Rs/share) 11


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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%) = Rs 140.625per share


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P/E BASED VALUATION

The market value of equity share is the product of "Earning

per share (EPS) " and the "Price Earnings Ratio". According tothis approach the value of the prospective acquisition

depends on the impact of the merger on the EPS. There could

either be 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 need 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


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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 dividendcan 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


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CAPM based valuation

The Capital Asset pricing model can be used to value the

shares. This method is useful when we need to estimatethe price for initial listing in the stock exchange. The cruxof this model is to arrive at the cost of the equity and thenuse it as the capitalization of dividend or earning to arriveat the value of share.

The formula is: ke = Rf + beta of the firm (Rm-Rf)

where,

Ke cost of

equityRf - Risk free rate of

returnRm - Market rate of return.


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Free Cash flow model

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 value of the firm is estimated by

a three step procedure:

Determine the free future cash flows: 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 preferable to base our valuation on the

average of 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 Berliner Method.


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VALUATION METHODS

When valuing a company, three techniques are

commonly used: comparable company analysis (or"peer group analysis", "equity comps", " tradingcomps", or "public market multiples"), precedenttransaction analysis (or "transaction comps", "deal

comps", or "private market multiples"), and discountedcash flow ("DCF") analysis. A fourth type of analysis, aleveraged buyout ("LBO") analysis, is often used toestimate the amount a financial buyer would pay for acompany. A fifth type of analysis, a sum-of-the-parts("SOTP" or "break-up") analysis may be used to value acompany as the sum of the values of its compositebusinesses.


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VALUATION METHODS


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VALUATION METHODS


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VALUATION APPROACHES Discounted Cash Flow determines the value of the

firm by ascertaining the present value of futurecash flows

Comparable Firm determines the value of the firm

at the value of a similar firm in the same industry Adjusted Book Value estimates the value of the

firm at the sum of market value of assets and

liabilities as a going concern

Option Pricing Model regards the equity of a

taken over company as an option and values it

like an option


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Approaches to ValuationValuation Models

Asset BasedValuation Discounted Ca shflowModels Relative Valuation Contingent ClaimModels

LiquidationValue

ReplacementCost

Equity ValuationModels

Firm ValuationModels

Cost of capital

approach

APV

approach

Excess Return

Models

Stable

Two-stage

Three-stageor n-st age

Current

Norma lized

Equity

Firm

Earnings BookValue

Revenues Sectorspecific

Sector

Market

Option todelay

Option toexpand

Option toliquidate

Patent UndevelopedReserves

Youngfirms

Undevelopedland

Equity introubledfirm

Dividends

Free Cashflowto Firm


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Discounted Cash Flow Valuation What is it: In discounted cash flow valuation, the value of an

asset is the present value of the expected cash flows on the

asset. Philosophical Basis: Every asset has an intrinsic value that

can be estimated, based upon its characteristics in terms of

cash flows, growth and risk.

Information Needed: To use discounted cash flow valuation,you need

to estimate the life of the asset

to estimate the cash flows during the life of the asset

to estimate the discount rate to apply to these cash flows to

get present value

Market Inefficiency: Markets are assumed to make mistakes

in pricing assets across time, and are assumed to correct

themselves over time, as new information comes out about


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Discounted Cashflow Valuation: Basis

for Approach

where CFt is the cash flow in period t, r is the discountrate appropriate given the riskiness of the cash flow andt is the life of the asset.

Proposition 1: For an asset to have value, the expectedcash flows have to be positive some time over the life

of the asset.Proposition 2: Assets that generate cash flows early in

their life will be worth more than assets that generatecash flows later; the latter may however have greatergrowth and higher cash flows to compensate.

Value =CF

t

(1+ r)t

t =1

t = n


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I. Equity Valuation The value of equity is obtained by discounting expected cashflows to

equity, i.e., the residual cashflows after meeting all expenses, tax

obligations and interest and principal payments, at the cost of equity, i.e.,

the rate of return required by equity investors in the firm.

where,

CF to Equityt = Expected Cashflow to Equity in period t

ke= Cost of Equity

Forms: The dividend discount model is a specialized case of equity

valuation, and the value of a stock is the present value of expected future

dividends. In the more general version, you can consider the cashflows left

over after debt payments and reinvestment needs as the free cashflow to

equity.

Value of Equity =CF to Equity t

(1+ ke )t

t=1

t=n


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II. Firm Valuation Cost of capital approach: The value of the firm is

obtained by discounting expected cashflows to the firm,i.e., the residual cashflows after meeting all operatingexpenses and taxes, but prior to debt payments, at theweighted average cost of capital, which is the cost ofthe different components of financing used by the firm,weighted by their market value proportions.

APV approach: The value of the firm can also bewritten as the sum of the value of the unlevered firmand the effects (good and bad) of debt.Firm Value = Unlevered Firm Value + PV of tax benefits of

debt - Expected Bankruptcy Cost

It is variant of DCF, is value of the target company if itwere entirely financed by equity plus the value of theimpact of debt financing in terms of the tax benefits aswell as bankruptcy cost.


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DCF Valuation Model

Cash flowsFirm: Pre-debt cashflowEquity: After debt

cash flows

Expected GrowthFirm: Growth inOperating EarningsEquity: Growth inNet Income/EPS

CF1 CF2 CF3 CF4 CF5

Forever

Firm is in stable growth:Grows at constant rate

forever

Terminal Value

CFn.........

Discount RateFirm:Cost of Capital

Equity: Cost of Equity

ValueFirm: Value of Firm

Equity: Value of Equity

DISCOUNTED CASHFLOW VALUATION

Length of Period of High Growth


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RELATIVE VALUATION What is it?: The value of any asset can be estimated by looking at how the

market prices similaror comparableassets.

Philosophical Basis: The intrinsic value of an asset is impossible (or close

to impossible) to estimate. The value of an asset is whatever the market is

willing to pay for it (based upon its characteristics)

Information Needed: To do a relative valuation, you need

an identical asset, or a group of comparable or similar assets

a standardized measure of value (in equity, this is obtained by dividing

the price by a common variable, such as earnings or book value)

and if the assets are not perfectly comparable, variables to control for

the differences

Market Inefficiency: Pricing errors made across similar or comparableassets are easier to spot, easier to exploit and are much more quickly

corrected.


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RELATIVE VALUATION

In relative valuation, an asset is valued on the

basis of how similar assets are currently priced

in the market.

every thing is relative even when it shouldnt

be. Humans rarely choose in absolute terms.

We dont have an internal meter that tells us

how much things are worth. Rather, we focus

on the relative advantage of one thing overanother, and estimate value accordingly.


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STEPS INVOLVED IN RELATIVE

VALUATION

Analyze the subject company

Select comparable companies

Choose the valuation multiples

Calculate the valuation multiples for

the comparable companies. Value the subject company


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BALANCE SHEET VALUATION MODELS

Book Value: the net worth of a company as shown on the balance sheet.

Liquidation Value: the valuethat would be derived if the firms assets

were liquidated.

Replacement Cost: the replacement cost of its assets less its liabilities.

DIVIDEND DISCOUNT MODELS

31 20 2 3

.......1 (1 ) (1 )

DD DV

k k k

Where Vo = value of the firmDi = dividend in year I

k = discount rate


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The Constant Growth DDM

2

0 0

0 2(1 ) (1 ) ......

1 (1 )D g D g V

k k

And this equation can be simplified to:

0 1

0

(1 )D g DV

k g k g

where g = growth rate of dividends.


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METHODS OF FINANCING MERGERS Cash payment

pay the purchase consideration by cash

Advantages of Cash payment

certain and clearly understood by the target company

improves the chances of a successful bid

Disadvantages of cash payment

raising the necessary cash can be difficult for the bidding company where the target

company is large Shares

issue of ordinary and preference shares

Advantages of purchase by Shares

a voids strain on the cash position of the company

Disadvantages of purchase by Shares

expensive way of raising capital

low gearing

Loan capital

debentures

convertible loans


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METHODS OF FINANCING MERGERS Cash offer:-

It is a straightforward means of financing amerger. It does not cause any Dilution in theearnings per share & the ownership of the

existing shareholders of the acquiringcompany.

It is also unlikely to cause wide fluctuations inthe share prices of the merging companies.

The shareholders of the Target company getcash for selling their shares to the acquiringcompany.


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METHODS OF FINANCING MERGERS

Share Exchange:-

A share exchange offer will result in the sharing of

ownership of the acquiring company between its

existing shareholders and new shareholders.

The earnings & benefits would also be shared

between these two groups of shareholders.

The precise extent of net benefits that accrue to

each group depends on the exchange ratio interms of the market prices of the shares of the

acquiring and the acquired companies.


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TARGET VALUATION

Methods:

Asset-based methods

Balance sheet or net book values approach

P = Total assets - total liabilities

No of ordinary shares issuedNet realisable values or replacement cost

P = net realisable value - total liabilitiesNo of ordinary shares issued

Stock market methods: For listed companies use the share price on the

stock exchange


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TARGET VALUATION

Cash flow methods:

Gordons growth model

Value of share= Dividend received

Rate of returngrowth in dividend

Free cash flow method:

PV of future cash flow-total liabilitiesNo of ordinary shares issued


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TARGET VALUATION

Dividend Yield = Gross dividend per shareMarket value per share

MV/S = Gross dividend per share

Dividend yieldP/E ratio = market value per shareEarning per share

Market value per share = P/E ratio x EPS


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CORPORATE CONTROL

Premium Buybacks

Standstill Agreements

Antitakeover

AmendmentsProxy contests


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Premium buy backs

It represents therepurchase of a substantial

stock holders ownershipinterest at a premium

above the market price(called green mail).


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A standstill agreement

It is written. This represents avoluntary contract in which

the stockholder who is bought

out agrees not to make further

attempts to take over the

company in the future.


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Antitakeover amendments

Are changes in the corporate bylaws to make

an acquisition of the company more difficultor more expensive. These include

Supermajority voting provisions requiring a

high percentage of stockholders to approve amerger,

Golden parachutes which award large

termination payments to existingmanagement if control of the firm is changed

and management is terminated.


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Proxy contest

An outside group seeks to obtainrepresentation on the firmsboard of

directors.

Since the management of a firm

often has effective control of the

board of directors, proxy contests areusually regarded as directed against

the existing management.

Th k ll f


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Thank you all for

listening

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Valuation Mergers and acquisition