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Mergers and Acquisitions: Advanced Valuation Methodologies

Business valuation concepts are introduced in ACCA Financial Management (FM, was F9). However, it’s very important for every senior finance managers to understand well of how to apply it in their financial decision making. Therefore, it is included in Advanced Financial Management exam as well.


In addition to the concepts learnt in FM, you need to know when are those methodologies applied in the merger or acquisition, what are the limitations of each methods and how can these methods in different scenarios.



Recap of Business Valuation


Determining the true value of a business can take several approaches. A business creates its value through asset building, share valuations, cash flow streams, and so on.


Some companies are listed and some unlisted, so these companies cannot be evaluated in the same way. Depending on the business size, nature of operations, assets and liabilities, cash flows, the valuation can take a different approach case to case.


Business and equity valuations matter most when making an acquisition or merger offer. Shareholders are normally concerned with equity valuation, i.e. the net business value after debts. For ongoing purposes, the equity valuation can be determined using current financial statements. In the case of acquisition or merger proposals, the equity valuations need to be adjusted as closer to the fair market value as possible.


With that approach any firm, listed or unlisted, can be valued in two ways:


  1. Pre-Acquisition valuation

  2. Post-Acquisition valuation


Normally the latest share prices of an entity reflect the market capitalization of that entity, but often these values are not up to date. In some cases, the private entities may not even be listed.


Either way, it’s pertinent to note that in case of an acquisition or merger offer a premium to the total market value of the business should be added. Otherwise, there is no incentive for existing shareholders to sell the entity shares.


In the case of unquoted entity, a proxy company from the same industry with similar size can be considered. In both pre-acquisition and post-acquisition scenarios, the valuation method can be categorized into three methods.


  1. Asset Based valuations

  2. Earnings based valuations

  3. Cash flow based valuations



Pre-Acquisition Valuation


Each method has its benefits and limitations. It depends on the entity under consideration to choose between the best suitable equity valuation methods.


Net Assets Valuation Method

This method is more suited for entities with more tangible assets. This valuation method considers the net asset value as the basis for the total business value. Net assets of an entity are total assets less than the borrowing and liabilities of the entity.


If the entity holds a large portion of intangible assets, then the valuation may differ from the actual market value. Since the tangible assets would include goodwill and intellectual capital. The calculation for the tangible asset based entity is straightforward. It can be calculated as:


Net Asset Value = (Assets – Liabilities) ÷ Total number of Shares


In the case of the business having more intangible assets such as brands, patents, and trademarks, the valuation can be used by determining the intangible asset valuation first.


Value of Intangible assets = Value of Equity – Value of tangible assets


In this scenario value of equity can be determined using the market capitalization or earning based methods.


Importance:

  • The valuation based on asset and liabilities which makes it a fairly simple method

  • It can provide a starting valuation price for tangible asset-based entities

  • Intangible asset valuation can be added to the basic net asset valuations


Limitations:

  • Difficult to evaluate the entity with intangible assets

  • Current asset valuations may not be accurate

  • This method ignores the future cash flows



Dividend Growth Model

This method is used assuming that the company will pay dividends over the years. Therefore, if we can calculate the expected growth in the dividends for upcoming years, we can determine the entity valuation.


In other words, it determines the future dividend cash flows to the present value to determine the entity value. Entities follow different dividend payout policies. The dividend payout can be constant or growing.


1. For a constant dividend paying entity


Value of the company = total Dividends ÷ Cost of Equity or numerically,


P = D / K


2. For an entity with growth dividend


P = D (1 + g) ÷ (K – g)


Where all other things being the same, g is the future growth rate for the dividends.


Importance:

  • It determines the future dividend payments to present values similar to the discounted future cash flow method

  • Uneven dividend growth can be divided into several periods where the dividend payout ratio remains constant

  • It remains theoretically correct and close to investors’ interests


Limitations:

  • Dividend payouts depend on the company policy which may change

  • It is difficult to forecast that the new entity will maintain the same dividend payout ratio, or pay dividends in cash at all.

  • Difficult to apply to unlisted companies



P/E Valuation Method

Perhaps one of the simplest valuation methods for listed companies. The entity valuation can be calculated with post-tax earnings and a suitable multiplier i.e. P/E ratio. P/E is simply the listed entity’s share price divided by its earnings per share or EPS. With this method the entity valuation is calculated as:


Value of the Company = Total Post-Tax Earnings × P/E Ratio.


This method assumes that the current P/E ratio reflects the total future earnings prospects of the entity. For unlisted companies, a proxy company’s P/E ratio can be used.


Sometimes, this method can also be used in post-acquisition valuation because of its simplicity. In that case, any additional values arising due to synergy, one-off transactions, and adjustments should be made to calculate the realistic entity value.


Importance:

  • Most widely used method with listed companies

  • It evaluates the entity on the basis that the current market share price represents the total future cash flows

  • For unlisted companies, the P/E of a proxy entity in a similar industry can be used for evaluation purposes


Limitations:

  • The P/E ratio is calculated often with operating profits

  • Future earnings and cash flows cannot be determined with accuracy

  • Difficult to apply to unlisted companies or without proxy entity information closer to the actual values of under consideration entity.


Free Cash Flow Valuation Method

It is perhaps theoretically the best valuation method in pre-acquisition scenarios. Free Cash flows are defined as all cash flows after deduction for interest, taxes, preferred dividends, and capital expenses. These cash flows are what is left for distribution for shareholders. So discounting these cash flows using cost of equity can give us the total equity valuation in the entity.



Post-Acquisition Valuation


Bootstrapping

Mergers and acquisitions happen mainly to take advantage of synergy effects. Increasing market share, access to valuable data, and increased market capitalizations are also active drivers behind the mergers and acquisitions. Theoretically, the combined market value of the new entity should be greater than the sum of the two pre-acquisition entities individually.


Market Value of (AB) > Market value of A + Market value of B


Although all methods used in pre-acquisition scenarios can be used in post-acquisition scenarios too. Sometimes the exact values of the merging companies and synergy estimations are not possible due to lack of data.


In that case, the individual entities’ post-tax profits are multiplied with the acquiring company’s P/E ratio. This method assumes that the acquiring (buyer) entity would apply the same methods and approach to the combined entity and hence will maintain the same P/E ratio. This concept is known as bootstrapping.


We can understand this concept with the help of a simple example.



Let’s suppose company A takes over the company B. the post-acquisition value can be calculated as:


Value of (A+B) Post-Acquisition = ($8 million +$2 million) × 15 = $ 150 million.


The additional value is due to synergy effects, hence the value of synergy in this case:


Value of combined entity – Value of A – Value of B =


$ 150m - $ 120m - $ 14m = $ 16 million.



Alternative Approach

The post-acquisition value of the combined entity can also be calculated by combining the pre-acquisition values of the entities and then adding the synergy gains. In the above example, the higher P/E ratio of the buyer entity is used assuming the combined entity will maintain the same P/E ratio. Alternatively, if the amount of synergy is already known it is simply added to the combined value of the new entity valuation.


Let’s suppose we have following information for company A and company B.


If entity A makes an offer of 3 to 5 new shares currently for entity B shareholders. It is assumed that the combined entity C would generate an additional value of synergy as $ 50 million.


Therefore, the market value of A= $ 800 million. Market value of B = $ 180 million


Value of Synergy = $ 50 million. If the acquisition happens then,


New Entity C value = 800 + 180 +50 = $ 1,030 million.


New shares in entity C = 200 + (3/5 × 90) = 254 million shares.


New Share price = 1,030/254 = $ 4.055 per share


Entity A shareholders hold the same number of shares, which is 200 million shares, in the new entity, i.e. Entity C. Entity B shareholders receive 54 million shares in Entity C if the offer is accepted. Then, changes in share valuation for both entity shareholders can be traced as:



Equity valuation methods in both pre-acquisition and post-acquisition scenarios depend on various factors. Both acquiring and acquired company nature of the business, assets, cash flows, and listing status plays an integral part in choosing the correct valuation method.



Conclusion


Business valuation is one of important financial decisions to be made in senior financial executives of a company. A company’s board members are looking for an answer in merger or acquisition to see whether it is financial sound to all stakeholders.


Understanding and mastering various business valuation methods are certainly helpful for the financial executives to advise in any growth opportunities from acquisitions and mergers. It is also the requirement to pass ACCA Advanced Financial Management (AFM) exam.

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