Valuation Methods Used In Mergers & Acquisition

Roshankumar S Pimpalkar

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Need for valuing shares (or business) As far as unlisted companies are concerned the price of shares of such company 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 of share of a listed company is already available on the stock market. Then why do we need to calculate the value of shares or business 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.

For example:
Balance sheet of A Ltd Liabilities Equity share capital of Rs 10 each General reserve 50000 Amt 100000 Assets Goodwill Plant and machinery Stock Amt 20000 100000 40000

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Creditors Tax payable Total

60000 30000 240000

Debtors Cash at bank Total

50000 30000 240000

Goodwill is worth nothing. Plant and machinery is valued at Rs 85000. Sundry debtors declared insolvent owed Rs 5000. Compute value per share. Solution: Calculation of net worth Goodwill Plant and machinery Stock Debtors Cash at bank Less: Creditors Tax payable Net worth (Rs.) No. of shares Value per share (Rs/share) (60000) (30000) 110000 10000 11 85000 40000 45000 30000

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.) No. of equity share Earning Per share (Rs/share) Normal Return on Investment = = = = 225000 10000 22.5 16%

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Value per share (22.5/16%)

= Rs 140.625 per share

PE based valuation The market value of equity share is the product of "Earning 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 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 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 marketreturn 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 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

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D1 Ke

- Dividend - 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, Ke - cost of equity Rf - Risk free rate of return Rm - market rate of return.

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 targetbusiness, 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..

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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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