Valuation Final

8/3/2019 Valuation Final

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Mergers And Acquisitions: Valuations


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Brand valuation

y Brand valuation mainly measures 2 criteria's

y Potential profitability of the brand

y Non- financial factors like brand recall

y In a brand valuation transaction, a company rarely pays book

value to acquire another company.

y The difference between the book value and actual acquisition

price paid is due to intangible assets, of which brands are animportant part.


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Valuing a brand

Relief from royalty method:

y The relief-from-royalty method determines the value of an intangible

asset by reference to the capitalized value of the hypothetical royaltypayments that would be saved through owning the asset, as comparedwith licensing the asset from a third party.

y It involves estimating the total royalty payments that would need to be

made over the assets life, by a hypothetical licensee to a hypotheticallicensor.

y The hypothetical royalty payments over the life of the asset are adjustedfor tax and discounted to present value and then are capitalized.


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Premium Profits Method

y The premium profits method involves comparing the forecast

profit stream or cash flows that would be earned by a business

using the intangible asset with those that would be earned by a

business that does not use the asset.

y The forecast incremental profits or cash flows achievable through

use of the asset are then computed.

y Forecast periodic amounts are capitalized through use of either a

suitable discount factor or suitable capitalization multiple.


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Valuation-different approaches

y Discounted cash flow- it relates the value of the asset to the

present value of the expected cash flows on that asset.

y Relative valuation approach- this method is used to estimate thevalue of an asset by analyzing the pricing of comparable assets

relative to a common variable such as earning, book value, cash

flows etc.


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Earning based valuation

y This method takes into consideration the future earnings of

the business and the appropriate value of the business

depends on projected revenues and costs in future, expected

capital outflows, number of years of projection, discounting

rate and terminal value of business.


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Market based valuation

y MBV for unlisted companies, comparable listed companies

have to be identified and their market multiples such as

market capitalization to sales or market PE are used to arrive

at a value.


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Asset based valuation

y Considers either the book value or the net adjusted value. If

the company has intangible assets, these are valued

independently and added to the net asset value to arrive at

the business value.


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Steps in Acquisition Analysis

y Step 1: Establish a motive for the acquisition

y Step 2: Choose a target

y Step 3: Value the target with the acquisition motivebuilt

in.y Step 4: Decide on the mode of payment - cash or stock,

and if cash, arrange for financing - debt or equity.

y Step 5: Choose the accounting method for the

merger/acquisition - purchase or pooling.


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Step 1: Motives behind acquisitions(1)Simplest rationale is undervaluation, i.e., that firms that are

undervalued by financial markets, relative to true value, will betargeted for acquisition by those who recognize this anomaly.

(2) A more controversial reason is diversification, with the intentof stabilizing earnings and reducing risk.

(3) Synergy refers to the potential additional value from combiningtwo firms, either from operational or financial sources.

y Operating Synergy can come from higher growth or lower costs

y Financial Synergy can come from tax savings, increased debtcapacityor cash slack.


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Step 2: Choose a target firm for the

acquisitionIf motive is Target firm

Undervaluation trades at a price below the estimated value

Diversification is in a business which is different from the acquiring firms business

Operating Synergy have the characteristics that create the operating synergyCost Savings: in same business to create economies of scale.

Higher growth: should have potential for higher growth.

Financial Synergy Tax Savings: provides a tax benefit to acquirer

Debt Capacity: is unable to borrow money or pay high rates

Cash slack: has great projects/ no funds


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Control badly managed firm whose stock has

underperformed the market

Managers Interests has characteristics that best meet CEOs ego

and power needs


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Step 3: Value Target Firm with motive

built in

If motive is Target firm

Undervaluation Value target firm as stand-alone entity

Diversification Value target firm as stand-alone entity

Operating Synergy Value the firms independently.

Value the combined firm with the operating synergy

Synergy is the difference between the latter and former

Target Firm Value = Independent Value + Synergy

Financial Synergy: tax

benefits:

Debt Capacity:

Value of Target Firm + PV of Tax Benefits

Value of Target Firm + Increase in Value from Debt


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Step 4: Decide on payment mechanism:

Cash versus Stock

Generally speaking, firms which believe that their stock is

under valued will not use stock to do acquisitions.

Conversely, firms which believe that their stock is over or

correctly valued will use stock to do acquisitions.

Not surprisingly, the premium paid is larger when an

acquisition is financed with stock rather than cash.

There might be an accounting rationale for using stock as

opposed to cash. You are allowed to use pooling instead of

purchase.

There might also be a tax rationale for using stock. Cash

acquisitions create tax liabilities to the selling firms stockholders.


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Step 5: Choose an accounting method for

the mergery Purchase Method:

The acquiring firm records the assets and liabilities of the acquired firm atmarket value, with goodwill capturing the difference between market valueand the value of the assets acquired.

y This goodwill will then be amortized , though the amortization is not taxdeductible. If a firm pays cash on an acquisition, it has to use the purchasemethod to record the transaction.

y Pooling of Interests: The book values of the assets and liabilities of the merging firms are added to

arrive at values for the combined firm. Since the market value of thetransaction is not recognized, no goodwill is created or amortized.

This approach is allowed only if the acquiring firm exchanges its commonstock for common stock of the acquired firm.

Since earnings are not affected by the amortization of goodwill, the reportedearnings per share under this approach will be greater than the reportedearnings per share in the purchase approach.


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Cost of capital: CAPM

( ) s f m f

k r E r r F ! -

where rf = the risk-free rate of return

E(rm) = the expected rate of return on the overall market portfolio

E(rm)- rf = market risk premium

= the systematic risk of equity


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Discounted cash flow approach

y Estimates are needed for:

y Incremental cash flow expected to be generated because of

acquisition

yDiscount rate


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Equity Valuation

y Value of equity is obtained by discounting expected cash

flows(after meeting all expenses, taxes, etc)

y Value of Equity= Cash flow to equity

(1+ke)t


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Measuring Free Cash Flows to the

Equity (FCFE)

y Buying equity of firm is buying future stream of free cash flows

(available, not just paid to common as dividends) to equity holders

(FCFE)

y FCFE is residual cash flows left to equity holders after:

y meeting interest/principal payments

y providing for capital expenditures and working capital to maintain

and create new assets for growth

FCFE

= NetI

ncome + Non-cashE

xpenses -C

ap.E

xp.- Increase in WC - Princ. Payments


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Stable Growth FCFE Model

y Used when firm is growing at stable growth rate

y The value of equity is a function of expected FCFE in the

next period, the stable growth rate and the required rate of

return.y V0 = FCFE1 / r-gn


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Discounted Free Cash Flow to the Firm

y Identify cash flows available to all stakeholders

y Compute present value of cash flows

y Discount the cash flows at the firms weighted average cost of

capital (WACC)


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Enterprise value

y Market capitalization of a company plus debt.

y The key performance metric to evaluate enterprise value.

y EV/EBITDA ratio

y EV/Revenue ratio

y EV/ sales


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Economic profit model

y Economic profit= invested capital*(ROIC-WACC)

y Value created by company must not only include theexpenses recorded in its accounting records but also the

opportunity cost of capital employed in the business.

Valuation Final

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