Wednesday, September 24

Valuation in Mergers & Acquisitions

Valuation is a critical part of the merger process. A deal that may be sound from a business standpoint may be unsound from a financial standpoint if the bidder firm pays too much. The purpose of a valuation analysis is to provide a disciplined procedure for arriving at a price. If the buyer offers too little, the target may resist and, since it is in play, seek to interest other bidders. If the price is too high, the premium may never be recovered from postmerger synergies. These general principles are illustrated by the following simple model.

Mergers increase value when the value of the combined firm is greater than the sum of the premerger values of the independent entities.

NVI = VBT – (VB - VT)

where NVI = net value increase
VB = value of bidder alone
VT = value of target alone
VBT = value of firms combined

A simple example will illustrate.
Company B (the bidder) has a current market value of Rs.40mn. Company T (the target) has a current market value of Rs.40mn. [Please note that this assumption of same market value for both the companies is rarely found]. The sum of the values as independent firms is therefore Rs.80mn. Assume that as a combined company synergies will increase the value to Rs.100mn. The amount of value created is Rs.20mn.

How will the increase in value be divided? Targets always (usually) receive a premium. What about the bidders? If the bidder pays a premium of less than Rs.20mn, it will share in the value increase. If B pays a premium larger than Rs.20mn, the value of the bidder will decline.

If the Bidder pays Rs 50mn the value of the bidder is (40+10) = 50mn implying that the values are shared equally.

If the Bidder pays Rs 60mn the value of the bidder is Rs (100 - 60) = 40mn implying that all synergies go to the target, the bidder gets no incentive to buy the target.

If the Bidder pays Rs 70mn, the value of the bidder is (100 - 70) = 30mn. This is dangerous. It implies that the value of bidder declines and the acquisition is not advised.
On the contrary, if the Bidder pays less Than 50 mn the value of the Bidder may be higher (100 – amount paid) but in this case the target does not accept the acquisition. As already said, the target always receives a premium.

Suppose B exchanges 1.0 of its shares for 1.0 share of T. Since the combined firm is valued at Rs.100mn, T will receive .5 X 100mn, which equals 50mn. The premium paid is 25 percent. Based on their previous 40mn values, B and T each owned 50 percent of the pre-merger combined values. Post-merger, the percentages of ownership will remain 50–50.
If B exchanges 1.5 of its own shares per share of T, this is equivalent to paying Rs.60mn in value for the target. Company T shareholders will own 60 percent of the combined company. None of the synergy gains will be received by the bidder shareholders.

Also note that the target shareholders will have 1.5 shares in the new company for every 1.0 share held by the bidder shareholders. The situation is even worse if B pays more than Rs.60mn for the target. Assume B pays Rs.70mn for the target (1.75 to 1 shares). Since the combined company has a value of Rs.100mn, the value of the bidder shares must decline to Rs.36.36mn. The consequences are terrible. The shares of the bidder will decline in value by Rs.3.64mn, or 9.1 percent. Furthermore, the B shareholders will own only 36.36 percent of the combined company; for every 1.0 share that they own, the target shareholders will own 1.75 shares.

Valuation Methods

The leading methods used in the valuation of a firm for merger analysis are the comparable companies or comparable transactions approach, the spreadsheet approach, and the formula approach.

In the comparable companies or comparable transactions approach, key relationships are calculated for a group of similar companies or similar transactions as a basis for the valuation of companies involved in a merger or takeover. It is a commonsense approach that says that similar companies should sell for similar prices.

Let’s look at an example. We need to value Potential Target (PT) Ltd. and we have three comparable companies. Potential Bidder1 (PB1), Potential Bidder2 (PB2) and Potential Bidder3 (PB3).

We take three ratios into account for simplicity purposes,
Enterprise Value / Revenues (EV/R) - 1.4, 1.2 and 1.0 for PB1, PB2 and PB3 respectively. Thus the average comes to 1.2

Enterprise Value / EBITDA (EV/EBITDA) - 15, 14 and 22 for PB1, PB2 and PB3 respectively. Thus the average comes to 17

Enterprise Value / Free Cash Flow (EV/FCF) - 25, 20 and 27 for PB1, PB2 and PB3 respectively. Thus the average comes to 24.

Next we need to apply these ratios to PT Ltd. Lets assume that Revenues, EBITDA and FCF of PT are 100mn, 7mn and 5 mn respectively.

Applying the respective averages we get Enterprise value in each case

EV based on Revenue = 100 x 1.2 = 120mn

EV based on EBITDA = 7 x 17 = 119 mn

EV based on FCF = 5 x 24 = 120 mn

The average EV would thus be (120 + 119 + 120) / 3 = 120 mn

Wow! pretty close huh? I doubt how often would you find such close figures from the three given methods. But still you now know just one of the methods of valuing a company in case of mergers / acquistions.

One of the advantages of the comparable companies approach is that it can be used to establish valuation relationships for a company that is not publicly traded. This is a method of predicting what its publicly traded price is likely to be. The methodology is applicable in testing for the soundness of valuations in mergers also. Both the buyer and the seller in a merger seek confirmation that the price is fair compared to the values placed on the other companies. For public companies, the courts will require such a demonstration if a suit is filed by an
aggrieved shareholder.
Typically, merger transactions involve a premium as high as 30 percent to 40 percent over the prevailing market price (before news of the merger transaction has leaked out). The relevant valuation for a subsequent merger transaction would be the transaction enterprise prices for comparable deals. The result would be a higher indicated price. We will use 30 percent as the premium factor. The indicated enterprise market value of company PT would be 156 million.

If there had been no comparable companies to be considered, we would go by the valued arrived at by comparable companies approach. But that is just the starting point. Mergers generally involve a lot of negotiations and PT would always seek high premium over its current market price.

We have used three ratios in case of comparable companies approach. In some situations, other ratios might be employed in the comparable companies or comparable transactions approach. Additional ratios could include sales or revenue per employee, net income per employee, or assets needed to produce Re. 1 of sales or revenue. Note that market values are not included in the ratios just listed and in the practical scenarios a veriety of methods are used to come to a Price.

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