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(Business Valuations & Acquisitions) - Coggle Diagram
Business Valuations & Acquisitions
Valuation Introduction
Understanding a business value for acquisition or sale
Raising finance
Establish benchmark to gauge progress
Establish tangible asset valuation
Establish Goodwill
Valuing employee share options plans
Establish equity value in new partnerships / retiree's
Preparing tax obligation when gifting shares
Calculate assets upon business diversification
Variables in valuation
Business value will change based upon latest circumastance
Political Stability
Inflation
Technology
Customer tastes & preferences
Leadership Team
Cash Based Business Valuation
Dividend Valuation Model (DVM) Theory
Value of company/share is the present value of the expected future dividends discounted at shareholder rate of return
Assume all cash flows to equity are paid out as dividend, DVM would give the same value as valuation by discounting CF to equity at COE
Strengths
Value is based on present value of future dividend stream (sound theory)
Useful for valuing minority shareholders who receive dividends with little entity control
Weaknesses
Difficult to forecast dividends & dividend growth especially in perpetuity
Difficult for unlisted companies to estimate cost of equity, nor will they have a consistent dividend policy
Cannot be used when annual growth rate is expected to change
Constant dividend
Po = do / Ke
Constant growth
Po= d1 / (Ke - g)
g = forecasted growth
Po = Value of company
Ke = Cost of Equity
do = Dividend at period start
d1 = Do x (1+g)
Gordon's Growth Model
(g = r x b)
Derive future growth rate
Rate of reinvestment
Return generated by investments
r = return on reinvested funds
b = proportion of funds retained
Assumptions
Entity all equity financed
Retained profits are only source of additional investment
Constant proportion of each years earnings are retained for reinvestment
Project financed by retained earnings earn a constant rate of return
Discounted Cash Flow Method
Value derived by estimating the future, after-tax cash flows
of the entity annually
Discounted at appropriate cost of capital
Discounted value of future cash flows represents shareholder wealth
Cash flows to equity (FCFE)
Free Cash Flow to Equity is cash available to equity shareholders after accounting for operating expenses, capital expenditures, and the net effect of debt (financing charges)
Similar to post-tax post-financing cash flows
They also include the net cash flows from sustainable capital & working capital investments
Post-tax cash flow are often used as an approximation for cash flows to equity
Only available to equity investors
Free Cash Flow (FCF)
Free Cash Flow is cash a company generates from its operations after accounting for capital expenditures needed to maintain or expand its asset base
Available cash flows to all investors
Key Notes
Income taxes are deducted as they reduce available cash
Non-cash (depreciation) added back as not cash flows
Adjustment to account for changes in working cap (current asset - current liabilities) investment
Increased investment = value subtracted
Decreased investment = value added
Adjustment to account for changes in NCA investment
Increased investment = value subtracted
Decreased investment = value added
Appropriate discount rate
FCF = WACC
FCFE = Cost of equity
Strengths
Theoretically the best method to use
Can be used to place a maximum value on the entity
considers time value of money
Weaknesses
Difficult to forecast cash flows accurately
Difficult to determine appropriate discount rate
What time period should we evaluate in detail & then how is value calculated in perpetuity
NPV method does not evaluate further options that may exist
Basic model assumes discount rate & tax rates are constant
Earnings based valuations
Earnings of a business are forecasted & earnings multiple applied
Multiplier calculated typically by using a P/E valuation method
P/E valuation
Values an equity of a business by applying P/E ratio to business earnings
Profit after tax, less preference dividend
P/E Ratio
Share price / Earnings
Indicates the markets perception of a company & it's future prospects
High = good
Proxy P/E ratios
If un-listed share price is unobtainable
Industry average must be taken or one of a similarly listed company
20/30% discount applied
Application of accounting standards is less stringent
Post Tax Earnings
A.K.A. Earnings Per Share (EPS)
Should be the expected, not the current as based historically
Historic earnings figure should be adjusted to:
One-off items which will not reoccur in the coming year
Directors salaries which may be adjusted after a takeover has been completed
Any savings (synergies) as part of the takeover
Weaknesses
Based on accounting profits rather than CF
Difficult to identify a suitable P/E ratio
Difficult to establish regular levels of sustainable earnings
Strengths
Commonly used & well understood
Relevant for valuing a controlling interest in an entity
Alternative multipliers to use
Market Price / Sales
Use share price to sales turnover to use
Enterprise Value & EBITDA
Enterprise value is market value of:
All Shares + Debt + Minority Interest + Preferred Share Cap - Cash and cash equivalents
EBITDA ignores differences in taxation
Capital Structure + NCA
Earning Yield Valuation
Reciprocal of P/E ratio ( EYV = 1 / (P/E))
Useful to check the stability over several months and impacts of different events
Consistency suggests a stability for growth to build upon
Asset based Valuation Model
Net Assets form the basis for valuation
Borrowings to be deducted if just equity to be valued
Most useful when a company is being broken up
Allows for a minimum price as difficult to account for intangible assets
Methods
Replacement Value
Calculates the cost of replacing the businesses assets
Relevant if selling off assets at minimum price
Break-up / Net realisable value
Individual assets priced at best price attainable
Book Value (Historic value)
Suffers from depreciation conventions (unrealistic)
Strengths
Fairly readily available
Provide a minimum value for the entity
Weaknesses
Future profitability expectations ignored
SOFP valuations depend on accounting conventions (differ from market)
Difficult to allow for valuation of intangible assets
Intangible assets
IA lack physical properties and represent legal rights or CA developed or acquired by the owner
To hold value IA's must generate some measurable amount of economic benefit to the owner
Characteristics
Identifiability
Identified specifically with reasonable descriptive names
Manner of acquisition
Purchased or developed internally
Determinate or indeterminate life
Determinate life will be established by law, and came into existence at an identifiable point in time as result of event
Transferability
IA's may be bought, sold, licensed, or rented
Intellectual Capital
Total stock of capital / knowledge-based equity
Can be both end result of knowledge transformation process or knowledge itself that is transformed to IP/IC
Includes:
'Big data'
Human resources
Intellectual assets
Intellectual property
Companies cannot recognise internally generated goodwill in accounts, but on acquisition the value of any brand should be considered
Valuation
Cost Approach
Replacement cost is most appropriate
Income approach
Best used when income producing
Converts future benefits to a single discounted value
Difficult to distinguish CF from whole company
Market Approach
Comparison between similar asset recently traded
Calculated Intangible Value (CIV) method
Estimate the value IA that are not recorder in SOFP
Used alongside basic asset valuation to give overall picture
Method:
Calculate profit before tax (3y average)
Find net asset at YE
Find comparable industry return on net asset (RONA)
Calculate expected profit before tax (Company net asset x RONA)
Deduct expected from actual
Adjust by tax over the period
Discount to PV using average cost of capital to perpetuity
Market Valuation of Businesses
Stock Market Efficiency
Market efficiency = information processing & it's impact on stock/share prices
Highly efficient market:
Stock price always reflects all information on an item
Any new info reflected immediately
No over / under valuation
All information is available with same risk profile
'Rational behaviours'
Absence of transaction costs (erosion of benefits)
Efficient Market Hypothesis (EMH)
Weak form efficiency
Price reflects historic information
Semi-strong form efficiency
Price reflects history & all published information
Strong form efficiency
Price reflects all possible information, including non-public information
Capital Asset Pricing Model (CAPM)
Determines the expected return on an investment, given its risk relative to the market
CAPM helps in assessing the cost of equity, which is an essential component for valuing companies, projects, or individual assets
Total Company Risk
Unsystematic Risk
Risk a companies cash flows being affected by company / industry specific factors
Systematic Risk
Risk the cash flows affected by a general macro-economic factors, i.e. tax, global pandemic etc
Impact of Diversification
Rational, risk averse investors will invest in in wide ranging portfolios
Allows for almost total mitigation of Unsystematic risk and focus on Systematic
Beta Factor
Measure of a share's volatility in terms of market risk
Market overall beta = 1
beta > 1 = Shares have more systematic risk than the market
beta = 1 = Share have same risk as the market
beta < 1 = Share have less systematic risk than the market
beta = 0 = Shares have no risk at all
Security Market Line (SML)
Gives the relationship between Systematic risk & return
2 Relationships:
Risk-Free Security
Carries no risk, beta = 0
Market Portfolio
Ultimate in diversification, only Systematic risk, beta = 1
CAPM
Ri = Rf + beta (Rm - Rf)
Where:
Ri = CAPM
Rf = Risk-free fate of return (Gov bonds)
Rm = Expected return of the market
beta = relevant beta of the investment
Market Premium ( Rm - Rf) = the premium expected by investors for taking on additional risk
Criticisms of CAPM
Single period model, only relevant for a finite period of time
Assumes no transaction costs
Beta calculation based on historical information, may not be relevant
Risk-free rate may change considerably, quickly
Only relevant for a well balanced diversified portfolio
Unable to find beta for unlisted companies, proxy needed
Equity, Business & Financial Risk
To calculate cost of equity and/or WACC must consider entities individual situation
Beta represents systematic risk of entity to market
Level of gearing will impact risk level of entity in relation to market
Highly geared company greater risk than lower geared.
Shares systematic business risk arises out of risky nature of company's operating CF
CAPM outcomes
High expected return indicates investment seems to be riskier
Low expected return indicates investment seems to be less risky
Mergers & Acquisitions
Introduction
Acquisitions: Two business come together with one dominant party
Mergers: Two businesses come together to form a single company
Divestments: Disposing of part of the business
Sell assets & trade
Sale of shares
Transfer of the trade to a new company & set up new company
Demergers: Splitting one part of a business from the rest to form an independently operated company
Causes of Acquisition Failure
Fit/lack of fit syndrome
Lack of industrial / commercial fit
Lack of goal congruence
'Cheap' purchases
Paying too much, don't realise value
Failure to integrate effectively
Reasons for Acquisitions, Mergers & Divestments
Elimnate competition & increase market share
Economies of scale
Cost & management synergies
Financial & Tax synergies
Sales Synergy
Accelerate growth
Asset acquisition
Supply chain improvements
Restriction of competitor supply
Access to new markets
Diversification
Strategies
Horizontal: Acquire a business the as our existing activities
Vertical: Acquire a company in supply chain
Concentric: Acquire a business in a different industry but same customers
Conglomerate: Acquire completely unrelated business
Divestment
Reasons
Focus on core activities
Diseconomies of scale
Lack of resources
Declining market
Risks
Sold below value
Loss of skills / Experience
Shareholder reaction
Possible government intervention
Independent management of activities within a company may be pragmatic
Sell the 'spin-off' divisions / company, releasing funds
Management buy-out (MBO)
Current management team buy it from company
Management buy-in (MBI)
External management team buy company segment
Take-away oversight & deliver better results
Valuation
Bidding Company
Maximise shareholder wealth
Calculate NPV of acquisition
Identify future CF
Consider financing
Assess risk of those CF to establish cost of capital
Discount future CF to PV = maximum amount invested
Aim to make investment below PV of future CF
CF should include synergies
Bootstrapping
Value the target company based on it adopting the acquirers characteristics
Only possible if purchaser is listed, transparency & enabling P/E ratio to be applied
Assumes acquired company is expansion of acquirer irrespective of differences
Risk of double counting
Premium for control
Additional value placed on market share to express the gaining of control
Target company share price will usually increase 20 - 30%
Valuation of debt
Debt has a market / fair value different to book value
When calculating WACC target value is used
Valuation using FCF = Total company value minus debt = Total equity
Buyer takes on debt liability
Debt valuation = discounted CF
Future CF of loan capital are known
Interest payable (coupon rate)
Amount redeemed at end of term
Timings written into debt instrument
Dscount rate applied consisting of:
Annual spot rate yield on gov bonds (RFR)
Credit spread for companies for different credit ratings
Impact of Mergers & Acquisitions on stakeholders
Synergy, maximising shareholder wealth
Premium paid to shareholders of target company for acquisition
Debt possibly repayable upon change of control
Possible need to source new financing, under relative rates for new company's risk profile
Possibility duplication of management roles
Competition laws can prevent
Process
Types of consideration
Cash
Bidding company uses existing cash surplus and / or raises cash from borrowings or a share issue
Bidder
Advantages
No dilution of control
Simple if target is small
Disadvantages
Buyer-owner manages may result in manager leaving post acq
Shareholders bear all the risk
Target
Advantages
Value of bid is fixed
Disadvantages
Shareholders lose interest/involvement
Dilution of existing control
Share-for-share
Bidding company issues new shares
Swaps old company chares for new company shares
Bidder
Advantage
No cash is used
Risks shared with target company
Disadvantages
Generous offer to mitigate share price variations
Dilution of existing control
Target
Advantages
Shares received can be sold if company is listed
Share in future growth
Disadvantages
If not listed, difficult to sell / exit
Considerations
Liquidity
Certainty
Dilution of control
Gearing
Taxation
Loan Stock
Target company shares are cancelled
Target company shareholders receive loan stock in combined business
Entitlement to receive interest each year before loan stock redeemed or converted
Bidder
Advantages
No need for use of cash
Any cash payment can be deferred by convertible stock
Delay / avoid dilution
Known future payments
Disadvantages
Increased gearing ratio
Plan for sufficient cash to redeem debt at some point
Target
Advantages
If listed holders of stock can decide when / how to sell
Can benefit from acquisition success
Disadvantages
If not listed, little flexibility
Defence against takeover
Boards responsibility to consider whether it is shareholders best interest & inform them
If undervalued they must reject or put in place counter proposal
Should not interefere
Pre-bid defences
Communicate effectively with shareholders
Revalue non-current assets
Poison Pill
Crown Jewel
Changes articles of association to require 'super majority' approval of takeover
Post-bid defences
Appeal to their own shareholders
Attack the bidder
White Knight
Counterbid (Pacman defence)
Refer the bid to competition authorities
Value realisation
Price / Earnings Multiple
P/E rises after the merger as the market uses the P/E of acquirer
A.K.A. bootstrapping effect
Alternatively a weighted P/E could also be calculated
Realising the benefits from the acquisition
Overpaying
Over-estimation of benefits or wanting to ensure ccompletion
Failure to identify value
Failure to play for integration of businesses
Must apply plans laid out in the valuation to realise value
Failure to manage value
Culture integration
Staff communication
Focus on existing business & customers
Strong leadership
If bootstrapping, more difficult to deliver value
Agency Issues
Senior leadership (board) may not have skills to manage merger
No conflict between the principals (shareholder) & Agents (board)
Conflict of interest
Overt actions
Clearly acting in their own interest
Agent bias
Subjective possibly subconscious bias, influences an outcome impacting the principal
Challenges in delivering value
Aim to achieve synergistic value through business combination
Limiting operational risk & implementing integration plan
Synergies create value through economies of scale
Cross selling products
External Growth
Market share
Gaining transformational value requires intense management / commitment to transform processes & systems
Approach for post-acquisition action plan
Identifying & Quantifying synergies
Protecting & maintaining the core business that existed pre-merger
Thoughtfully attempting to achieve economiess of scale & improved efficiencies to capture synergies
Selectively implementing transformational synergies aimed at radically transforming:
Processes
Systems
Business functions
Other Contexts of valuation
Stock market listing
Positive
Availability to capital investors
Asset creation of company stock liquidity
Higher profile / better credibility to obtain debt finance
Opportunity to incentivise staff through stock
Founders can realise profit with control loss
Negative
High costs of IPO & ongoing compliance
Ability to deal with new investors
Current shareholder control / influence
Reverse Takeover
Private company purchases chares to take control publicly
Share in public company are swapped for shares in private company
Non-trading public company then becomes the vehicle for new share listings
Venture Capital (Risk Capital)
Targeting liquidity event in 5-7 yrs
Provide funding that laws may not permit banks to allow new businesses
Positive
Business expertise
New connections
Additional resource / support
Patient money
Focus on growth, not continual financing
Better performance
Negative
Loss of control
Potential minority ownership
Forced management change
All in or nothing
Considerations
Open to external input?
Live with the cost of ownership & control loss
Appreciate additional expertise / resources
Gain from VC connections
VC Rejection reasons
More traction & market demand
Competing portfolio company
Too late for the trend
Too early for the market
Too expensive
Unsure on the business / proposition
Private Equity (PE)
Investment management providing financial backing & makes investment to companies
Borrow money to invest, aim of selling for a profit
Types
Leverage buyouts: underperforming / cheap made profitable & sold
Capital: Purchases smaller stakes for longer term growth
Mezzanine financing: High risk / interest, close financing gap / bridging
Features
Investment last 5-7 year
Exit Strategies:
IPO
Strategic Sale
Secondary buyout
Costs
Smaller than VC but still high
Annual management fee & Roughly 20% profit
Ability to achieve high returns
Time-based & Aggressive incentives
Aggressive use of debt
Determined focus on CF & margins
Independance from public company regulations
Focus on improving EBITDA
PE Considerations for taking on a company
Senior management capabilities
Clear strategic vision
Roadmap to eliminate threats
Systems & controls in place
Overall industry characteristics
Growth prospects
Reliability of revenue base
Cost reduction ability
Ability to apply synergies
Company considerations when taking on PE
Do you trust them
Positive track record
Deploy the right type of capital
Does investment size align with the business
Can future goals be met
Comfortable with source of funds
Understand PE firms management style
Comfortable with PE oversight requirements
Provide - value added capabilities
Aligned on business plan
Track record
Can you work with them?
Positives
Active involvement
Increased financial rewards
Operational value creation
More autonomy & less bureaucracy
Access to capital
Negatives
Dilution / Loss of control
Loss of management control
Reduced Job security
Always for sale
Increased debt
Different definitions of value