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 Amt Assets Amt

Equity share capital of 100000 Goodwill 20000

Rs 10 each Plant and machinery 100000

General reserve 50000 Stock 40000

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Creditors 60000 Debtors 50000

Tax payable 30000 Cash at bank 30000

Total 240000 Total 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 85000

Stock 40000

Debtors 45000

Cash at bank 30000

Less:

Creditors (60000)

Tax payable (30000)

Net worth (Rs.) 110000

No. of shares 10000

Value per share (Rs/share) 11

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.) = 225000

No. of equity share = 10000

Earning Per share (Rs/share) = 22.5

Normal Return on Investment = 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 market-
return 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 - Dividend

Ke - 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 target-
business, 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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