6.

SHARE VALUATION, MERGER AND ACQUISITION

6.1 VALUATION OF SHARES AND BUSINESS

6.1.1 Theories of share valuation

There are three theories of share valuation namely:
a. Fundamental theory
b. Technical theory and
c. Random walk theory

a. Fundamental Theory
Shares have intrinsic values; these values can be calculated using financial data of the
company e.g earnings, cash flow, dividends, net income, etc.

Methods used to calculate share value under fundamental theory includes;

1. Net Assets Basis

2. Dividend Yield Basis
3. The CAPM
4. The Super Profit Method
5. The Dual Capitalization Method
6. The Earnings Basis
7. The Cash Flow Approach
8. The Replacement Cost Method
9. The Net Realization Value Method
10. The Balance Sheet Approach

b. Technical Theory
Believes that share values or prices can be predicted by observing past price movement.
From past price movement one can establish a trend in the movement of share price thus
one can use statistical forecast methods to deduce future price.

c. Random Walk Theory

Believe that neither past price movement no financial data (earnings, dividends, cash flows
etc) can be used to predict future share price. They argue that prices are reflection of
market ideas about the company. The movement of prices is determined by the arrival of
new information about the company. Good information about the company will cause
price to move upward, while bad information will push down the price. Because we have
equal chances of good and bad information, it is not possible to predict the future price of
the share. The price of the share will, therefore, move up and down in the random fashion
depending on the information about the company.

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Efficiencies Market Hypothesis (EMH)

Asset prices (stock prices) reflect all available information:
• markets adjust immediately to new information
• prices incorporate expectations about future

Implication of market efficiency:

If stock market is efficient, then stock prices already reflect all relevant, available
information. So, using the same information to predict future prices will not work.

If future stock prices were predictable.

- You expect price to rise tomorrow.
- Then you buy it today,
- Price rises TODAY.

Stock price today reflects our expectations about future price movements; therefore,
stock prices are close to a “random walk”

There are three major forms of the hypothesis: "weak", "semi-strong", and "strong".
Weak EMH claims that prices on traded assets already reflect all past publicly
available information. Semi-strong EMH claims both that prices reflect all publicly
available information and that prices instantly change to reflect new public
information. Strong EMH additionally claims that prices instantly reflect even hidden
or "insider" information.

Weak form of market efficiency - discussed

In weak-form efficiency, future prices cannot be predicted by analyzing prices from
the past. Excess returns cannot be earned in the long run by using investment strategies
based on historical share prices or other historical data. Technical analysis techniques
will not be able to consistently produce excess returns, though some forms
of fundamental analysis may still provide excess returns. Share prices exhibit
no serial dependencies, meaning that there are no "patterns" to asset prices

Semi-strong form of market efficiency - discussed

In semi-strong-form efficiency, it is implied that share prices adjust to publicly
available new information very rapidly and in an unbiased fashion, such that no excess
returns can be earned by trading on that information. Semi-strong-form efficiency
implies that neither fundamental analysis nor technical analysis techniques will be able
to reliably produce excess returns.

Strong form market efficiency - discussed

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In strong-form efficiency, share prices reflect all information, public and private, and
no one can earn excess returns. If there are legal barriers to private information
becoming public, as with insider trading laws, strong-form efficiency is impossible,
except in the case where the laws are universally ignored

6.1.2 Reasons for Share Valuation

a) For Quoted Companies

These are companies that are listed with the capital market (e.g. CRDB, TOL, TCC, TBL,
TATEPA, Swissport, TOL, Twiga Cement, etc). Shares of these companies are valued when
there is a take over bid and the offer price is an estimated fair value in excess of the current
market prices of the shares.

b) For Unquoted Companies

Unlisted companies, they are not known in the capital market i.e. they are not registered to the
capital market.

Valuation of shares is important for such companies for the following reasons:

- When the company wishes to go public and must fix an issue price for its
shares.

- When there is a scheme of merger and the value of shares for each company in
the merger must be assessed.

- When there is a need to value shares for the purpose of taxation or when share
are pledged as collateral for a loan.

c) For Subsidiary Companies

Valuation is important on the group holding companies in negotiating a sale of a subsidiary to
an outside buyer.

6.1.3 Valuation Methods

1. Dividend Yield Method

Define value of a share by discounting expected future dividends (finding the PV) using cost
of equity (ke) as discounting rate

There are three versions:

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i. Constant Dividend Yield Basis
ii. Constant Dividend Growth Model
iii. The Multi-period Dividend Discount Model

i) Constant Dividend Yield Basis

- Assumes constant dividend (i.e. no growth in dividend, growth rate = 0)
- Gross dividend is used and not dividend net of income tax.

Value of Share = Gross Dividend = D

Cost of equity ke

ii) Constant Dividend Growth Model

Assumes none zero growth rate in dividend, we calculate value of share using the
following formula:

Share Value (Po) = Do (1 + g)

ke - g

Do = Current dividend per share

ke = Cost of equity
g = Growth rate in dividend

ke > g

iii) The Multi-period Dividend Discount Model

Assumes that the dividends are not growing at a constant rate i.e. there are more than
one growth rate in dividends, share value here is calculated in phases depending on the
number of growth rates.

To value a share having for example two growth rates in dividends we use the
following formula;

n ∞

Share Value = Σ Do(1 + gs)t + Σ Dn(1 + gn)t - n

t
t=1 (1 + ke) t=n+1 (1 + ke)t

Where: Do = Current dividend per share

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gs = Dividend growth rate in the first period
gn = Dividend growth rate in the second period
ke = Required return on equity

and,
∞

Σ Dn(1 + gn)t – n = Dn(1 + gn) x 1 n

t=n+1 (1 + ke)t ke – gn (1+ke)

Example:
A firm has just paid its annual dividends of TZS 120/share. Due to the introduction of
new a new product, dividends are expected to grow at 50% per year, over the next 3
years. After that they will slow down and grow at 10% per year for ever. If the
required rate of return on the stock is 15%, what is the theoretical stock price?

2. Super Profit Method

Value of the Firm = Value of Tangible Assets + Goodwill
Goodwill base on super profit (super normal profit)

Super profit = Actual (expected) profit – Normal profit

Normal profit = Value of tangible assets x Required Return

Goodwill then calculated by either discounting the super profit at appropriate discounting rate
or by multiplying super profit by number of years (number of years purchase method).

3. Duo Capitalization Method

Uses the following formula:

Value of Business = Value of Tangible Assets + Value of Intangible Asset

Value of Intangible Assets (VIA)

Obtained by capitalizing the Earnings Attributable to the Intangible Assets by the
return on the intangible assets

VIA = Earnings Attributable to Intangible Assets (EAIA)

Return on Intangible Assets

EAIA = Total Earning – Earnings Attributable to Tangible Assets (EATA)

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4. Statement of Financial Position (Balance Sheet) Method

The method uses statement financial position to value the firm. The value obtained is based on
historical cost. The method is not preferred for valuation as historical costs are not relevant for
decision making. Statement of financial position should not play part in business negotiations
(Mergers or Acquisitions)

5. Net Realizable Value Method

Calculates the cash which the shareholder could get by liquidating the business and therefore
represent the minimum price they would accept.

6. Replacement Cost Method

Values the business by calculating the cost of setting up a similar business as the one under
purchase consideration. The Replacement cost represents the maximum price the purchaser
will be prepared to offer.

7. Net Assets Basis

We divide the net tangible asset attributable to shares by the number of shares in issue to get
the value of the share. Intangible assets e.g. goodwill are excluded from the valuation unless
they have marketable value. The net assets figure is obtained by adding the value of a fixed
asset net of depreciation to the net current asset figure, other claims e.g. from preference
shareholders and debenture holders are subtracted from the net asset figure to get the so called
Net Asset Value of Equity. This figure is divided by the number of shares in issue to get the
value of the share.

8. Earnings Basis
The method uses earnings to value shares as well as firms. Value of a share is determined by
two principle elements, EPS and P/E ratio.

Value of Share = EPS x P/E ratio

Total value of equity = EACS x P/E Ratio

= Price per share x number of shares outstanding

P/E ratio = Price per share

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EPS

= Total Value of Equity

EACS

EPS = Earnings Available to Common Shareholders

Number of Common Shares in Issue

9. Capital Asset Pricing Model

The method is used in conjunction with other methods e.g divided yield basis. CAPM is used
in this case to determine the required rate of return on the shares, this can be determined if the
company is quoted in the stock exchange market. For unquoted companies, financial data of
similar quoted company may be used.

Rj = Rf + (R’m – Rf)βj

Value of the share = Do(1+g)

ke - g

ke = Rf + (R’m - Rf)βj

(Example: Nov. 97 – Qn. 3)

6.2 MERGERS AND ACQUISITIONS

6.2.1 Mergers & Acquisition Defined:

Merger
Occurs when two companies join together to form a new company having a name of one of
the companies or a completely different name. Share holders of old company (ies) become
share holders of a new company.

Acquisitions:
Occurs when one company buys (takeover) another; old (bought) company ceases to exist.

Friendly vs. Hostile Takeovers/Acquisition:

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Friendly Takeover:
In this takeover, before a bidder makes an offer to buy another company, first informs the
company's board of directors. If the board feels that accepting the offer serves shareholders
better than rejecting it, it recommends the offer be accepted by the share holders.

Hostile Takeover
Hostile takeover is a type of acquisition in which, the company being purchased (target
company) does not want to be purchased at all, or does not want to be purchased by a
particular buyer (acquirer) that is making a bid. In other words, the acquired intends to gain
control of the target company and force it to agree to the sale. The word 'hostile' in dictionary
means 'unfriendly, aggressive'.

Why a Hostile Takeover?

The major reason for hostile takeover is financial gain apart from economic and business gain.
The acquiring company may think that the target company can generate more profit in the
future than the selling price. E.g. If a company can make $100 million in profits each year,
then buying that company for $200 million makes sense. That is why it is observed that so
many corporations have subsidiaries that do not have anything in common -- they were
bought purely for financial reasons (Article Source: http://EzineArticles.com/1216445)

Preventing hostile takeover (Poison Pills)

1. Flip-over Strategy
Current shareholders of a targeted firm will have the option to purchase
discounted stock after the potential takeover. The strategy gaves a common stock
dividend in the form of rights to acquire the firm's common stock or preferred
stock under market value. Following a takeover, the rights would "flip over" and allow
the current shareholder to purchase the unfriendly competitor's shares at a discount. If
this tool is exercised, the number of shares held by the unfriendly competitors will
realize dilution and price devaluation.

2. The flip-in Strategy

Is a provision in the target company's corporate charter or bylaws which gives current
shareholders of a targeted company, other than the hostile acquirer, rights to purchase
additional stocks in the targeted company at a discount. These rights to purchase occur
only before a potential takeover, and when the acquirer surpasses a certain threshold
point of obtaining outstanding shares (usually 20 - 50%). If the potential acquirer
triggers a poison pill by accumulating more than the threshold level of shares, it risks
discriminatory dilution in the target company. The threshold level therefore effectively
sets a ceiling on the amount of stock that any shareholder can accumulate before being
required, for practical purposes, to launch a proxy contest.

3. A voting plan Strategy

Also called voting rights plan, is another poison pill that a target firm can issue against
hostile takeover attempts. These plans are implemented when a company
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charters preferred stock with superior voting rights to common shareholders. If an
unfriendly bidder acquired a substantial quantity of the target firm's voting common
stock, it would not be able to exercise control over its purchase. For example, a
company can established a voting plan in which 99% of the company's common
stock would only harness 16.5% of the total voting power.

Other types of takeovers:

Reverse takeover:
Is a type of takeover where a private company acquires a public company.

Backflip takeovers:
Is any sort of takeover in which the acquiring company turns itself into a subsidiary of
the purchased company.

Economic Types of Merger:

Horizontal Merger
Combining two companies in the same line of business. The economies achieved by this
means results primary from eliminating duplicate facilities and offering broader product line
in the hope of increasing total demand.

Vertical Merger
A company expands either forward towards the ultimate consumer or backward toward the
source of raw materials. This type of merger gives the company more control over its
distribution and purchasing.

Conglomerate Merger
Combining two companies in unrelated lines of business (e.g soft drinks & textile business)

6.2.2 Reasons for economic merger / acquisition;

1. Increase in economies of scale – arising from the expansion of business operations,

production per unit falls.
2. Increase in sales/revenues (e.g. Procter & Gamble takeover of Gillette)
3. Strengthening financial position of a new company.
4. Skills and knowledge sharing
5. Increase competitive power against other big companies.
6. Venture into new businesses and markets
7. Increased efficiency as a result of corporate synergies/redundancies (jobs with
overlapping responsibilities can be eliminated, decreasing operating costs)

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6.2.3 Payment Terms in Merger/Acquisition Deals:

1. Share holders of the acquired company (Target Company) may be given cash.
2. Acquiring company may issue shares to the shareholders of the target company.
3. Acquiring company may issue bonds or debentures, to the share holder of the
acquired company. Bond or debenture given may be convertible.
4. Acquiring company may also issue preference shares to the shareholders of Target
Company.
5. Acquiring company may purchase the target company and the payment terms will
be a combination of any of any of the above mentioned terms.

6.2.4 Key issues to consider in merger/acquisition;

1. Number of shares to be issued by the acquiring company to the shareholders of the

target company upon acquisition.
2. Effect of the merger or acquisition on the EPS and price of the share.
3. Effect of the merger or acquisition on the Net Assets Per Share (NAPS).

1. Number of shares to be issued by the acquiring company

Number of shares to be issued = Total value of shares (of target company)

Value per share of acquiring company

Exchange ratio = Number of shares issued: Number of shares of target company

Earnings Basis

P/E Ratio = P
E

Price = P ratio x EPS

E

Total Value = Price per share x Number of Shares in Issue

2. Effect of merger or acquisition on EPS & price of a share

Effect on EPS
Acquiring Company:
Compare earning per share (EPS) before and after the merger or acquisition

EPS before the merger/acquisition = EPSbm/a = Total Earnings

No. of shares in issue

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EPS after merger / acquisition

Two cases:

a) Without Synergy

EPSam/a = Earnings of acquiring + target company

No. of shares issued + shares in issue before merger

b) With Synergy

EPS = Total Earnings after the merger

No. of shares issued + shares in issue before merger

Effect on the Price of the Share

To know the effect of the merger on the price of the share we compare the price of the
share before and after the merger.

Price before the merger may be determined by

Price = P/E ratio x EPS

Price of the share after acquisitions/merger may be calculated as

Price = New P/E Ratio x EPS after merger

New Price/ Earnings Ratio

Is calculated as weighted average of individual P/E ratio, the weights being calculated
based on the earnings of individual companies.

New P/E Ratio = P ratio EA + P ratio EA

E EA + ET E EA + ET
[AC] [TC]

Where: EA = Earnings of acquiring company

ET = Earnings of target company
AC = Acquiring Company
TC = Target Company

3. Effect on merger and acquisition on Net Asset Per Share ( NAPS )

Determined by comparing the Net Assets per share before and after the merger.
Net Asset Per Share before the merger is calculated as follows

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NAPS (before) = Net Assets
Number of shares in issue

NAPS (after) = Net Asset of acquiring company + Net Asset of target company
Total number of shares after merger

6.2.5 Perceived negatives of takeover

1. Goodwill, often paid in excess for the acquisition.

2. Reduced competition and choice for consumers in oligopoly markets. Bad for
consumers, although this is good for the companies involved in the takeover.
3. Likelihood of job cuts.
4. Cultural integration/conflict with new management
5. Hidden liabilities of target entity.
6. The monetary cost to the company.
7. Lack of motivation for employees in the company being bought up.

Example:
Combined Breweries Ltd has a current share price of TZS 5.50 per share and a price-earnings
ratio of 15. At present it has 25 million – TZS 2.50 ordinary shares in issue. Combined
Breweries Ltd is considering the takeover of Associated Breweries Ltd. The current price of
each of associated Breweries Ltd’s 10 million issued shares is TZS 8.25. Associated
Breweries Ltd’s Price/Earnings ratio is 10. Combined Breweries Ltd expects to be able to
purchase the shares at their current price and will pay for them with (an issue of) its own
shares valued at their current price.

Required:
Combined Breweries Ltd wishes to know how many shares to offer for each of
Associated Ltd’s shares, and the effect of the takeover on Combined Breweries Ltd’s
reported earnings per share and share price.

Quote of the term:

Don’t say something is impossible; say what it would take to make it possible.

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