Lecture 7

Mergers and Acquisitions

& Valuation (of a company/shares)

Learning Outcomes

At the end of this lecture you should be able to:

 Distinguish between the different types of M & A

 Discuss the motives behind M & A

 Methods of valuation
Market based
Asset based
Earnings based

Merits of methods
M&A

Forms of strategic alliance

Alternative to organic growth

Involves rapid and dramatic change

Difference:

Merger - joint agreement

Acquisition (or takeover) - target ‘disappears’ and

management replaced
M&A

Merger

 A friendly re-organisation of assets into a new firm

 Mutual agreement of both sets of managers

 Merge shares into new company e.g. a potential new joined company: Just Eat

Takeaway.com N.V. 

 Usually firms of similar size and industry

Takeover/Acquisition

 Acquisition of one company’s share capital by another. E.g. A makes a direct offer to

shareholders of B to gain control. Price usually above market value e.g.

 Santander took over Abbey–latter name disappeared
 HSBC took over Midland – latter name disappeared

 Can be hostile or friendly

Example:

Just Eat & Takeaway.com agree terms on £8.3bn merger

 https://www.theguardian.com/business/2019/jul/29/just-eat-merger-takeawaycom

  In January 2018, Just Eat bought the UK firm HungryHouse.

 Takeaway.com was founded in 2000 and operates in 10 European countries as well

as Israel and Vietnam, but it does not have a presence in the UK. The two
companies have little geographical overlap apart from Switzerland.

 Comparing these two companies customer numbers, orders received, and revenue:
In 2018 Just Eat Takeaway.com

customers 26.3 million 14.1 million

orders 221 million 94 million

revenue £780m €232m

 Information Asymmetry
Announcement Date Just Eat & Takeaway.com agree terms on £8.3bn merger

29 July 2019 According to ‘Investor Chronicles’, Just eat announced a potential merger.
https://www.investorschronicle.co.uk/shares/2019/07/31/just-eat-plans-merger-as-delive
ry-push-dents-margins/

5 Aug. 2019 Recommended all-share combination of Takeaway.com N.V. and Just Eat plc
& Combined Group will be Just Eat Takeaway.com N.V. 
Just Eat Shareholders will be entitled to receive: 0.09744 New Takeaway.com Shares in
exchange for each Just Eat Share
1 Just Eat share = 0.09744 New Takeaway.com share
The terms of the Combination imply a value for Just Eat of 731 pence per Just Eat Share
based on Takeaway.com's closing share price on 26 July 2019 of €83.55. This value
represents a premium of 15% to Just Eat's closing share price on 26 July 2019 (being the
last Business Day before the date on which Takeaway.com and Just Eat announced a
possible all-share combination).

21 Oct. 2019 Just Eat revenue rises as it hopes for £9bn end-of-year merger with Takeaway.com
(from CityAM)

22 Oct. 2019 hostile bid from Prosus, a part of South African conglomerate Naspers, held talks with
Just Eat but, after failing to reach agreement on terms, said it had decided to go directly
to shareholders – a process known as a hostile bid.
29 Oct. 2019 the deal agreed with Takeaway.com in July is no longer viable after the sharp fall in the
value of the Dutch group’s shares. The all-paper offer, under which Just Eat shareholders
would receive 0.09744 new Takeaway.com shares for each Just Eat share they own, was
worth 731p a share at the time it was struck, but that had fallen to 594p on Monday.
Types of M&A

 Horizontal
 same business field
 e.g. Morrisons & Safeway
 Vertical
 expand backward/forward
 different stage of supply chain
 Forward: Brewers and pubs, oil companies and filling stations
 Backward: retailer buying a supplier
 e.g. P&G bought Gillette
 Conglomerate
 unrelated diversification
 e.g. Unilever, Hanson
 https://www.unilever.com/investor-relations/understanding-unile
ver/acquisitions-and-disposals/
Motives

 Three categories
 Economic – synergy
 Financial
 Managerial Motives
Economic - synergy

Concept ‘2 + 2 = 5’- operating synergy

economies of scale

growth /new markets

limit competition/market power & share

acquire knowledge - managerial/technical

product/market extension

risk reduction

speed /learning curve

Financial

 Financial Synergy
 increase debt capacity
 reduce cost of debt & cost of finance overall
 increase liquidity
 stabilise earnings
 Tax effects
 tax-exhausted companies gain benefits by taking over a
company that is not tax exhausted
 Target Undervaluation
 In an efficient market?
 Inside information
 Displace inefficient management

 EPS/PE effect – known as bootstrapping

 If the acquirer has higher PE than the target, it can increase EPS by using share-for-share offer.
 Bootstrapping
example

Firm A
 Earnings = £1m
 10m ordinary shares trading at £2
 EPSA = £1m/10m shares =10p each
 PEA ratio = £2/10p = 20

Firm B
 Earnings = £1m
 10m ordinary shares trading at £1
 EPSB = £1m /10m shares = 10p each
 PEB ratio = £1/10p = 10
 …continued..

 A acquires B
 The offer is 1 share of A for 2 shares of B
 Result: new group - earnings = £2m & 15m issued shares
 10m shares of B bought with 5m of A (new issue)

 New EPS = 13.33p (£2M/15M shares) and if the market

believes that the new entity has the same earnings potential
and growth as Firm A, i.e. a PE ratio of 20 would be applied:
 So share price = EPS x PER = 13.33 x 20 = £2.67
Managerial Motives

 Raising issues of the agency relationship

 Power needs, empire building…
 Executive compensation
Stages and process of acquisition bid

 Firm appoints advisers

 Identify suitable target companies

 Obtain information on these targets

 Value each target company and decide on the maximum purchase price

 Choose the best potential target

 Identify the best way to finance the acquisition

 Select tactics likely to make the bid successful

 Approach the target

 Notify shareholders

 Negotiation

 Recommendation to shareholders
Regulation of Mergers in
UK
 Competition and Markets Authority (CMA).
 a statutory body: formerly The Competition Commission
closed on 1 April 2014.
 reviews all activity that concerned with the outcome of the
merger/takeover
 ensure the deal is in the public interest
 Eg. CMA case in 2017 Just Eat acquired Hungry House
 https://www.gov.uk/cma-cases/just-eat-hungryhouse-
merger-inquiry
 Takeover Panel
 a self-regulatory body
 deal with conduct of the takeover/merger
 City code on behaviour (tactics)
Price to pay?

 Two values emerge…

 Current market value of target
 PV of target co. in new hands

 Price paid needs to be in between ……….to tempt

old shareholders to sell but….

…. Can’t give away all of the benefits….

 If you over pay… whose wealth has increased…

your shareholders?
Financing Method

 Method must be both attractive to target shareholders

and acceptable to acquirer

 Options:
 Cash - Ordinary Shares in Acquirer (bidder) firm
 Loan stocks of Acquirer (bidder) firm
 Combination
 Cash and ordinary shares tend to be the preferred methods
 See appended slides for consequences

 NB: Acquirer will have to take into account the effect on

capital structure
Valuation

 The hardest part…..

 Assessing a firm from the outside….
 Value the firm in your hands…..
 It’s a matter of judgement
 If returns look good …
The risk might be high….

Assets Debt
Equity
Methods of valuation

1. Market valuation

2. Asset based valuation

3. Earnings based valuation

4. Dividend valuation model

5. Discounted cashflow
1 Market valuation

 = Market capitalisation

 = market value of equity

 = No. of issued shares x current SP

 SP’s are always changing in response to market

changes – so value isn’t constant

 Values calculated as such may not reflect the real

value of the company – in a takeover bid the value

rises due to demand, purchasers often over pay….
2 Asset based valuation methods

Three basis can be used:

Net asset value (book value)

 Non-current assets + net current assets – long-term debt
 Uses historic costs, which though factual and available, do not reflect current valuations
 Usually lower limit of a company's value

Replacement cost
 Cost of forming the business from scratch

 Max a purchaser should pay

 If its a ‘going concern’ value should include goodwill

 As goodwill = income based value – tangible assets

Net Realisable value

 Residual value after selling assets, less liquidation costs and other liabilities
 Lower than other values – minimum value
 If income valuations were lower – better ‘closing’
Example – asset basis

Extract of Balance Sheet £000's

Non-current Assets 600
Net Current Assets 50
650

Shares ( £1.00 ) 400

Reserves 100
Loan 150
650

Notes
Intangibles - (goodwill) is estimated at £200,000
The fixed assets are highly specialised and it would cost £800,000 to replace them
but if sold they would only realise £252,000.
 Value – net asset / Book value

Balance Sheet £000’s

Total assets 650
Less loan 150
Shareholder value 500

Value = £500,000
Value per share £500,000 / 400,000 = £ 1.25
Value - Replacement cost

Balance Sheet £000’s

Asset replacement 800

Net current assets 50
Less loan 150
Shareholder value 700

Value per share £700,000 / 400,000 = £ 1.75

But if assume that you will need to spend £200k to establish good will…..

Value = £900,000 /400,000 = £ 2.25

Value – Realisable (liquidation)

Balance Sheet £000’s

Intangible assets 0
Asset disposal 252
Net current assets 50
Less loan 150
Shareholder value 152

Value per share £152,000 / 400,000 = £ 0.38

Asset based valuation methods

 Most likely differs to market capitalisation

 Useful when:

 Firm is being purchased to ‘asset-strip’

 Sold off – hence realisable value is basis

 To establish minimum takeover price

 Bare minimum is usually net asset value
 Revaluing balance sheet is often defence tactic in takeover
 Normal going concern – value at replacement cost
Weaknesses

 Fundamental
 In most cases a firm is bought for the
earnings/cashflow potential of the assets not the
assets themselves..
 Should value what is being purchased –
earnings/cashflow

 Other
 Ignores intangible assets
 Skilled workforce
 Know how
 Strong management team
 Competitive positioning of company’s products
3 Earnings-based valuation – PE ratio

Share value = EPS x PE ratio

Where PE = SP/EPS or MV of firm / total
earnings
Company value
 = PAT (total earnings) x PE ratio
PE ratio represents number of years earnings to
repay the initial investment
Can be applied to non-quoted companies using
proxy company
Example

X plc is trying to calculate an offer price for Y Ltd., an unquoted company,

with 100,000 issued shares and current earnings after tax of £60,000
X shares are currently trading at £2.00 and the latest financial statements
show an EPS of £0.20.
What should X offer for one Y share ?

Answer
X: P/E = SP = £2.00 = 10
EPS £0.20

Estimated market value of Y (Y earnings in X’s hands)

Earningsx P/E ratio
£60,000 x 10 = £600,000

Per share £600,000 = £6.00

100,000
Which PE to use?

There are several possibilities:

Target
Acquirer
Sector average for target/proxy
Weighted average for target and acquirer

Note: we looked at bootstrapping when

acquirers higher PE is applied. A further
example is appended to slides
 Problems with PE ratios

 Often have to use a proxy company which is quoted, to value an

unquoted firm
 Difficult to find a similar company with growth prospects
 Adjustments may be required as:
 Shares in private co. less liquid
 More risky – fewer controls, management etc
 High growth level
 And to earnings – future will change..
 May need to adjust earnings level, eg. Cost savings, change in
directors pay etc
 Tax – EPS part of PE is based on after tax earnings whereas
valuation should reflect prospects..
tax position may differ in your proxy too
4 Dividend valuation model
Also called ‘Gordons Growth model’

• SP0 = PV of future CF stream

= future divs + future disposal value = D1 + D2 + D3 …. + Dn + SPn

• But SPn = Dn+1 Dn+2 …etc

• So SP0 = constant future dividend stream….
• = perpetuity ! Where PV = cashflow/r%

• If Ke = rate of return to shareholder

• Discount dividends at Ke to get PV (SP)
• Simplifies SP0 = div/Ke

SP0 = D0 (1+g)

Ke –g
Example: Co Z pays a dividend of 15p per share

Shareholders require a return (Ke) = 12%

SP = 15p / 12% = 125p = £1.25

5. Discounting cash flow

 Value = PV of future CF stream (as per NPV model)

 Example: R plc are considering purchasing S Ltd.
S is currently making profits of £50,000 per annum.
 The future cash flow excluding the purchase
consideration are:
0 -£ 50,000
1 -£ 40,000
2 £ 80,000
3 £ 100,000
4 £ 150,000
5 £ 150,000

R has a required rate of return of 15%.

What is the maximum R should pay for S Ltd
Value of S

Year Cash Flow D Factor DCF

0 -£ 50,000 1.000 -£ 50,000
1 -£ 40,000 0.870 -£ 34,783
2 £ 80,000 0.756 £ 60,491
3 £ 100,000 0.658 £ 65,752
4 £ 150,000 0.572 £ 85,763
5 £ 150,000 0.497 £ 74,577
£ 201,800

R could pay up to £201,800

and still create wealth for the shareholders
Advantages & disadvantages

 Ups:
 Theoretically best method
 Can value all or part of company

 Downs:
 Relies on estimates of both cashflow & DR
 May be hard to establish
 Time horizon? Hard?
 Value beyond the time horizon set
 Assumes DR, Tax & inflation rate are constant
through the period..
Reading

W & H Ch 11

https://
www.ey.com/en_gl/ccb/21/mergers-acquisitions-t
rend-continues-as-c-suite-builds-optionality-into-
strategic-decisions