M&a Valuation Techniques

-

Merger & Acquisition Valuation Techniques

- Harsh - F - 3 - R. No. 19

TABLE OF COTENTS INTRODUCTION INCOME APPROACH DISCOUNTED CASH FLOW TECHNIQUE FREE CASH FLOW FROM EQUITY TECHNIQUE MARKET APPROACH ASSET APPROACH NET ASSET VALUE TECHNIQUE ECONOMIC VALUE ADDED TECHNIQUE MARKET VALUE ADDED TECHNIQUE CONCLUSION

3 6 7 9 10 11 12 14 15 17

2

A merger is said to occur when two or more business combine into one. This can happen through absorption of an existing company by another. In a consolidation, which is a form of merger, a new company is formed to takeover existing business of two or more companies. In India, mergers are called amalgamations in legal parlance. The acquisition refers to the acquisition of controlling interest in an existing company. A takeover is same as acquisition, except that a takeover has a flavor of hostility in majority of cases. For this reason, the company taken over is usually called the target company and the acquirer is called the predator. The mergers are different from acquisitions in the sense that acquisitions generally do not involve liquidation of the target company. Why Mergers and Acquisitions take place? The common objective of both the parties in a M&A transaction is to seek synergy in operating economies by combining their resources and efforts. Now we shall see the reasons for M&A from the perspective of both, the buyer company as well as the seller company.

Objectives in a M&A transaction?  An opportunity for achieving faster growth

3

 Obtaining tax concessions  Eliminating competition  Achieving diversification with minimum cost  Improving corporate image and business value  Gaining access to management or technical talent Objective for Companies to offer themselves for sale?  Declining earnings and profitability  To raise funds for more promising lines of business  Desire to maximize growth  Give itself the benefit of image of larger company  Lack of adequate management or technical skills M&A under the Companies Act, 1956 The procedure for putting through a M&A transaction under the Companies Act, 1956 is very tedious and a lot of time is consumed in completion of the process. Sections 391 to 396 deal with the procedure, powers of the court and allied matters. “The basic difference between a merger and an acquisition is that the transferor company will be dissolved in case of a merger, whereas in case of acquisition the transferor company continues to exist.” M&A under the Income Tax Act, 1961 Tax implications can be understood from the following three perspectives: a) Tax concessions to the Amalgamated (Buyer) Company b) Tax concessions to the Amalgamating (Seller) Company c) Tax concessions to the shareholders of an Amalgamating Company

Valuation of Target Company

4

The principal incentive for a merger is that the business value of the combined business is expected to be greater than the sum of the independent business values of the merging entities. The difference between the combined value and the sum of the values of individual companies is the synergy gain attributable to the M&A transaction. Hence, Value of acquirer + Stand alone value of Target + Value of Synergy = Combined Value. There is also a cost attached to an acquisition. The cost of acquisition is the price premium paid over the market value plus other costs of integration. Therefore, the net gain is the value of synergy minus premium paid. Suppose VA = Rs. 200 (Merging Company, or Acquirer) VB = Rs. 50 (Merging Company, or Target) VAB = Rs. 300 (Merged or Amalgamated Entity) Therefore, Synergy = VAB – ( VA + VB ) = Rs. 50. If the premium paid for this merger is Rs. 20, Net gain from merger of A and B will be Rs. 30 (i.e. Rs. 50 – Rs. 20). It is this 30, because of which companies merge or acquire. One of the essential steps in M&A is the valuation of the Target Company. Analysts use a wide range of models in practice for measuring the value of the Target firm. These models often make very different assumptions about pricing, but they do share some common characteristics and can be classified in broader terms. There are several advantages to such a classification: it is easier to understand where individual models fit into the bigger picture, why they provide different results and where they have fundamental errors in logic. There are only three approaches to value a business or business interest. However, there are numerous techniques within each one of the approaches that the analysts may 5

consider in performing a valuation. The Approaches and Techniques are as follows: -

Income Approach The Income Approach is one of three major groups of methodologies, called valuation approaches, used by appraisers. It is particularly common in commercial real estate appraisal and in business appraisal. The fundamental math is similar to the methods used for financial valuation, securities analysis, or bond pricing. However, there are some significant and important modifications when used in real estate or business valuation. Under this approach two primary used methods to value a business interest include: a) Discounted Cash flow method b) Capitalized Cash flow method Each of these methods depends on the present value of an enterprise’s future cash flows.

6

Discounted Cash flow Technique The Discounted Cash flow valuation is based upon the notion that the value of an asset is the present value of the expected cash flows on that asset, discounted at a rate that reflects the riskiness of those cash flows. The nature of the cash flows will depend upon the asset, dividends for an equity share, coupons and redemption value for bonds and the post tax cash flows for a project. The Steps involved in valuation under this method are as under: Step I: Estimate free cash flows available to all the suppliers of the capital viz. equity holders, preference investors and the providers of debt. Free Cash Flow = EBIT (1- T) + Depreciation – CAPEX ΔNWC, where: • EBIT is earnings before interest and taxes. • T is the marginal cash (not average) tax rate, which should be inclusive of federal, State and local, and foreign jurisdictional taxes. • Depreciation is noncash operating charges including depreciation, depletion, and Amortization recognized for tax purposes. • CAPEX is capital expenditures for fixed assets. • ΔNWC is the change in net working capital. Step II: Estimate a suitable Discount Rate for acquisition, which is normally represented by weighted average of the costs of all sources of capital, which are based on the market value of each of the components of the capital. 7

WACC = Wd*kd*(1-T) + We*ke , where: • k d is the interest rate on new debt. • ke is the cost of equity capital (see below). • Wd, We are target percentages of debt and equity (using market values of debt and equity.) T is the marginal tax rate. Step III: Cash flows computed in Step I are discounted at the rate arrived at in Step II. Step IV: Estimate the Terminal Value of the business, which is the present value of cash flows occurring after the forecast period. TV = CFt (1+ g) , k-g where, CFt is the cash flow in last year, g is constant growth rate and k is the discount rate Step V: Add the present value of free cash flows as arrived at in Step III and the Terminal Value as arrived at in Step IV. This will give the value of firm. Step VI: Subtract the value of debt and other obligations assumed by the acquirer to arrive at the value of equity. So, in all Terminal Value is,

8

FCFE Technique (Free Cash Flow From Equity) The Capitalized Cash flow technique of income approach is the abbreviated version of Discounted Cash flow technique where the growth rate (g) and the discount rate (k) are assumed to remain constant in perpetuity. This model is represented as under: Value of Firm = Net Cash flow in year one (k–g)

9

Market Approach The origin of market approach of business valuation is established in the economic rationale of competition. It states that in case of a free market, the demand and supply effects direct the value of business properties to a particular balance. The purchasers are not ready to pay higher amounts for the business and the vendors are not ready to receive any amount, which is lower in comparison to the value of a corresponding commercial entity. It the value of a firm by performing a comparison between the firms concerned with organizations in the similar location, of equal volume or operating in the similar sector. It has a large number of resemblances with the comparable sales technique, which is generally utilized in case of real estate estimation. The market value of shares of companies that are traded publicly and are involved in identical commercial activities may be a logical signal of the value of commercial operation. In this case the company shares are bought and sold in an open and free market. This process allows purposeful comparison of the market value of shares. The problem exists in distinguishing public companies, which are adequately corresponding to the company concerned for this intention. In addition, in case of a private company, the liquidity of the equity is lower (put differently, its shares are difficult to trade) in comparison to a public company. The value is regarded as somewhat lesser in comparison to that a market-based valuation will render. E.g. - Suppose a company operating in the same industry as ABC with comparable size and other situations has been sold at Rs. 500 crores in last week provides a good measurement for valuation of business. Considering the circumstances, 10

value of the business of ABC should be around Rs. 500 crores under market approach.

Assets Approach The first step in using the assets approach is to obtain a Balance Sheet as close as possible to the valuation date. Each recorded asset including intangible assets must be identified, examined and adjusted to fair market value. Now all liabilities are to be subtracted, again at fair market value, from the value of assets derived as above to reach at the fair market value of equity of the business. It is important to note here that any unrecorded assets or liabilities should also be considered while arriving at the value of business by the assets approach.

11

Net Asset Value Approach Net asset value (NAV) is a term used to describe the value of an entity's assets less the value of its liabilities. The term is most commonly used in relation to open-ended or mutual funds due to the fact that shares of such funds are redeemed at their net asset value. The NAV will usually be below the market price for the following reasons:  The NAV describes the company's current asset and liability position. Investors might believe that the company has significant growth prospects, in which case they would be prepared to pay more for the company than its NAV.  The current value of a company's assets may be higher than the historical financial statements used in the NAV calculation.  Certain assets, such as goodwill (which broadly represents a company's ability to make future profits), are not necessarily included on a balance sheet and so will not appear in an NAV calculation. For valuation purposes it is common to divide net assets by the number of shares in issue to give the net assets per share. This is the value of the assets that belong to each share, in much the same way that PE Ratio measures profit per share. E.g. - One way to calculate NAV is to divide the net worth of the company by the total number of outstanding shares. Say, a company’s share capital is Rs. 100 crores (10 crores shares of Rs. 10 each) and its reserves and surplus is another Rs. 100 crores. Net worth of the company would be Rs. 200 crores (equity and reserves) and NAV would be Rs. 12

20 per share (Rs. outstanding shares).

200 crores

divided

by 10

crores

NAV can also be calculated by adding all the assets, and then subtracting all the outside liabilities from them. This will again boil down to net worth only. One can use any of the two methods to find out NAV. One can compare the NAV with the going market price while taking investment decisions.

13

Economic Value Added (EVA) Approach Economic Value Added or EVA is an estimate of economic profit, which can be determined, among other ways, by making corrective adjustments to GAAP accounting, including deducting the opportunity cost of equity capital. The concept of EVA is in a sense nothing more than the traditional, commonsense idea of "profit," however, the utility of having a separate and more precisely defined term such as EVA or Residual Cash Flow is that it makes a clear separation from dubious accounting adjustments that have enabled businesses such as Enron to report profits while in fact being in the final approach to becoming insolvent. EVA can be measured as Net Operating Profit After Taxes(or NOPAT) less the money cost of capital. EVA is similar to Residual Income (RI), although under some definitions there may be minor technical differences between EVA and RI (for example, adjustments that might be made to NOPAT before it is suitable for the formula below). Another, much older term for economic value added is Residual Cash Flow. In all three cases, money cost of capital refers to the amount of money rather than the proportional cost (% cost of capital). The amortization of goodwill or capitalization of brand advertising and other similar adjustments are the translations that can be made to Economic Profit to make it EVA.

14

MARKET VALUE ADDED APPROACH (MVA) Market Value Added (MVA) is the difference between the current market value of a firm and the capital contributed by investors. If MVA is positive, the firm has added value. If it is negative, the firm has destroyed value. The amount of value added needs to be greater than the firm's investors could have achieved investing in the market portfolio, adjusted for the leverage (beta coefficient) of the firm relative to the market. The formula for MVA is: MVA = V - K Where: MVA is market value added V is the market value of the firm, including the value of the firm's equity and debt K is the capital invested in the firm

The higher the MVA the better it is. A high MVA indicates the company has created substantial wealth for the shareholders. A negative MVA means that the value of management's actions and investments are less than the value of the capital contributed to the company by the 15

capital market (or that wealth and value have been destroyed). MVA is the present value of a series of EVA values. MVA is economically equivalent to the traditional NPV measure of worth for evaluating an after-tax cash flow profile of a project if the cost of capital is used for discounting. None of the above methods is the best or none of them is the worst but each one has its own advantages and viewpoints different from others. All these methods should be used in combinations to arrive at proper valuation of the business.

16

CONCLUSION These aspects, which we talked about in this article, will justify the exchange process in a Merger & Acquisition transaction if they are duly considered and their impact is properly arrived at. Hence their review becomes a prime and critical stage before proceeding with the big deal. These assumptions might not, and probably do not, reflect the actual conditions of the market in which the subject business might be sold. However, these conditions are assumed because they yield a uniform standard of value, after applying generally accepted valuation techniques, which allows meaningful comparison between businesses that are similarly situated. I would also say that no method is Perfect. Every situation demands different approaches to be applied, and quite often more than one approach would be used.

17