VALUATIONS, ACQUISITIONS AND MERGERS

REASONS FOR VALUATIONS

Valuations of businesses and financial assets may be needed for several reasons, eg

 . To establish the terms of takeover bids or mergers;

 . To fix a share price for an initial public offering;
 . For investors to make buy, hold or sell decisions;
 . For capital gains tax or inheritance tax purposes;
 .Where a major shareholder or director wishes to dispose of a large block of shares;
 .When the company needs to raise additional finance.

METHODS OF SHARE VALUATION

The main approaches are:

 . The dividend valuation model or dividend growth model;

 . The discounted cash flow basis;
 . The PE ratio (or earnings yield) basis;
 . The net assets basis;
 . The dividend yield method.

THE DIVIDEND VALUATION MODEL

This method is based upon the fundamental theory of share valuation, whereby a current share
price is taken to reflect the PV of expected future cash flows, discounted at the required rate of
return of the shareholder. In the case of minority shareholders, this would represent the PV to
infinity of the future dividend stream. In the case of majority shareholders, these amounts will be
increased by the PV of synergies achieved as a result of the acquisition.

Example Winter plc

The market expects a rate of return of 20% per annum on ordinary shares in Winter plc, a
company which is expected to pay constant annual dividends of 20c per share.

At what price will the market value the shares?

Example

Marven plc is expected to pay a dividend of 30c per share next year. The market expects
dividends to grow at the rate of 5% per annum and has a required return of 20%.

Estimate the share price.

Page 1 of 12
Example Nelson plc

Nelson plc is just about to pay a dividend of 40c per share. Future dividends are expected to
grow at the rate of 6% per annum. The market’s required return on shares of this risk level is
25%.

What is the cum-div share valuation?

Example Rita plc

Rita plc has just paid a dividend of 15c per share. The market is in general agreement with
directors’ forecasts of 30% growth in earnings and dividends for the next 2 years. Thereafter, a
reasonable estimate is 15% growth in year 3 followed by 6% growth to perpetuity.

The market’s required return on investments of this risk level is 25% per annum.

Estimate the share value.

DISCOUNTED CASH FLOW BASIS

This method is based upon the present value of the free cash flow to equity of an enterprise,
either for a limited time horizon (fifteen years may be regarded as typical) or to infinity.

There are a number of variations in the definition of free cash flow to equity, but it is often
described as follows:

Free cash flow to equity is the cash flow available to a company from operations after interest
expenses, tax, repayment of debt and lease obligations, any changes in working capital and
capital spending on assets needed to continue existing operations (ie replacement capital
expenditure equivalent to economic depreciation)

In theory, this is probably the best method by which to value a company. However it relies on
estimates of cash flows, discount rates, tax rates, inflation rates and the choice of a suitable time
horizon. The notion of using a valuation to infinity is probably unrealistic.

Page 2 of 12
Example Miller Ltd
The predicted free cash flows of Miller Ltd, an all equity company, for its planning horizon,
(which for simplicity is taken to be the next five years) are:
Year Free cash flows
$000
1 150
2 200
3 250
4 375
5 500
A cost of capital of 12% is assumed to represent the systematic risk of the cash flows of Miller
Ltd.
What is the estimated market capitalisation of this company?

Example Monison Ltd

The following data relating to Monison Ltd is expected to continue annually for the foreseeable
future:

$m

Turnover 525

Cost of goods sold, excluding depreciation 315

Distribution costs and administrative expenses, excluding depreciation 36

Capital allowances claimed 46.5

Non-current assets purchased in the year 72

Irredeemable bonds (market value $130) 21

Working capital changes are assumed to be insignificant because of the absence of growth.

Corporation tax rate 30%

Weighted average cost of capital in nominal (ie money) terms 13.3%

Predicted inflation rate 3%

Calculate the estimated equity market capitalisation of this company.

Page 3 of 12
PRICE EARNINGS RATIO BASIS

This income based method is popular for the valuation of majority holdings in a going concern.
It requires the prediction of a maintainable EPS for the company being valued and the use of the
PE ratio of a listed company, whose activities are very similar to those of the business being
valued (proxy) ie

Share value = EPS of company being valued x PE of similar listed company (proxy)

If a similar listed company (pure-play company) is not readily available, it may be appropriate to
use the average PE for the market sector in which the company operates.

It may be necessary to adjust the PE used or the final calculated price, if the company being
valued is an unlisted company, or where the company in question has different risk or different
growth potential from the similar company or constituents of the industry average.

Since an earnings yield is simply a reciprocal of the PE ratio, a valuation on an earnings yield
basis would be as follows:

Share value = EPS of company being valued ÷ earnings yield of similar listed company.

Example Flycatcher Ltd

Flycatcher Ltd wishes to make a takeover bid for the shares of an unlisted company, Mayfly
Ltd. The earnings of Mayfly Ltd over the past five years have been as follows.

2002 $50,000 2005 $71,000

2003 $72,000 2006 $75,000

2004 $68,000

The average P/E ratio of listed companies in the industry in which Mayfly Ltd operates is 10.
Listed companies which are similar in many respects to Mayfly Ltd are:

Bumblebee plc, which has a P/E ratio of 15, but is a company with very good growth prospects;

Wasp plc, which has had a poor profit record for several years, and has a P/E ratio of 7.

What would be a suitable range of valuations for the shares of Mayfly Ltd if P/E ratio of
unlisted company should be adjusted to 70%?

Page 4 of 12
NET ASSETS BASIS

Asset-based valuation models include:

 net book value (balance sheet basis) – largely a meaningless figure, since it is affected by
accounting conventions;
 net realisable value basis – again, not particularly relevant. However, where the break-up
value exceeds income-based valuations, it would be advisable for the proprietor to cease
trading and sell the assets as quickly as possible;
 net replacement cost basis – this represents the current cost of setting up the existing
business. Sadly it totally ignores goodwill, which can only be established by using
income-based valuations.

Example Cactus Ltd

The current balance sheet of Cactus Ltd is as follows:

$ $

Fixed assets

Land and buildings 160,000

Plant and machinery 80,000

Motor vehicles 20,000

Goodwill 20,000

280,000

Current assets

Stocks 80,000

Debtors 60,000

Short-term investments 15,000

Cash 5,000

160,000

440,000

Page 5 of 12
Capital and reserves

Ordinary shares of 50c 80,000

Reserves 140,000

220,000

4.9% preference shares of $1 50,000

270,000

12% debentures 60,000

Deferred taxation 10,000

70,000

Creditors: amounts falling due within one year

Creditors 60,000

Taxation 20,000

Proposed ordinary dividend 20,000

100,000

440,000

What is the value of an ordinary share using the net assets basis?

Page 6 of 12
DIVIDEND YIELD BASIS

This income based method is popular for the valuation of minority holdings in a going concern.
It requires the prediction of a maintainable dividend for the Company being valued and the use
of the dividend yield of a listed company, whose activities are very similar to those of the
business being valued, ie:

Share value = Dividend of the company being valued

Dividend yield of similar listed company

If a similar listed company (pure-play company) is not readily available, it may be appropriate to
use the average dividend yield for the market sector in which the company operates.
It may be necessary to adjust the calculated price if the company being valued is an unlisted
company, or where the company in question has different risk or different growth potential from
the similar company or constituents of the industry average.

Care must be taken to ensure consistency in the treatment of tax credits ie look at the information
given in a question very carefully to establish whether the yields given are net or gross dividend
yields and whether the dividends provided include or exclude related tax credits.

Example Taylor Ltd

Taylor Ltd, which has on issue $500,000 ordinary shares of 25c each, intends to pay a constant
dividend of $360,000 (net) for the foreseeable future. Listed companies within the same industry
sector as Taylor Ltd currently provide a gross dividend yield of 5% p.a. The current rate of tax
credit on gross dividends is 10% (ie 1/9th of net dividend).

Estimate a current share price for Taylor Ltd

VALUATION OF DEBT AND PREFERENCE SHARES

Irredeemable debt

Example Koren plc

Koren plc has on issue 7% irredeemable loan stock. The gross return required by investors is 5%
p.a. The corporation tax rate is 30%. Establish the current market value for this stock.

Redeemable loan stock

Example Beattie plc

Beattie plc has issued $1,000,000 of 6% redeemable bonds. Interest payments will be made at the
end of March, June, September and December of each year until redemption occurs on 30 June
2010 at $120 per cent. Bondholders require a gross redemption yield of 1% per quarter.

Page 7 of 12
Calculate the current market value of these bonds at 1 January 2007.

Preference shares

Example Steele Ltd

Steele Ltd has on issue some 9% preference shares of $1 nominal value. Investors require a
return of 12.5% p.a. on these shares.

Estimate the current market price per share.

Convertible debt

The value of a convertible cannot fall below its value as debt, but upside potential exists due to
the possibility of an increase in the share price prior to expiry of the conversion period.

Therefore the theoretical value of a convertible (known as its “formula value”) is the greater of
its value as debt and its value as shares ie its conversion value. In practice the actual price of
convertibles will tend to trade at a value in excess of formula value, reflecting so called “time
value” ie the possibility that the share price could rise prior to expiry of the conversion period.

Example Kora plc

Kora plc has 11% convertible loan notes on issue. Each $100 unit may be converted at any time
up to the date of expiry (in seven years time) into 15 fully paid ordinary shares in Kora plc. Any
loan notes which remain outstanding at the end of the seven year period are to be redeemed at
$120 per cent.

Loan note holders normally require a yield of 9% p.a. on seven year debt.

Recommend whether investors should convert, if the current share price is:

(a) $7.00, or

(b) $8.00, or

(c) $9.00.

Page 8 of 12
THE THREE ACQUISITION TYPES

Type I acquisitions

These are acquisitions that do not disturb the acquirer’s exposure to either business risk or
financial risk. In theory, the value of the acquired company, and hence the maximum amount that
should be paid for it, is the Present Value of the future cash flows of the target business
discounted at the WACC of the acquirer. The valuation techniques already considered would
deal adequately with this type of business combination.

Type II acquisitions

These are acquisitions which do not disturb the exposure to business risk, but do impact upon the
acquirer’s exposure to financial risk, eg through changing the gearing levels of the acquirer. Such
acquisitions may be valued using the Adjusted Present Value (APV) technique by discounting
the Free Cash Flows of the acquiree using an ungeared cost of equity and then adjusting for the
tax shield.

Example Heincarl plc

The directors of Heincarl plc are considering the acquisition of Newscot Ltd, an unlisted
company. The shareholders of Newscot Ltd are willing to sell the business on 1st January 2009
for $500 million. From the perspective of the directors of Heincarl plc, the projections of the
performance of Newscot Ltd are as follows:

Current

year Projections during planning horizon (years)

2008 2009 2010 2011 2012 2013 2014

$m $m $m $m $m $m $m

EBITDA 117.00 138.70 162.57 188.83 217.71 249.48 251.48

Depreciation
&
amortisation (40.00) (42.00) (44.00) (46.00) (48.00) (50.00) (52.00)
EBIT 77.00 96.70 118.57 142.83 169.71 199.48 199.48

Interest charges - (32.00) (26.88) (20.19) (11.73) (1.28) -

Profit before tax 77.00 64.70 91.69 122.64 157.98 198.20 199.48

The assumed rate of corporation tax is 35% p.a. The terminal value of the investment is treated
as a constant perpetuity equal to the free cash flows for the year 2014. The risk free rate of
interest is assumed to be 6% p.a., the return on a market portfolio is taken to be 13.5%, whilst an
asset beta of 1.1 is used for purposes of the appraisal.

Page 9 of 12
Annual capital expenditure from 2008 onwards is estimated at $20 million each year indefinitely.
Newscot Ltd currently has on issue $400 million of 8% debt and it is intended that all available
cash flows should be applied to repaying this debt at the earliest opportunity.

Advise the directors of Heincarl plc whether to proceed with the acquisition.

Type III acquisitions

These are acquisitions that impact upon the acquirer’s exposure to both business risk and
financial risk. In order to estimate WACC there is a need to establish the cost of capital of the
combined businesses. However, the Ke of the combination is dependent upon the price paid for
the equity capital of the target, but it is impossible to establish the price to be paid until the value
of the target is determined.

Example Edwards plc (Self practice question)

Edwards plc is considering the acquisition of a 100% stake in Colman Ltd in order to achieve
backward vertical integration. Considerable savings are anticipated due to the combination of
both the marketing operations and distribution networks of the two companies. Therefore
synergies will arise to create cash flows which are in excess of the current estimated cash flows
of the two separate companies. Upon the acquisition of Colman Ltd, Edwards plc will
immediately sell one of the warehouses of the target company, providing instant cash inflows of
$5 million.

The forecast cash inflows of the merged businesses are as follows:

Year $ millions Year $ millions

2008 (proceeds from warehouse sale) 5.00 2014 92.32

2009 60.00 2015 100.63

2010 65.40 2016 109.68

2011 71.29 2017 119.55

2012 77.70 2018 130.29

2013 84.69 Terminal value 2,396.84

The forecast rate of corporation tax is expected to remain at 30%. The risk free rate of interest is
to be taken at 5% and the expected return on a market portfolio is 9%.

Page 10 of 12
Information currently relating to the two companies is as follows:

Edwards plc Colman Ltd

$m $m

Market values:

Debt 100 20

Equity 900 280

Total 1,000 300

ß asset 0.9 2.4

Cost of debt 7% 7%

Edwards plc plans to make a cash offer of $380 million for the purchase of the entire share
capital of Colman Ltd. This cash offer will be funded by additional borrowings undertaken by
Edwards plc.

Advise the directors of Edwards plc whether to proceed with the acquisition.

Page 11 of 12
HIGH GROWTH START-UPS

The valuation of Start-ups create additional problems to that of well established businesses. This
may be due to:

 . their lack of a proven track record,

 . initial on-going losses,
 . untested products with little market acceptance,
 . little market presence,
 . unknown competition,
 . high development costs, and
 . inexperienced managers with over-ambitious expectations of the future.

The valuation procedures depend upon the reasonableness of financial projections, the length of
the period chosen for long-term projections and the selection of future growth rates. The growth
in earnings may be forecast using Gordon’s growth approximation ie g = br, where normally b =
1, since all profits made are likely to be reinvested into the business. Therefore the sole
determinant of growth is the measure of “r”.

The decision as to growth expectations is rather critical as shown in the following illustration:

Example Bednar plc

Bednar plc anticipates costs of $1,200 million in the coming year, thereafter growing at a rate of
4% per annum. The anticipated revenues for that year are expected to be $320 million. The
company expects to achieve a return on reinvested funds of between 16% and 18% per annum.
Furthermore the directors of Bednar plc do not anticipate the payment of any dividends for the
foreseeable future.

Using a cost of equity of 20% p.a., produce a valuation for Bednar plc based upon both the
maximum and the minimum growth rate predictions, using the Growth Model combined with
Gordon’s growth approximation.

NB
g = br
where g is the annual growth rate in dividends
b is the proportion of profits that are retained
r is the rate of return on new investments

Page 12 of 12