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Valuation Methods Used In Mergers & Acquisition Roshankumar S Pimpalkarroshankumar.2007@rediffmail.com
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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 notreadily available, so we need to determine the value of shares of such companies, but this isnot the case with the listed companies. The price of share of a listed company is alreadyavailable on the stock market. Then why do we need to calculate the value of shares orbusiness 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 flowsAssets Based ValuationThe book value of a firm is based on the balance sheet value of owners equity or in otherwords Assets minus liabilities. For assets value to be useful, the target company shouldhave followed a regular depreciation, replacement and revaluation policy. The reasons forusing 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 firms 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 LtdLiabilities Amt Assets AmtEquity share capital of 100000 Goodwill 20000Rs 10 each Plant and machinery 100000General reserve 50000 Stock 40000roshankumar.2007@rediffmail.com
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Creditors 60000 Debtors 50000Tax payable 30000 Cash at bank 30000Total 240000 Total 240000Goodwill is worth nothing. Plant and machinery is valued at Rs 85000. Sundry debtorsdeclared insolvent owed Rs 5000. Compute value per share.Solution:Calculation of net worthGoodwill -Plant and machinery 85000Stock 40000Debtors 45000Cash at bank 30000Less:Creditors (60000)Tax payable (30000)Net worth (Rs.) 110000No. of shares 10000Value per share (Rs/share) 11Earnings based ValuationThere are two methods here. Capitalization of earnings and PE based value.Capitalization of EarningsExample:Profit available for equity shareholders(Rs.) = 225000No. of equity share = 10000Earning Per share (Rs/share) = 22.5Normal Return on Investment = 16%roshankumar.2007@rediffmail.com
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Value per share (22.5/16%) = Rs 140.625 per sharePE based valuation The market value of equity share is the product of "Earning per share (EPS) " and the "PriceEarnings Ratio". According to this approach the value of the prospective acquisition dependson the impact of the merger on the EPS. There could either be positive impact or a dilutiveimpact. 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 thetransaction undesirable. However the prevailing PE in the market may not always befeasible. Some aspects that will influence the valuers 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 drivenA 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 costfigures. ROCE computed on current cost basis is more meaningful than historical cost basis.Dividend Based ValuationQuite often, the amount of dividend paid is taken as the base for deriving the value of ashare. The value on the basis of the dividend can be calculated asNo growth in Dividends S = D1/Ke where, S - Current share priceroshankumar.2007@rediffmail.com
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D1 - Dividend Ke - cost of equityConstant Growth in Dividends S = [Do(1+g)] / (Ke-g) where, Do - Dividend of last year g - Expected growth rateCAPM based valuationThe Capital Asset pricing model can be used to value the shares. This method is usefulwhen we need to estimate the price for initial listing in the stock exchange. The crux of thismodel is to arrive at the cost of the equity and then use it as the capitalization of dividend orearning 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 modelFree cash flow model facilitates estimating the maximum worthwhile price that one may payfor 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 merelythe additional investments required to maintain growth, but also the tie-up of funds needed tomeet incremental working capital requirements. Under this model value of the firm isestimated 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..roshankumar.2007@rediffmail.com
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However while estimating future cash flows, the sensitivity of cash flows to various factorsshould also be considered.Fair ValueInstead of placing reliance on a single method, it preferable to base our valuation on theaverage of results of two or three types discussed above. Normally fair value is ascertainedas the average of net asset value (NAV) per share and the capitalized value of earnings pershare (EPS). This particular method is also known as Berliner Method.roshankumar.2007@rediffmail.com
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