Finance Notes Valuation of Merger and Acuquisition

1. Valuation Methods
Used In Mergers &
Acquisition

2. Need for valuing shares (or business)
As far as unlisted companies are concerned the price of shares of such
company is not readily available, so we need to determine the value of
shares of such companies, but this is not the case with the listed
companies.The price of share of a listed company is already available on
the stock market. Then why do we need to calculate the value of shares
or business 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 flows
Assets Based Valuation
The book value of a firm is based on the balance sheet value of owner's
equity or in other words Assets minus liabilities. For assets value to be
useful, the target company should have followed a regular depreciation,
replacement and revaluation policy. The reasons for using this method
are
 It can be used as a starting point to be compared and
complemented byother analysis
 Where large investment in fixed assets is required to generate
earnings, the book value could be a critical factor especiallywhere
plant and equipmentare relatively new.
 The study of firm's 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.

3.  Some entities may wish to sell only part of their business. In such
case bookvalue may fall flat.
For example:
Balance sheet of A Ltd
Liabilities Amt Assets
Amt
Equity share capital
of 100000 Goodwill 20000
Rs 10 each Plant and
machinery 100000
General
reserve 50000 Stock 40000
Creditors 60000 Debtors
50000
Tax payable 30000 Cash at
bank 30000
Total 240000 Total
240000
Goodwill is worth nothing. Plant and machinery is valued at Rs 85000.
Sundry debtors declared insolvent owed Rs 5000. Compute value per
share.
Solution:
Calculation of net worth
Goodwill -
Plant and machinery 85000
Stock 40000
Debtors 45000
Cash at bank 30000
Less:

4. Creditors (60000)
Tax payable (30000)
Net worth (Rs.) 110000
No. of shares 10000
Value per share (Rs/share) 11
Earnings based Valuation
There are two methods here. Capitalization of earnings and PE based
value.
Capitalization of Earnings
Example:
Profit available for equity shareholders(Rs.) = 225000
No. of equity share = 10000
Earning Per share (Rs/share) = 22.5
Normal Return on Investment = 16%
Value per share (22.5/16%) = Rs 140.625 per
share
PE based valuation
The market value of equity share is the product of "Earning per share
(EPS) " and the "Price Earnings Ratio". According to this approach the
value of the prospective acquisition depends on the impact of the merger
on the EPS. There could either be positive impact or a dilutive impact.
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 the transaction undesirable. However the
prevailing PE in the market may not always be feasible. Some aspects
that will influence the valuer's choice of PE ratio include:

5.  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 driven
A modifiedmethod 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) Assignweights to the past
capital employed to arrive at weighted average capital
employed
(b) Assignweights to the past profits to arrive at the
weighted average profitafter 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 cost figures. ROCE computed on current costbasis
is more meaningful than historical cost basis.
Dividend Based Valuation
Quite often, the amount of dividend paid is taken as the base for deriving
the value of a share. The value on the basis of the dividend can be
calculated as
No growth in Dividends
S = D1/Ke

6. where,
S - Current share price
D1 - Dividend
Ke - cost of equity
Constant Growth in Dividends
S = [Do(1+g)] / (Ke-g)
where,
Do - Dividend of last year
g - Expected growth rate
CAPM based valuation
The Capital Asset pricing model can be used to value the shares. This
method is useful when we need to estimate the price for initial listing in
the stock exchange. The crux of this model is to arrive at the cost of the
equity and then use it as the capitalization of dividend or earning 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 model

7. Free cash flow modelfacilitates estimating the maximum worthwhile price
that one may pay for 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 merely the additional
investments required to maintain growth, but also the tie-up of funds
needed to meet incremental working capital requirements. Under this
model value of the firm is estimated 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 assumptionthat 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.
However while estimating future cash flows, the sensitivity of cash flows
to various factors should also be considered.
Fair Value
Instead of placing reliance on a single method, it preferable to base our
valuation on the average of results of two or three types discussed above.
Normally fair value is ascertained as the average of net asset value (NAV)
per share and the capitalized value of earnings per share (EPS). This
particular method is also known as Berliner Method.
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