Chapter 8 Business valuation Flashcards
1.1 Organic growth vs growth by acquisition
Organic growth is achieved through internally generated projects whether funded with retained earnings or new finance. The advantages over acquisition includes spreading costs and no disruption. Disadvantages include risk, slower and barriers.
In an acquisition, a bidder company acquires a target company either entirely or by buying enough shares to exercise control.
Advantages of acquisition include synergy, risk reduction, reduced competition and vertical protection. An acquisition may be considered successful if it increases shareholder wealth. So if the additional cash flows exceed the cost of acquisition and/or overall risk is reduced. The disadvantages is the synergy is not automatic (must be pursued), restructuring costs following the acquisition may be significant and buying company may end up paying more in terms of price and fees than it gains in synergistic benefits.
2.1 Valuation
The price has many factors include how desperate is the seller to sell, how desperate is the buyer to buy, if the company is listed (share price value), is the consideration in cash or shares and is the purchase of a controlling interest. There are two main numerical approaches to valuing a business:
- Asset based approach: value business is dependent on the assets it owns
- Income based approaches: value business dependent on income that the business is likely to generate in the future
2.2 Asset based approach to valuation
Starting point is the net tangible assets of a company divided by the number of shares (historic). This is adjusted as it is based on historic cost rather than market value (revalued). The adjustment is done by using net realisable value (cash that would be generated from selling all the assets in the business – minimum price for seller) or replacement cost (cost of setting an equivalent business up from scratch – maximum price for a buyer).
The problem with the approach is the value of intangibles not included on the balance sheet will be missed (staff, brand value etc). A digital asset is stored electronically and provides value for the company. Valuing digital since value is only generated if the assets are well managed.
2.3 Income based approaches
There are three techniques that differ only in what is taken as the future income stream. The income can be viewed as dividends, earnings and cash flows.
Dividend approach: used for valuing a minority interest, therefore income will depend on the dividends that the company is likely to pay out. The value is the present value of the future expected dividend payments discounted at Ke. If the dividends are expected to grow by a constant rate in perpetuity, then:
PV = d1 x (1/Ke-g), or d0 (1 + g) x 1/(Ke – g)
A more simplistic valuation is achieved using the yield: Yield = dividend / price
The problems with this is estimating future dividends, finding similar listed companies and if Ke is estimated by using the CAPM, or looking at other quoted companies, then a private company valuation will need to be adjusted downwards to reflect the lack of marketability.
Earnings based approach: used to value controlling interests, the investor can control dividend policy and can extract all of the earnings from the company. There are two key method for earnings based valuations and both are a multiple of the relevant earnings for an investor.
Problems with valuation is if earnings are erratic then the latest figure is misleading, accounting policies can be used to manipulate earnings figures, finding appropriately similar listed companies and a private company valuation will need to be adjusted downwards to reflect the lack of marketability.
PE multiple valuation: Equity value = earnings x PE ratio
- Earnings are taken as profit after tax and preference dividends, but before ordinary dividends
- The PE ratio is generally found by looking at the PE ratios of a range of similar listed companies
- A high PE ratio implies a high level of investor confidence that earnings will grow strongly
- A low PE ratio implies the opposite; therefore, it is important to select a PE ratio from listed companies that have similar growth expectations to the target
EBITDA multiple: Enterprise value = EBITDA x EBITDA multiple
This gives the enterprise value, rather than just equity value. Enterprise value is the MV of equity, preference shares, minority interest and debt less cash and cash equivalents. If we look at the MV of equity, we need to deduct the MV of other types of finance and add back cash and cash equivalents.
EBITDA is earnings before interest, tax, depreciation and amortisation. The EBITDA multiple is enterprise value / EBITDA. The multiple indicates how long it would take for an acquisition to earn enough to pay its cost. A high valued company will have a high multiple
Cash flow based approach: used to value controlling interests, calculated by estimating post-tax operating cash flows of the target company. The value calculated will be value of equity and debt, therefore the MV of debt needs to be deducted to give the equity value. Therefore the value is calculated as:
PV of cash flows to infinity, discounted at WACC less MV of debt.
Issues is it is difficult to estimate the future of cash flows and the relevant discount rate. A common way to estimate cash flow to infinity is use estimates of the seven value drivers of a shareholder value analysis. The drivers are estimated for the competitive advantage period (3-5 years normally), then an assumption is made about cash flows from that point to infinity.
2.4 Valuation of start-ups and technology companies
Can be complicated due to volume to digital assets, no profits and unknown competition. Possible approaches include:
- Asset method: difficult as tangible asset value may not be high. Value can be assessed by estimating how much it would cost an investor to create the assets from scratch
- Earnings method: not suitable, may be no earnings in early years
- Dividend method: unlikely a dividend will be paid, not appropriate
- Market multiples: possible to use ratios on other valuations of similar companies. It may be difficult to find a similar company however
- Discounted cash flow: most valid approach, different cash flows could be modelled based on companies with a similar business model. Cash flows should be discounted at a risk adjusted discount rate
3.1 Methods of payment
Can pay shareholders in either:
- Cash: advantage is buyer gets full control as well as entitlement to future profits, and the seller may prefer the method as they receive an unconditional amount. Disadvantages is the buyer has to obtain the cash, the seller’s expertise may be lost and CGT tax liabilities arise immediately
- Bid company shares: advantage is no need to fund cash, the seller is motivated for the success of the combination and CGT impacts are deferred. Disadvantages is control is diluted and future profits will be shared with the seller
- Loan stock: advantages of cash payment without the need to find immediate finance and the buyer will have to pay interest on the debt until it is redeemed
4.1 Dividend and other forms of restructuring
Subsidiaries may be divested (sold) for a number of reasons including: raising cash, lack of fit, diseconomies of scale and cheaper than liquidation. It may be sold to existing management, an external management team or another established business.
Spin off: shares in subsidiary are given to shareholders of the parent in proportion to their shareholdings. A group of companies are split into two separately held entities and no cash changes hands. Reasons for this include lack of fit, diseconomies of scale and forced division due to a competition commission ruling.
Share repurchase: where a company buys back shares from shareholders, either in proportion to their shareholdings or from a single member. Reasons for a repurchase in proportion to their holdings include reducing level of equity and therefore gearing, to get unused funds back into the hands of the shareholders and to maintain EPS following divestment. Reasons for a repurchase from a single shareholder include providing an exist route for an investor and to take a listed company off the market and back into private ownership.
A debt for equity swap: where creditors give up debt for an equity stake in the company. Tends to happen when company is unable to pay interest or repayment on its debt. Often shareholders lose a significant amount of control as a result.
Liquidation: where company is wound up, and its assets passed out to its shareholders. A company may be forced into liquidation by its creditors if it cannot pay its debts. The shareholders may receive nothing from this situation. Alternatively, a solvent company may be put into liquidation because the shareholders wish to wind up the company and take their money.
