D. Business valuation Flashcards
what is a merger?
the joining together of two or more entities where the entities join together to submerge their separate identities into a new entity
often used even when an acquisition/takeover has actually occurred- it sounds more like a partnership between equals
what is a acquisition/takeover?
when one entity acquires a majority shareholding in another and (usually) submerges the identity of the acquired entity into its own
what is horizontal integration?
when two entities in the same line of business combine. e.g. bank and building society mergers
what is a vertical integration?
acquisition of one entity by another which is at a different level in the chain of supply
what is a conglomerate?
when two entities in unrelated businesses combine
what are the specific reasons for merger/acquisition?
- SYNERGIES
- increase MARKET SHARE/power:price control
- ECONOMIES OF SCALE:total prod costs increase less than output
- COMBINING COMPLEMENTARY NEEDS:small entity merge with larger, more capable
- IMPROVING EFFICIENCY:management, operational improvement to take advantage of lucrative market
- LACK OF PROFITABLE INVESTMENT OPPS:excess cash makes it ideal for acq
- TAX RELIEF:claim tax relief for low profits, merge with more profitable company
- REDUCED COMPETITION:be careful of regulators
- ASSET STRIPPING:predator sells target’s easily separable assets, closes down some operations
- BIG DATA OPPS:amount of knowledge, data and expertise can help develop competitive advantage
what is big data?
large volumes of data beyond the normal processing storage and analysis capacity of typical database application tools
identify repeatable business patterns in this unstructured data
why is big data so important?
- driving innovation by reducing time taken to answer key business questions and therefore make decisions
- gaining competitive advantage
- improving productivity
what is the relevance of Big Data in mergers/acquisitions?
access to larger database
better competitive advantage
what are some questionable reasons for M&A?
DIVERSIFICATION, TO REDUCE RISK
- different type of business could diversify risk for the entities involves but this is irrelevant to the shareholders
- could have performed exactly the same diversification simply by holding shares in both entities
SHARES OF TARGET ENTITY ARE UNDERVALUED
-this would conflict with the efficient markets theory and assumed that the acquirer entity’s management are better at valuing shares than professional inventories in the market place
what is synergy?
two or more entities coming together to produce a result not independently obtainable
what are the 3 sources of synergy?
operating economies
financial synergy
other synergistic effects
for a successful business combination, what should we be looking for in an M&A?
MV of combined company (AB) > MV of A + MV of B
whole is worth more than sum of parts
what are some examples of operating economies?
EOS
- can occur in the production, marketing or finance areas
- horizontal:reduce costs
ECONOMIES OF VERTICAL INTEGRATION
-‘cut out middle man’
COMPLEMENTARY RESOURCES
-e.g. combining R&D company with a company strong in marketing could lead to gains
ELIMINATION OF INEFFICIENCY
-if the victim company is badly managed
what are some examples of financial synergy?
DIVERSIFICATION
- reduces risk even if earning stay the same (i.e. no operating economies
- there could still be an increase in value of the company due to the lower risk
DIVERSIFICATION AND FINANCING
-the variability of operating cash flows may be reduced, which is more attractive to creditors so could lead to cheaper financing
BOOTSTRAPPING
-companies with high P/E ratios are in a good position to acquire other companies as the can impose their high P/E ratios on the victim firm and increase its value
what are some examples of other synergistic effect?
SURPLUS MANAGERIAL TALENT
-acq of inefficient companies is good way to utilise skilled managers
SURPLUS CASH
-acq uses surplus cash if increased dividends are not considered to be appropriate
MARKET POWER
-horizontal combinations may give monopoly power that can increase profitability
SPEED
-far faster than organise growth
how does M&A affect acquiring company’s shareholders?
creation of synergy could benefit them in maximising wealth
how does M&A affect target company’s shareholders?
pay a premium to the shareholders of the target company to encourage them to sell shares
of financial benefit to them when a takeover happens
how does M&A affect lenders/debt holders?
debt often repayable in the even of a change in control
risk profile of the acquirer may be quite different from that of the original borrower an the lender will not wish to become exposed to a higher credit risk
how does M&A affect managers and staff?
redundancies made to generate synergies but bigger combined company may give better career opportunities
may retain higher skilled staff
-may seek assurance and contractual tie-ins to ensure that such people remain with the business for a certain period of time
how does M&A affect society as a whole?
government monitors takeovers carefully to protect public interest
competition law in most countries prevents monopolies being created which might be able to exploit their power to take advantage of customers
what are some reasons that M&As fail?
- synergy does not automatically arise: management issues, IT system integration
- premium paid on acq was too high:shareholder wealth sometimes reduces
- opp cost of the investment could be too high: could give higher returns elsewhere
- cultural clashes between staff
- lack of goal congruence
- ‘cheap’ purchases: higher price than expected in terms of resources, effort
- inability to manage change: unsmooth takeover, difference in systems
what are the tax implications of M&A?
- difference in tax rates and double tax treaties
- group loss relief
- withholding tax
how can companies avoid double taxation?
use OECD model Double Taxation Convention
what is the significance of the OECD model double tax treaty?
- OECD model is used as a guide for double tax treaty
- states which country has right to tax income
what is group loss relief?
members of a group of companies may surrender losses to other profitable group members for corresponding accounting periods
losses surrendered us be set against the claimant company’s taxable total profits of a ‘corresponding’ accounting period
what are the key considerations group loss relief?
tax planning seeks to ensure losses are used within the group to save the most tax. Losses are first set against profits taxed at the highest rate
group relief is only available for losses and profits generated after a company joins a group. It is not possible to have group relief for preacquisition losses or to relief preacquisition profits
group relief ceases to be available once arrangements are in place to sell the shares of a company. This will usually occur sometimes before the actual legal sale of the shares
what is withholding tax?
also called retention tax
government requirement for the payer of an item of income to withhold or deduct tax from the payment and pay that tax to the government
between companies: consider dividends, interest, loans
treated as a payment on account of the recipient’s final tax liability
may be refunded when tax return is filed
who monitors takeovers and mergers on behalf of national governments?
competition authorities
-can block takeover completely or allow ti to proceed after laying down conditions
what is the role of competition authorities?
- to strengthen competition
- to prevent or reduce anti-competitive activities:25%+ of market share
- to consider the public interest e.g. national security, media quality, financial stability i.e. banks
what are investigations performed by competition authorities?
may take several months
give time for defence or abandoning takeover
can accept, or reject proposals
could give extra criteria
what are some examples of competition authorities getting involved with M&As?
Sainsbury’s and ASDA merger investigated
Reduce dominance of Big Four
blocked proposed merger of the LSE and Deutsche Borse (Frankfurt stock exchange)
what is divestment?
disposal of part of its activities by an entity
what are some reasons for divestment?
- sum of parts of the entity may be worth more than the whole
- divesting unwanted or less profitable parts
- to shift the strategic focus onto the core activities
- a response to crisis: need cash quickly
what are the methods of divestment?
sell off (trade sale)
spin off (demerger)
management buy out (MBO)
what is a sell off/trade sale?
sale of part of an entity to a third party usually for cash
what are the most common reasons for a sell-off?
- to divest of a less profitable business unit if an acceptable offer is received
- to protect the rest of the business from takeover:sell most attractive part p the business
- generate cash in time of crisis
what is a spin off/demerge?
a new entity is created where the shared of that new entity are owned by the shareholders of the entity that made the transfer of assets into the new entity
now two entities, each owning some of the assets of the original single entity
ownership not changed and in theory the value of the two individual entities should be the same as the value of the single original entity
what are the reasons for spin-offs?
- they allow investors to identify the true value of a business that was hidden within a large conglomerate
- they should lead to a clearer management structure
- the reduce the risk of a takeover bid for the core entity
- no cash generated
what is an MBO?
purchase of a business from its existing owners by members of the management team, generally in association with a financing institution
how is an MBO different from sell off/spin off?
purchasers is not another company but the existing management
management provide some of the capital for the buyout but the majority is provided by other financiers such as VC and financial institutions
in an MBO, what are some considerations for the divesting company?
- members of the buyout team may possess detailed/confidential knowledge of other parts of the vendor’s business and the vendor will therefore require satisfactory warranties over such aspects which it will not be able to control
- key members of the MBO team may have vital skills to the vendor’s operation, especially in regard to information services and networking
- vendor may be reluctant to allow key players to end their contracts of service to take part in an MBO because losing vital operational skills can hardly be compensated by forms of warranty
LOSS OF HO support and quality of management
what are some considerations before an MBO?
- do the current owners wish to sell?
- potential of the business
- loss of head office support
- quality of the management team
- the price
how are MBOs financed?
the acquiring group usually lacks the financial resources to fund the acquisition, especially for larger buyouts
can use institutions like:
- VCs
- banks
- PR firms
- other financial institutions
what is a leveraged buyout?
when an investor, typically a PE firm, acquired a controlling interest in a company’s equity and where a significant percentage of the purchase price is financed through leverage (borrowing)
involve institutional investors and financial sponsors making large acquisitions without committing all the capital required for the acquisition
what is a venture capitalist?
advance funds for 5-10 years for returns of 25% or more (compounded and received at exit, rather than annually)
take one or more seats on the board of directors (but not a majority)
what are some key points to consider in the role of VCs?
- the form of finance: equity %, controlling stake, debt, convertible shares (debt an equity)
- exit strategy
- ongoing support
why are convertible shares often used in VC funding?
benefit from long term success (can convert to equity) but short term management retains control
-preference shares carry covenants, management don’t retain control
what role for PE firms have in funding?
buy mature companies that are already established: may be deteriorating or slow down in profits
- streamline operations to restore profitability
- buy 100% ownership
what is the difference between PE and VC?
VC: usually invest in start ups, high growth, 50% or less in equity, spread out risk by investing in many
PE: mature, already established companies, sometimes on a decline, 100% ownership, concentrate on one single company
what are the levels of risk/reward in complex capital structures?
SECURED BORROWINGS
-usually obtained from a bank, with a first charge on the assets take over by the venture
SENIOR DEBT
- require security over all the assets involved in the MBO venture
- undertakings from the MBO team regarding the provision of financial information
- restrictions on the MBO’s capacity to raise other debt finance and to dispose of assets
JUNIOR DEBT/ mezzanine finance
-intermediate stage between senior debt and equity finance in relation to both risk and return
VENTURE CAPITAL
EQuitY HOLDING GRANTED TO THE MBO TEAM
-gain when MBO is exited
what does the return on mezzanine finance comprise of?
mixture of debt interest and the ability to convert part of the debt into equity, perhaps by the conversion of warrants
lender can in time have share in the premium resulting from eventual exit from the venture
debt will carry a risk premium as it is subordinate to the senior debt and with less security: may even be unsecured
what are the considerations for the financiers in an MBO?
- what is actually for sale, and why?
- whether activities are profitable and enjoy a satisfactory cash flow
- whether the management is sufficiently strong
- whether price is reasonable and a sufficient contribution is being made by the managers
what are some reasons MBOs might fail?
- bid price offered by the MBO team might be too high
- a lack of experience in key areas such as financial management
- a loss of key staff who either perceive the buyout as too risky or do not have capital to invest
- a lack of finance
- problems in convincing employees and fellow colleagues of the need to change working practices or to accept redundancy
why will debt holders have a clear exit route?
debt finance will normally have a specified repayment date assuming company can afford to repay debt
what is an exit route?
in the MBO, the financiers will be keen to identify a potential exit route at the time the MBO takes place
what is the most common exit route for an equity investor?
sale of the shares to another investor
what are the methods of selling shares to another investor as an exit route?
trade sale
IPO
independent sale to another shareholder (perhaps the managers)
what does trade sale as an exit route involve?
if another company offers to buy all shares, financiers will realise their investment
management would have to sell their shares too
may not be happy to so this as they may rather want to own their own company
what does an IPO as an exit route involve?
sell shares on stock market, shares can be freely traded and can increase in value
also more susceptible to takeover
managers can keep shares
have to satisfy certain, stringent criteria to join stock exchange, significant costs associated with this
what does independent sale to another shareholder as an exit route involve?
managers buyout the other financiers
would be expensive but maintain control if they can afford it
what are the downsides to trade sale?
management may not be happy selling all their shares to bidding company
what are the downsides to an IPO?
-more susceptible to takeover
have to satisfy certain, stringent criteria to join stock exchange, significant costs associated with this
what is forward vertical integration?
where a company makes an acquisition of another business further down the supply chain i.e. closer to the eventual consumer of the product
what is backward vertical integration?
where a company makes an acquisition of another business further up the supply chain i.e. further from the eventual consumer of the product
what is the value of a business affects by?
- reported sales, profits and asset values
- forecast sales, profits and asset values
- type of industry
- level of competition
- range of products sold
- breadth of customer base
- breadth of customer base
- perspective-the buyer and the seller will often have different expectations and hence may value the business differently
how are quoted companies valued?
current stock market share price should be used as a starting point for the calculations (market capitalisation)
not necessarily a definitive final figure
buyer will often have to pay a premium
how are unquoted companies valued?
estimates have to made based on available information taken from similar quoted companies (‘proxy’ companies
irl, hard to find similar quoted company
why is the final estimate price for the valuation of unquoted companies usually discounted 25-35%?
to account for
- relative lack of marketability of unquoted shares-it is more difficult for investors to sell their shares if the company is not listed
- lower levels of scrutiny, therefore greater risk of poor quality financial information
- higher risk of being a smaller, less well-regarded company with, possibly, a more volatile earnings record
what are the 3 basic valuation methods?
asset based valuation
earning based valuation
cash flow based valuation
what is the asset based valuation?
the business’ assets for the basis for the valuation
sum of the value of its assets
when is it difficult to apply the asset based valuation method?
when businesses have high levels of intangible assets
what is the earnings based valuation method?
projected future earnings for a business will give an indication of the value of that business
e.g. higher forecasted earnings mean more attractive to purchaser so valued highly
what is the cash flow based valuation method?
value is equal to the present value of future cash flows, discounted at an appropriate cost of capital
when should each method be used?
- if high intangible assets, dont use asset based (give low valuation as intangibles not included)
- asset based useful when company is being broken up
what deductions/additions are made during asset based valuation?
- deduct borrowings if just equity is being acquired
- don’t deduct borrowings if only the physical and related liabilities are being purchased without acquiring any liability for the borrowings
what are some alternatives to asset based valuation?
book value
- largely a function of depreciation policy
- e.g. written down prematurely and others carried at values above real worth
- not of practical use
replacement value
- useful for buyer
- given estimate of minimum price that would have to be paid to buy the asset and set up a similar business from scratch (esp if intangible value can be added on)
breakup value/net realisable value
- useful for the seller
- considers the amount they would receive if they were to liquidate the business as an alternative to selling the shares
- tradable investments valued at market price
what are the strengths of asset based valuations?
- the valuations are fairly readily available
- they provide a minimum value for the entity
what are the weaknesses of asset based valuations?
- future profitability expectations are ignored
- statement of financial position valuations depend on accounting conventions which may lead to valuations that are very different from market valuations
- it is difficult to allow for the value of intangible assets.
why does asset based valuation method for a listed company give a value below market capitalisation?
doesn’t include the intangibles
so this method is not used by shareholders/the market
shareholders are buying company for potential income, not due to assets
- income generated fro use of SOFP assets with intangible assets like a skilled workforce, strong management team and competitive positioning of firm
- so SOFP if only one dimension of overall value
what is an intangible assets?
- lack physical properties
- represent legal rights or competitive advantages developed or acquired by an owner
- should have some economic benefit
- owners can exploit intangibles either in their own business or through a licence fee or royalty (indirect use)
what are the 4 characteristics of an intangible asset?
identifiability:created and terminated at an identified time
manner of acquisition:can be purchased or developed internally
determinate or indeterminate life:established by law or contract
transferability:can be bought, sold, licensed or rents
what are some examples of intangible assets?
franchises, trademarks, patents, copyrights, goodwill, equities, mineral rights
intellectual capital such as employee knowledge, skills, business training or any proprietary information that may provide the company with a competitive advantage
what is intellectual capital?
intellectual property, intellectual assets and knowledge assets
owned by a business
total stock of capital or knowledge based equity
what does intellectual capital include?
- HR: skills, experience and knowledge of employees. Large bulk of value of service industries
- Intellectual assets:knowledge which is defined and codified such as drawing, computer program or collection of data
- Intellectual property: intellectual assets which can be legally protected such as patens and copyrights
how is branding accounted for?
IP is legally defined and recognised regularly for accounting purposes
internally generated goodwill and branding isn’t recognised in their accounts but is recognised in valuation for acquisition
what are some examples of digital assets?
- websites and apps
- branding
- cryptocurrency
- domain names
why is valuing digital assets complicated?
changing regulations: new phenomenon, need to pay attention to regulatory models that shape development and recognition
usage rights:created in partnership or with third party so ned to consider usage rights, due diligence procedures on these rights
what are the 3 methods of valuing intangible assets?
market approach
cost approach
income approach
what is the market approach valuation method for intangible assets?
comparing an IA to an asset identical/similar to one that has been recently traded in an arm’s length transaction
hard to find comparison, not usually publicly available info if separate asset sale
look for direct market evidence e.g. emission rights, internet domain names
what is the cost approach valuation method for intangible assets?
historical cost easy to identify
direct and meaningful cost approach
e.g. for internally developed software such as websites or apps
ignores amount, timing and duration of future economic benefits, as well as risk of performance within a competitive environment
what is the income approach valuation method for intangible assets?
when the IA is income producing or generates its own cash flow
converts future benefits to a single, discounted amount usually as a result of increased turnover or cost savings
distinguishing the cash flows related to specific IA is difficult
what is the relied from royalty method of valuation?
one of the most common income approach methods
-cost savings from using IA such as trademark or patent are directly estimated
what is the CIV method?
Calculated Intangible Value
- income approach method
- multi-period excess earning model
- estimates value of IAs that do not appear in SOFP
- used alongside basic asset valuation to five more accurate valuation
what comparison is the CIV method based on?
total return that the company is producing against the return that would be expected based on industry average returns on tangible assets
-any additional return is return on IA
what are the drawbacks of the CIV method?
- same as asset valuation method ie. based on historical figures
- assumes growth in income coming from IAs will be constant at the cost of capital
- based on profit rather than cash flow
- based on an industry average return which might not be representative of the company being valued
what is the earnings multiple?
applied to earnings based valuation
number negotiated between buyer and seller or could be a perpetuity factor based on suitable cost of capital
-if based on cost of capital, earnings forecast is being taken as an approximation of cash flow and effectively a discounted cash flow approach is being used
what is the P/E valuation method?
values the equity of a business by applying a suitable P/E ratio to the business’ earnings (PAT)
which earnings figure is used in the P/E valuation method?
starting point: PAT or EPS but this is historic so adjust for -one off items which will not recur -directors salary which might be adjusted after takeover -synergies savings
what is the P/E ratio?
for listed companies:market driven share price divided by EPS
unlisted use proxy P/E ratio
what does the P/E ratio indicate?
market perception of the company’s current position and its future prospects
e.g. is P/E ratio is high, indicates that the company has a relatively high share price compared to its current level of earnings, suggesting that the share price reflects good growth prospects of the company
what is a proxy P/E ratio?
use a P/E for similar company as proxy
used in context of bootstrapping
what are the strengths of P/E method valuations?
- they are commonly used and are well understood
- they are relevant for valuing a controlling interest in an entity
what are the main weaknesses of P/E method valuations?
- the are based on accounting profits rather than cash flows
- it is difficult to identify a suitable P/E ratio, particularly when valuing the shared of an unlisted entity
- it is difficult to establish the relevant level of sustainable earnings
what is the earnings yield?
reciprocal of the P/E ratio
how can we further analyse the earnings yield?
examining the trend of share price over a number of quarters in the light of any events such as profits warnings and acquisitions and the likely effect that they have had on earnings
-stability as important as growth
what is the dividend valuation model theory?
value of the company/share is the PV of the expected future dividends, discounted at the shareholders’ required rate of return
how does the DVM theory link to NPV?
links to NPV, where DCF from a project represented the gain in wealth to shareholders if the project were undertaken-wealth (share value) linked to DCFs
assume all CFs to equity are paid out as dividends, the DVM would therefore give the same result as valuing a company by discounting cash flows to equity at the cost of equity
what did Gordon’s growth model argue?
derives future growth rate rather than extrapolate
argued that in increase in the level of investment by a company will give rise to an increase in future dividends so 2 key elements in determining future dividend growth will be:
- rat of reinvestments by the company
- return generated by the investments
what are the assumptions in Gordon’s growth model?
- the entity must be all equity financed
- retained profits are the only source of additional investment
- a constant proportion of each year’s earnings is retained for reinvestment
- projects financed from retained earnings earn a constant rate or return
what are the strengths of the dividend based valuations?
- value based on the PV of future dividend income stream (cash flow to investor) so the method has a sound theoretical basis
- they are useful for valuing minority shareholdings where the shareholder only receives dividends from the entity, over which he or she has no control
what are the weaknesses of using the dividend valuation model?
- very difficult to forecast dividends and dividend growth especially in perpetuity
- particularly for unquoted companies, can be difficult to estimate the cost of equity
- for unquoted companies, a constant dividend policy with constant growth rate is unlikely
how do we deal with uneven growth rates?
entity’s value can be calculated by doing an NPV calculation of the forecast future dividends, discounted at a cost of equity (Ke)
what principle does the DVM demonstrate?
that a company is worth the sum of its discounted future cash flows
what are the drawbacks of the DVM?
simplistic model
must be applicable to reality
what is the cash flow valuation DCF method?
value of the equity is derived from estimating the future annual after tax cash flows and discounting them at an appropriate cost of capital
best way to value business as shows
what is the best way of valuing a business?
the DCF method as future cash flows show shareholder wealth
how are cash flows to equity similar to post-tax post-financing cash flows?
cash flows to equity include average sustainable levels of capital and working capital new cash flow investments over the longer term rather than this year’s figures
what is free cash flow?
cash generated by the business that is ‘freely’ available for distribution to investors after having met all the intermediate obligations of the business and investment in working capital and in NCAs that is necessary to sustain on-going operations
what is cash flow to equity?
cash flow generated by the company after tax, reinvestment needs and debt-related cash flows i.e. cash flow attributable to equity investors
what is cash flow to all investors?
cash flow generated by the company after tax and reinvestment needs but before debt-related cashflows i.e. cash flow attributable to all investors, both debt and equity investors
what is free cash flow to equity/investors?
sustainable cash flow to equity/investors
under what assumption does the DCF company valuation method give the same result as the DVM valuation method?
that a company pays out all of its cash flow to equity as a dividend, where the CF to equity used in the DCF calc are assumed to grow at a constant rate and the same growth rate is used in the DVM valuation
what is the problem of lack of information in free cash flows?
in project appraisal, the CFs generated from the project are easily identifiable but in a business valuation, they can be harder to identify and quantify as there are so many of them and necessary info is not public
so have to estimate using readily available accounting info
when can cost of equity be used as a discount rate?
used to discount CF to EQUITY in order to value the equity in a company directly
equity/shareholder value=entity value minus debt value
when can WACC be used as a discount rate?
used to discount CF to (before financing charges) when valuing a project. Need to deduct debt to find equity value.
entity value = equity value + debt value
why is the equity valuation method more appropriate for dividends?
they commonly report on a pre-financing basis
do not have their own capital structure and therefore the cost of financing that is required to calculate entity value
what cost of capital do quoted and unquoted companies use?
quoted: easily identifiable through publicly known information
unquoted: lack of info, use a proxy
what are the strengths of the DCF method?
- theoretically the best method of valuation
- used to place a maximum value on the entity
- considers the time value of money
what are the weaknesses of the DCF method?
- difficult to forecast CFs accurately
- difficult to determine an appropriate discount rate
- what time period should we evaluate in detail
- the model assumed that the discount rate and tax rates are constant through the period
- NPV does not evaluate further options that may exist
what must we be careful of when using a proxy cost of capital?
that the business risk and the capital structure of the entity are accurately reflected
-proxy will have different gearing therefore different risk so must be accounted for
what is risk adjusted cost of capital?
adjusting proxy for risk as gearing levels are different so overall risk is different
accounts for any differences in the gearing levels
what is the CAPM?
capital asset pricing model
enables us to calculate the required return from an investment given the level of systematic risk associated with the investment (measured by its beta factor)
-for well-diversified investor who is not subject to unsystematic risk
what is total risk made of?
systematic and unsystematic risk
what is systematic and unsystematic risk?
unsystematic: company specific factors, can be eliminated by diversification e.g. strikes, R&D
systematic risk: general economic factors, cannot be eliminated e.g. recession, exchange rates
what is diversification?
hold portfolio to reduce unsystematic risk
e.g. ice cream and umbrellas-cover both weather
how can unsystematic risk be reduced?
if the investor has approximately 25 well-chosen shares in the portfolio, unsystematic risk will be eliminated
what is the Beta factor?
measure of a share’s volatility in terms of market risk
-illustrated the relationship of an individual security to the market as a whole, or conversely the market return given the return on an individual security
what is the B factor of the market as a whole?
1
what are the 4 categories for B values?
B>1: more systematic risk than market
B=1:same systematic risk as stock market average
B<1:less systematic risk than stock market average
B=0:no risk at all i.e. well-diversfied portfolio
B=0.8:shares have 20% less systematic risk than the average
what is the SML?
security market line
relationship between the systematic risk and return
what are the 2 relationships in SML?
- the risk -free security
- no risk so B=0 - the market portfolio
- ultimate diversification so B=1
how is the market premium calculated in CAPM formula?
difference between Rm and Rf
how are beta factors calculated?
statistically from past observed returns e.g. LBS ‘Risk Measurement Service’ published quarterly using monthly returns from the previous 5 years to calculate each quoted share’s beta
how stable are Beta factors?
more stable for highly diversified shares such as investment trusts for more focused companies
-more stable if company’s systematic risk stays the same i.e. operates in same areas of business over time
what is the most accurate method of calculating beta factors?
statistically more reliable than more separate data so longer period is better
- can be tricky if risk changes with new project
- many businesses use sector average rather than own in this case
what is an ‘abnormal’return?
amount higher or lower than expected
what is the alpha value of a share?
average abnormal return i.e. variance per year
should be 0 in a perfect word
what are the criticisms of the CAPM?
- single period value:only valid for short period, regular recalculation
- beta values are calculated on historical values:capital structure or business risk might change
- CAPM assumes no transaction costs associated with trading securities
- risk free rate may change over time
- CAPM assumes an efficient market where it is possible to diversify away unsystematic risk, and no transaction costs
- the idea that all unsystematic risk is diversified away will not hold true if stocks change in terms of volatility. As stocks change over time it is very likely that the portfolio becomes less than optimal
- assumes all stocks relate to going concerns, this may not be the case
why is the beta factor for a geared company greater than the beta factor for an equivalent ungeared company?
beta factor is measure of risk which is dependent on the level of business risk and the level of financial risk (gearing) associated with an entity
why are shareholders only interested in systematic risk?
they hold a well diversified portfolio
what type of risk do shareholders in a geared company suffer?
business and financial risk
what is business risk?
risk of the operating cash flows
what is financial risk?
increased volatility of dividend payments to shareholders as gearing increases
how does systematic business risk arise?
the risky nature of the company’s business cause by:
- revenue sensitivity
- proportion of fixed to variable production costs
how does systematic financial risk arise?
how the company is financed
-its gearing or capital structure
what are 4 important implications of the degearing and regearing beta factors?
- A company’s equity beta will always be greater than its asset beta, except
- if its all equity financed (and so has no financial risk), when its equity beta and asset beta will be the same
- companies in the same ‘area of business’ (i.e. same business risk) will have the same asset beta but
- companies in the same area of business will not have the same equity beta unless the also happen to have the same capital structure
what are the implications of the Efficient Market Hypothesis (EMH) in business valuation?
share price is a sum of all the known information about a company. As such, the share price is always a ‘fair price’ and a true valuation-a particular share is neither under of over valued at any point in time
without additional info, currently not taken into account by the share price, no investor will be able to ‘beat the market.’ The only way to get higher returns would be to invest in higher risk (higher beta factor) investments
in the weak form of market efficient, what does the share price reflect?
any and all information that can be discerned by past trends in share prices.
- The day traders and other investors who attempt to speculate by studying past trends and predicting future movements will be wasting their time (and money) if markets are weak form efficient.
- if such speculators can foresee movements then their actions will have the effect of updating the share price. The very fact of them, say, buying shares that are going to increase in price will push up the price.
patterns of past trades can be a sign of a future bid
ONLY HISTORIC INFO
in the semi-strong form of market efficient, what does the share price reflect?
the share price will reflect all information that is publicly available
- analysts can analyse this to identify mispriced shares
- could benefit from ability to watch news in real time and respond to events before they become public knowledge
- the reaction will update market and cause flurry as it is a signal
any info that suggests a probability of a bid will affect price
MARKET INCLUDES ALL PUBLIC INFO
in the strong form of market efficient, what does the share price reflect?
share price will reflect all information, even if it has not been made publicly available
- may not seem credible but info can be leaked due to insider trading
- activity suggests person is in the know and price may respond accordingly
- insider trading is illegal but does not stop perpetrators
suggests that share prices could rise because of employee dishonesty which creates a signal
MARKET INCLUDES PUBLIC AND PRIVATE INFO
does EMH mean it is wrong to pay a premium over market price?
not if it is in order to acquire control as bidder is hoping to benefit from an exploitative synergy
EMH suggests that the markets will take the possibility of a future bid into account in setting prices
in which circumstances is asset based methods of valuation most useful?
- when valuing capital intensive businesses with plenty of tangible assets(service based undervalued)
- in times of uncertainty, this approach avoids the need to forecast future earnings or cash flows, so it may be favoured in these circumstances
in which circumstances is DVM valuation most useful?
- when valuing a minority stake, the dividends represent the forecast income from the investment which will impact his wealth
- for majority stake, would be more relevant to consider overall company cash flows or asset values as a basis for the valuation
in which circumstances is P/E method and DCF valuation most useful?
- both based on forecasts of the future, and often use proxy information from proxy companies. There factors may be difficult to identify in practice
- if forecasts are accurate, these methods value the business based on its future prospects, so automatically include a measure of the GW/IAs associated with the business
- for service businesses, this method is preferred
what pre-bid defences should a board of directors consider if they decide to fight a bid that appears to be financially attractive to their shareholders?
- communicate effectively with shareholders
- revalue non-current assets
- Poison pill
- Change the Articles of Association to require ‘super majority’ approval for a takeover
what post-bid defences should a board of directors consider if they decide to fight a bid that appears to be financially attractive to their shareholders?
- Appeal to their own shareholders
- Attack the bidder
- White Knight
- Counterbid-sometimes called a ‘Pacman’ defence
- Refer the bid to the Competition authorities
what are the following takeover defences:
- communicate effectively with shareholders
- revalue non-current assets
- Poison pill
- Change the Articles of Association to require ‘super majority’ approval for a takeover
having a PR officer specialising in financial matters liasing constantly with the entity’s stockbrokers, keeping analysts fully informed, and speaking to journalists
NCAs are re-valued to current values to ensure that shareholders are aware of true asset value per share
takes steps before a bid has been made to make itself less attractive to a potential bidder.
Articles of Association are altered to require that a higher % of shareholders have to vote for the takeover
what is the most common method of the Poison pill strategy?
Most common method is for existing shareholders to be given rights to buy future bonds or preference shares. If a bid is made before the date of exercise of the rights, then the rights will automatically be converted into full ordinary shares
what are the following takeover defences:
- Appeal to their own shareholders
- Attack the bidder
declare value placed on the target company’s shares is too low in relation to the real value and earning power of the company’s assets, or alternatively that the market price of the bidder’s shares is unjustifiably high and is not sustainable
concentrating on the bidder’s management style, overall strategy, methods of increasing earnings per share, dubious accounting policies and lack of capital investment
what does a well managed campaign post-defence look like?
i) aggressive publicity on behalf of the company preferably before a bid is received. Investors may be told of any good research ideas within the company and of the management potential or merely be made more aware of the company’s achievements
ii) direct communication with the shareholders in writing stressing the financial and strategic reasons for remaining independent
Under the City Code in the UK, who must examine and report any forecasts?
auditors or consultant accountants
what are the following takeover defences:
- White Knight
- Counterbid-sometimes called a ‘Pacman’ defence
- Refer the bid to the Competition authorities
directors of the target company offer themselves to a more friendly outside interest. Should only be adopted as a last resort as it means loss of independence. tactic is acceptable provided that the information given to a bidder is also given to a hostile bidder. the alternative company’s management will be considered to be sympathetic to the target company’s management
where the bidding company is itself the subject of a takeover bid by the target company
the target entity could seek government intervention by bringing in the Competition authorities. For this to be effective, it would have to be proved that the takeover was against the public interest
what are the 2 questions about the form of consideration that should be addressed when one firm acquires another?
- what form of consideration should be offered? cash offer, share exchange, or earn-out are the 3 main choices
- if a cash offer is to be made, how should the cash be raised? the choice is generally debt finance or a rights issue to generate the cash (if the entity does not have enough cash already)
what is a cash offer consideration?
target company shareholders are offered a fixed cash sum per share
For which types of acquisitions are cash offers suitable?
relatively small acquisitions, unless the bidding entity has an accumulation of cash
what are the advantages of a cash offer?
- SPEED: when bidder has sufficient cash, the takeover can be achieved quickly and at a low cost
- CERTAINTY ABOUT THE BID’S VALUE i.e. there is less risk compared to accepting shares in the bidding company
- INCREASED LIQUIDITY TO TARGET COMPANY SHAREHOLDERS i.e. accepting cash in a takeover, is a good way of realising an investment
- LOWER COST TO BIDDER- the acceptable consideration is likely to be less than with a share exchange, as there is less risk to target company shareholders
what are the disadvantages of a cash offer?
- TAXABLE CHARGEABLE GAIN-will often arise if shares are sold for cash, but the gain may not be immediately chargeable to tax under a share exchange
- TARGET COMPANY SHAREHOLDERS ARE BOUGHT OUT-so may be unhappy with a cash offer, since they do not participate in the new group. This could be seen as an advantage of a cash offer by the bidding company shareholders if they want to keep full control of the bidding company
- FINANCING PROBLEMS-with larger acquisitions the bidder must often borrow in the capital markets or issue new shares in order to raise the cash. Increased borrowing may have an adverse effect on gearing, and also cost of capital due to the increased financial risk
why might the amount of finance needed be higher than expected?
if there is a plan to repay the target entity debt at the time of the takeover. This can sometimes be a requirement of the target entity’s lenders, as stipulated in a debt covenant.
what are the three main sources for raising the cash needed?
existing cash reserves-can only be used if the bidder has a large cash surplus
borrowings-from the bank or by issuing bonds
rights issue to existing shareholders
what is an advantage and disadvantage of bank borrowings?
advantage: low cost in servicing the debt
disadvantage: increase in the bidding company’s gearing
what is an advantage and disadvantage of rights issue to existing shareholders?
advantage: gearing is not affected, atlhough its earnings per share will fall as new shares are issued
disadvantage: it is the shareholders themselves who have to find the money to invest
what is a share exchange?
the bidding company issues some new shares and the exchanges them with the target company shareholders. The target company shareholders therefore end up with shares in the bidding company, and the target company’s shares all end up in the possession of the bidding company
what type of acquisitions involve share exchange?
large acquisitions almost always involve an exchange of shares, in whole or in part
what are the advantages of a share exchange?
- can be used to finance very large acquisitions
- no cash needed
- bootstrapping opportunity the bidder has a higher P/E ratio than the acquired entity
- shareholder capital is increased-an gearing similarly improved-as the shareholders of the acquired company become shareholders in the post-acquisition company
what are the disadvantages of a share exchange?
- sharing gains-bidding company’s shareholders have to share future gains with the acquired entity, and the current shareholders will have a lower proportionate control and share in profits of the combined entity than before
- price risk-there is a risk that the market price of the bidding company’s shares will fall during the bidding process, which may result in the bid falling
why is there price risk in a share exchange?
e.g. if 1 for 2 share exchange is offered based on the fact that the bidding company’s shares are worth approximately double the value of the target company’s shares, the bid might fail if the value of the bidding company’s shares falls before the acceptance date
what is the value of the combined company after the takeover?
value of bidding company + value of target company + value of synergy
how do you calculate the number of shares after the takeover?
no/ shares originally in the bidder + no/shares issued to target shareholders
what is bootstrapping?
the valuation of a company post-acq by applying the larger company’s higher P/E ratio to the earnings of the combined company
what assumption is bootstrapping based on?
that the market will assume that the management of the larger company will be able to apply common approach to both companies after the takeover, thus improving the performance of the acquired company by using the methods that they have been using on their own company before the takeover
what is an earn-out arrangement?
procedure whereby owners/managers selling an entity receive a portion of their consideration linked to the financial performance of the business during a specific period after the sale. The arrangement gives a measure of security to the new owners, who pass some of the financial risk associated with the purchase of a new entity to the sellers
how is the purchase consideration sometimes structured in an earn-out?
there is an initial amount paid at the time of acquisition, and the balance deferred
some of the deferred balance will usually become payable if the target entity achieves specified performance targets
when are earn outs often employed?
when the buyers and sellers disagree about the expected growth and future performance of the target company
popular amount PE investors who do not have the expertise to run the target business post-acq
how long does a typical earn out take? what % of purchase price?
over three to five year period after acquisition
may involve 10-50% of the purchase price being deferred and paid across during that period
what are earn out targets? which do sellers and buyers prefer?
financial targets used in an earn-out calculation may include revenue, net income, EBITDA or EBIT targets
some on non-financial such as executing contract
sellers prefer revenue as its simplest but can be boosted through activities that harm business interest
buyers prefer net income as the most accurate reflection of overall economic performance, but this number can be manipulated downward through extensive capital expenditures and other front-loaded business expenses
what are the limitations of earn-outs?
- work best when the business is operated as envisioned at the time of the transaction rather than in circumstances where the business plan changes, often in response to a change in the business environment
- in some transactions, the buyer may have the ability to block the earn-out targets from being met. Outside factors may also impact the company’s ability to achieve earn-out targets
- sellers need to negotiate earn-out terms very carefully, taking into account all these issues
how are issues relating to forms of consideration affected by the position of the target company’s shareholders?
may want to retain interest, don’t want cash offer but greater certainty as shared fluctuate and valuations may be inaccurate
how are issues relating to forms of consideration affected by the position of the bidding company and its shareholders?
bidding company will have to issue new shares which may require current shareholders consent, they may be concerned in a share exchange that their control of the bidding company will be diluted by the issue and exchange of shares
another effect is the takeover on the bidding company’s financial statements. new share issue could affect EPS which is used by market analysts. however, if a cash offer is made, the raising of the necessary cash could have a significant impact on the gearing of the bidding company
how do you interpret the likely acceptance of a share for share offer?
calculate the synergy generated
what is a material adverse change clause often used for in a takeover?
to make the target entity’s borrowings repayable if the company is sold
-bidding company will have to ensure that sufficient funds are available to purchase the shared from the target entity’s shareholders and repay the debt
what are Druker’s 5 Golden Rules to apply to post-acq integration?
- Ensure a ‘common core of unity’ is shared by the acquired entity and acquirer. Shared technologies or markets are an essential element
- The acquirer should not just think ‘What is in it fo us?.’ but also ‘ What can we offer them?’
- The acquirer must treat the products, markets and customers of the acquired entity with respect
- Within 1 year, the acquirer should provide appropriately skilled top management for the acquired company
- Within 1 year, the acquirer should make several cross-entity promotions of staff
What are some key points to consider when determining a strategy for a combined entity?
- the integration strategy must be in place before the acquisition is finalised
- review each of the business units for potential cost cuttings/synergies or potential asset disposals.
- consider the effect on the workforce and determine how many, if any, redundancies are likely and what the cost will be
- risk diversification ay well lower the cost of capital and therefore increase the value of the entity
- the entity’s cost of capital should be re-evaluated
- make a positive effoct to communicate the post-acq intentions within the entity to prevent de-motivation and avoid adverse post-acq effects on staff morale
- there may be economies of scale to identify and evaluate
- undertake a review of assets, or resource audit, and consider selling non-core elements or redundant assets
- there may well be a need to pursue a more aggressive marketing strategy
- the risks of the acquisition need to be evaluated
- there need to be harmonisation of corporate objectives
what is the impact of an acquisition on the acquirer’s post-acq share price?
need to do detailed analysis of the accounts and comparison to other companies in similar business sectors can help to assess whether the likely impact will be favourable
does PV of combined earnings take into account the downsides costs (reverse synergy and getting to know you costs) of putting two different entities together, each with its own management style
