Mergers And Acquisitions: Valuations

Brand valuation
y Brand valuation mainly measures 2 criteria's
y Potential profitability of the brand y Non- financial factors like brand recall

y In a brand valuation transaction, a company rarely pays book

value to acquire another company. y The difference between the book value and actual acquisition price paid is due to intangible assets, of which brands are an important part.

Valuing a brand
Relief from royalty method:
y The relief-from-royalty method determines the value of an intangible

asset by reference to the capitalized value of the hypothetical royalty payments that would be saved through owning the asset, as compared with licensing the asset from a third party.
y It involves estimating the total royalty payments that would need to be

made over the assets life, by a hypothetical licensee to a hypothetical licensor.

y The hypothetical royalty payments over the life of the asset are adjusted

for tax and discounted to present value and then are capitalized.

Premium Profits Method

y The premium profits method involves comparing the forecast

profit stream or cash flows that would be earned by a business using the intangible asset with those that would be earned by a business that does not use the asset.
y The forecast incremental profits or cash flows achievable through

use of the asset are then computed.

y Forecast periodic amounts are capitalized through use of either a

suitable discount factor or suitable capitalization multiple.

Valuation-different approaches
y Discounted cash flow- it relates the value of the asset to the

present value of the expected cash flows on that asset.

y Relative valuation approach- this method is used to estimate the

value of an asset by analyzing the pricing of comparable assets relative to a common variable such as earning, book value, cash flows etc.

Earning based valuation

y This method takes into consideration the future earnings of

the business and the appropriate value of the business depends on projected revenues and costs in future, expected capital outflows, number of years of projection, discounting rate and terminal value of business.

Market based valuation

y MBV for unlisted companies, comparable listed companies

have to be identified and their market multiples such as market capitalization to sales or market PE are used to arrive at a value.

Asset based valuation

y Considers either the book value or the net adjusted value. If

the company has intangible assets, these are valued independently and added to the net asset value to arrive at the business value.

Steps in Acquisition Analysis

y Step 1: Establish a motive for the acquisition y Step 2: Choose a target y Step 3: Value the target with the acquisition motive built

in. y Step 4: Decide on the mode of payment - cash or stock, and if cash, arrange for financing - debt or equity. y Step 5: Choose the accounting method for the merger/acquisition - purchase or pooling.

Step 1: Motives behind acquisitions

(1)Simplest rationale is undervaluation, i.e., that firms that are undervalued by financial markets, relative to true value, will be targeted for acquisition by those who recognize this anomaly. (2) A more controversial reason is diversification, with the intent of stabilizing earnings and reducing risk. (3) Synergy refers to the potential additional value from combining two firms, either from operational or financial sources.
y Operating Synergy can come from higher growth or lower costs y Financial Synergy can come from tax savings, increased debt

capacity or cash slack.

Step 2: Choose a target firm for the acquisition

If motive is Undervaluation Diversification Operating Synergy Target firm trades at a price below the estimated value is in a business which is different from the acquiring firms business have the characteristics that create the operating synergy Cost Savings: in same business to create economies of scale. Higher growth: should have potential for higher growth.

Financial Synergy

Tax Savings: provides a tax benefit to acquirer Debt Capacity: is unable to borrow money or pay high rates Cash slack: has great projects/ no funds

Control

badly managed firm whose stock has underperformed the market has characteristics that best meet CEOs ego and power needs

Managers Interests

Step 3: Value Target Firm with motive built in

If motive is Undervaluation Diversification Operating Synergy Target firm Value target firm as stand-alone entity Value target firm as stand-alone entity Value the firms independently. Value the combined firm with the operating synergy Synergy is the difference between the latter and former Target Firm Value = Independent Value + Synergy

Financial Synergy: tax benefits: Debt Capacity:

Value of Target Firm + PV of Tax Benefits Value of Target Firm + Increase in Value from Debt

Step 4: Decide on payment mechanism: Cash versus Stock

 Generally speaking, firms which believe that their stock is

under valued will not use stock to do acquisitions.  Conversely, firms which believe that their stock is over or correctly valued will use stock to do acquisitions.  Not surprisingly, the premium paid is larger when an acquisition is financed with stock rather than cash.  There might be an accounting rationale for using stock as opposed to cash.You are allowed to use pooling instead of purchase.  There might also be a tax rationale for using stock. Cash acquisitions create tax liabilities to the selling firms stockholders.

Step 5: Choose an accounting method for the merger

y Purchase Method:
The acquiring firm records the assets and liabilities of the acquired firm at

market value, with goodwill capturing the difference between market value and the value of the assets acquired. y This goodwill will then be amortized , though the amortization is not tax deductible. If a firm pays cash on an acquisition, it has to use the purchase method to record the transaction.
y Pooling of Interests:
The book values of the assets and liabilities of the merging firms are added to

arrive at values for the combined firm. Since the market value of the transaction is not recognized, no goodwill is created or amortized. This approach is allowed only if the acquiring firm exchanges its common stock for common stock of the acquired firm. Since earnings are not affected by the amortization of goodwill, the reported earnings per share under this approach will be greater than the reported earnings per share in the purchase approach.

Cost of capital: CAPM

k s ! r f  E ( rm )  r f F
where rf E(rm) E(rm)- rf = the risk-free rate of return = the expected rate of return on the overall market portfolio = market risk premium = the systematic risk of equity

Discounted cash flow approach

y Estimates are needed for: y Incremental cash flow expected to be generated because of

acquisition y Discount rate

Equity Valuation
y Value of equity is obtained by discounting expected cash

flows(after meeting all expenses, taxes, etc)

y Value of Equity= Cash flow to equity (1+ke)t

Measuring Free Cash Flows to the Equity (FCFE)

y Buying equity of firm is buying future stream of free cash flows

(available, not just paid to common as dividends) to equity holders (FCFE)

y FCFE is residual cash flows left to equity holders after: y meeting interest/principal payments y providing for capital expenditures and working capital to maintain

and create new assets for growth FCFE = Net Income + Non-cash Expenses - Cap. Exp. - Increase in WC - Princ. Payments

Stable Growth FCFE Model

y Used when firm is growing at stable growth rate y The value of equity is a function of expected FCFE in the

next period, the stable growth rate and the required rate of return.
y V0 = FCFE1 / r-gn

Firm Valuation
y Obtained by discounting cash flows to the firm after meeting

all expenses at the weighted average cost of capital

y Value of firm = cash flow to the firmt

(1+WACC)t

Discounted Free Cash Flow to the Firm

y Identify cash flows available to all stakeholders y Compute present value of cash flows
y Discount the cash flows at the firms weighted average cost of

capital (WACC)

Enterprise value
y Market capitalization of a company plus debt. y The key performance metric to evaluate enterprise value.
y EV/EBITDA ratio y EV/Revenue ratio y EV/ sales

Economic profit model

y Economic profit= invested capital*(ROIC-WACC) y Value created by company must not only include the

expenses recorded in its accounting records but also the opportunity cost of capital employed in the business.