Business Valuation

- Placing a value on a company’s shares is one of the most examined topics

within the ACCA P4 examination.
- The syllabus categories acquisitions into three categories:
Type 1: Don’t disturb business or financial Risk
Type 2: Disturb Financial risk but not business Risk
Type 3: Effect both business and financial Risks.

- However, it is easier to think of valuations in two ways:

o Pre-acquisition / Range of Values
o Post-Acquisition Valuation

- Remember, business valuation is “an art not an exact science”.

Pre-Acquisition
- In this situation, the aim is to establish a value for a business’s equity capital.
There are several methods that can be used here:

1. Latest price on the stock market

- The value of the entity is:
- Value = No of issued equity shares x Current price (Po) per share
-
- The weaknesses of this method are:
o The company may not have a listing
o The price is based on trading not on selling a controlling interest in the
company.

2. Net asset valuation

- Business is worth just the value of its net Assets.
- To establish the net assets:
- Total Assets – (Total Liabilities + Preference Shares)
- The net Asset value equals the Ve and can be based on:
a) Book Values
b) Net realizable Value (NRV)
c) Replacement Cost

- It is useful for:
a) “Seller” to set minimum value of the company (NRV)
b) Companies with lots of tangible high value assets such as a property
Investment Company.
- The major weaknesses are:
a) Not include non-tangible assets.
b) Excludes what all assets generate future:
i. Dividends
ii. Profits
iii. Cash flow

3. Price-earning model
- A business is worth a multiple of its profits and so;
Ve = Sustainable PAT x Suitable P/E or
Po = Sustainable EPS x Suitable P/E
- To find the sustainable PAT – there maybe adjustment to the latest reported
reports for non-reoccurring items (post tax).

- The suitable P/E ratio is taken from a proxy listed company or the industry
average. This value may have to be ARBITARILY adjusted to make it fit the
business under consideration. For example, it is common to REDUCE the
listed company P/E ratio by 30%when applying this to a non-listed entity.
- The concerns with this method are:
o Finding a proxy Co P/E,
o Adjustments are arbitrary, and
o Sustainable profits need forecasting adjustments.

4. Dividend valuation approaches

- The company is worth the present value of its future dividends discounted at
the cost of equity.
- If there is a constant future growth rate in dividends then the calculation can
be summarized via:
Ve = Total Do (1+g) / (Ke-g)

- Otherwise, the valuation must be computed using the DEFINTION as stated

below:
- Present Value of all future dividends discounted at Ke.
Po=Do (1+g) / (Ke-g)

- Issues to note:
o Growth may not be constant forever
o Where do we get “g” from?
o CAPM may be needed to find Ke.
o Often better for valuing a small shareholding.
 5. Free Cash Flow Method
- A business is worth the discounted value of its future free cash flows.
- There are two approaches:
a) FCF co discounted at the Co WACC. This gives V entity.
b) FCF equity discounted at Ke. This gives V equity.

- Preparing a schedule of forecast FCF Is very important.

FCF Co FCF Equity

Revenue xxx xxx
Cash Costs (xx) (xx)
Tax Allowable (xx) (xx)
Depreciation
Operating Profit xxx xxx
Interest - (xx)
PBT xxx xxx
Tax (xx) (xx)
Add Back: TAD xxx xxx
Less: Inv in NCA (xx) (xx)
Less: Inv in W. Capital (xx) (xx)
Free Cash Flow xxx xxx
x Discount Rate WACC Ke
Present Value xxx xxx
Less: Value of debt (xx) (xx)
Value of Equity xxx xxx
 Post-Acquisition Valuations
- Now it’s time to consider what will be the value of the combined businesses
assuming the acquisition/merger progresses as planned.
- The main aim of an acquisition is to add value i.e. 2+2 =5, although this is
not guaranteed.

- Both groups of shareholders will only vote for the business combination
providing both groups gain from the takeover.
- To establish post-acquisition value there are several methods to consider can
be used.

1. Boot Strapping Method

- It is used when the buyer has a higher PE ratio than the seller.

Latest PAT of Buyer xxx

Latest PAT of Seller xxx
Add: Post Tax Synergy Benefits xxx
Combined PAT xxx
PE Ratio of Buyer xxx
Combined Company Value xxx

2. Add-Together Method

Pre-Acquisition Value of Buyer xxx

Pre-Acquisition Value of Seller xxx
Add: Present Value of Synergy xxx
Benefits
Combined Value xxx

3. Free Cash Flow Method

- Value = Present Value of Future Cash Flows

1. Cash Offer
Current Share Price xxx
Cash Offer xxx
Gain xxx
 2. Share for Share Exchange
Current Share Price xxx
Combined Share Price xxx
Gain xxx

3. Bond Offer
Current Share Price xxx
M.V of Bonds xxx
Gain xxx

Management Buy-Out
- When the directors, managers or the employees of a company takeover or
acquire the company from its owners, it is called a Management Buyout.

Advantages
- Quickest method of sale.
- Owners have a peace of mind that the company is being sold to people who
are running it.
- No resistance from employees because duh.
- Less costly than selling to a 3rd party.
- May get a better price as the management knows the real worth of the
company.

Disadvantages
- Requires a change in mindset from employees to managers, which may be
difficult.
- Difficulty in raising as new management might be considered risky for outside
investors.
- Creates a conflict of interest if mentality of the new management is not right.
 Management Buy-In
- When managers of some outside company takeover or acquire a company.
This is called a Management Buy-In.

Advantages
- Helpful if the current owners and the management are not able to run the
company.
- New management might have better expertise.
- Change in management might motivate the current employees.

Disadvantages
- Existing managers might feel demotivated and threatened.
- Employees may resist if they are too connected with the current ownership.

Synergy Benefits
1. Revenue Synergy
- Increase in revenue due to increase in market share.
- Two different consumer bases combine so the company’s revenue is
increased.

2. Cost Synergy
- Reduced costs as the company will be able to get better prices from suppliers
as the size of order will increase if both companies deal in the same product.
- Less rental and operating expenses as both companies will combine and work
in a same building or factory depending on the nature of the business.

3. Financial Synergy
- Increased negotiation power in financial transactions, such as borrowing a
loan from the bank, as the company account has grown bigger due to the
companies combining. Most likely will result in loan being acquired at lower
rates.
- Can also result in a reduce in cost of equity as the company risk will reduce
due to the increase in market share i.e., less competition.
 Regulations in relation to Acquisitions
- Once you get an agreement from majority shareholders i.e., 75%-80%, you
can force minority shareholders to sell their shares.
- All shareholders must be treated equally.
- Mandatory bid rule means that price offered to shareholder should not be
lower than the highest price offered to shareholders in the last 6–10-month
period.

Defenses against Takeover Bids

- When a company does not want an external takeover-bid to succeed, these
strategies can be used.

1. Poison Pill Strategy

- Company issues a Rights Issue. This increases the number of shares, hence
increasing the overall price per share that the takeover company must pay.
- It also raises finance from existing shareholders, putting on a public
impression that shareholder confidence is high.

2. Disposal of Crown Jewels

- Company can sell its most valuable asset to the takeover company in hope
that it will sway away the takeover bid.

3. White Knight Strategy

- Company offers itself for sale to a friendly company if they want to avoid a
hostile takeover from a company that might destroy the legacy of the
company.

4. Pacman Defense
- King move imo. Company counters the offer to buy shares in the company
that wants to takeover. Takeover company can get rid of the fighting the dog,
but still can’t get rid of fight in the dog.

Dividend Capacity
- It is the maximum amount of dividend a company can pay.
- It is calculated as:
FCF Equity xxx
Any additional inflows or outflows
(Additional tax or Dividend Remitted from Subsidiary) x/(x)
Dividend Capacity xxx
 Securitization and Tranching
- Basically, you pimping.

Risks of Securitization
1. Default Risk: Original loan borrower default on interest payments.
2. Timing Risk: Obvious.
3. Correlation Risk: Heavily co-related with the economic conditions.