Valuation of Mergers and

Acquisitions
 Outline
• Introduction
• Pricing of merger/takeover
– Rules for valuation
• Pricing Estimators
– Book value of the target firm
– Liquidation value of the target firm
– Replacement cost of the target firm
– Current market value of the target firm
– Trading Multiples of Peer Firms
– Transaction Multiples for Peer Firms
• Conclusion
• References
• What amount of consideration is to be offered to
target shareholders?
• What value should I pay for the target firm?
• What are rules and approaches of valuation for an
appropriate price being paid for the deal?

Pricing of Mergers & Pricing the Competitive Bid for Takeover

 Rules for Valuation
• Rule # 0: The best method to value a firm is ‘NOT TO
VALUE IT’
• Rule # 1: Think like an Investor: Ask whether one will
be wealthier or not as a result of a transaction…
I. Look to the future, not the past
II. Focus on economic reality
III. Get paid for the risk you take
IV. Value Creation: Time is money
V. Remember “Opportunity Cost”.
• It helps in defining the kind of deals a firm will do or will not do.
• It also directs the analyst to consider alternative strategies for the
buyer and seller
 Rules for Valuation, contd..
VI. Information is the key source of advantage in identifying value-
creating investments – focus on what you know about a target
company that the market does not already know. (Anyone not
aware of the fool in the market probably is the fool in
the market- Warren Buffet, 1989)
VII. Diversification is good
• Rule # 2:Intrinsic Value is unobservable; One can only
estimate it.
– The different methods of valuation are just vantage points from which
to assess the intrinsic value – these values are not necessarily intrinsic
– The results of valuation analysis are estimates
– One should work with many estimates and estimators
– Work with ranges of value instead of point estimates
 Rules for Valuation, contd..
• Rule # 3: An opportunity to create value exists
where price and intrinsic value differ
– Concept of Enterprise Value vs. Equity Value
• Rule # 4: So many estimators, so little time – It
helps to have a view
– Book value of the target firm
– Liquidation value of the target firm
– Replacement cost of the target firm
– Current market value of the target firm
– Trading Multiples of Peer Firms
– Transaction Multiples for Peer Firms
– Discounted cash flow of the target firm.
Rules for Valuation, contd..
Rule # 4: Book value of the target firm
• Book value is the value of individual assets that are kept on the
books of accounts or values carried to balance sheet
• It means assets are recorded at historical cost and are depreciated
over years.
• Formula: Cost of asset –accumulated depreciation
• It is based on the GAAP principles
• Based on the principle of conservatism-What had happened
• Ignores price appreciation like inflation
• The difference in BV of assets and BV of liabilities are called net
asset value or net worth or shareholders funds.
• Net Worth=Total Assets-Total outside Liabilities
• BV per share= Net worth/No of Shares outstanding
 Book Value Example
• Assets(after deducting depreciation)=$80 million
• Liabilities=$5 million
• Difference in Book value of A & L = networth=
$80mn -75mn (recorded at books of a/c)
• No of shares=5
• Book value per share=75mn/5mn=$15mn
• BV on its own do not signify much.
• Say Market Value or Market Price=$18, then we
can compare MV with BV
• BV≠MV =MV is more, so company is doing better
Book Value Example
• Asset cost=$10,000
• Expected Life=10 Years
• Annual
Depreciation=$1000
• Assets Book value after
6 years-$10,000-
$6000=$4000
Rules for Valuation, contd..
Rule # 4: Liquidation value of the target firm

• It is the amount or values that the a company might realize

in event of liquidation of the firm today.
• Liquidation value is calculated when the operation of the
company are assumed to cease .
• A variation of liquidation value, commonly known as bust-
up value.
• It is more realistic than the book value
• Liquidation value vary according to industry and time
• It does not directly measure the earning power of the firm’s
assets.
• Liquidation value may be over estimated or
underestimated value.
 Liquidation Value
Assets ($ mn) Liabilities ($mn)

• Cash=1000 • Loans=1500
• Fixed assets=9000 • Amount Payable=1500
• Inventory=2000 • Mortgage=1000
• Receivables=1000
• Patents=1000

Liquidation Value: TA-TL

=(1000+9000+2000+1000)-(1500+1500-1000)=$9000 mn

Note: Patents is excluded since it is an intangible asset. In liquidation value the value of
intangibles are excluded since company ceases to exist.
Rules for Valuation, contd..
Rule # 4: Replacement cost of the target firm

• Replacement cost values of firms are estimated

by determining the cost to replace the assets of
the firm today.
• In other words, it is amount that company is
required to spend if it were to replace its existing
assets in current condition.
• If Liquidation value is the estimated amount of
money that an asset or company could quickly be
sold for, such as if it were to go out of business,
Replacement value is the value of an asset as
determined by the estimated cost of replacing it.
 Replacement Value Example
• Washing machine purchased in 2012=Rs 7000
• Washing machine to purchase in 2013=Rs
8000
• Rs 8000 is the replacement cost
• Basically current value of asset compared to
original value of asset.
Rules for Valuation, contd..
Rule # 4: Current market value of the target firm

• The current market value of an enterprise is simply the sum

of the market values of its debt and equity.
• The value of equity is simply share price times the number
of shares.
• The value of debt can be estimated by literally estimating
the present value of debt cash flows.
• It is also called market price
• Market prices reflect what is known about a firm.
• Market value are expected to be higher than book value
per share for profitable growing firms.
• These prices will be relatively more useful if the target
firm’s securities are actively traded.
 Rules for Valuation, contd..
– Trading multiples of comparable firms applied to the
target: Identify comparable firm similar to target firm
• P/E Multiple
• Price/ Cash profit per share
• EV/EBITDA
• EV/EBIT
• Price/ Sales per share
• EV/ Sales
• P/B Multiple
– Transaction Multiples of comparable acquisitions
applied to the target: purchase price of comparable
companies recently acquired
Comparable Companies Method
A comparable firm is similar to firm to be valued in following aspects:

 Customer mix
 Degree of leverage
 Firm Size
 Indebtedness
 Market served
 Perceived Risk
 Potential Growth Rate in
Earnings or cash flows
 Product offering
 Profitability
 Same Industry
 Size
 Comparable Companies Method
• Example
Suppose firm A is to be valued.
Firm Profit margin grow annually=10%
Beta=1.2 (Risk)
Products offering= computer hardware
Then as a investor you have to find a firm similar to that
characteristics in either same industry as well as
different industry.
Rules for Valuation, contd..
Rule # 4: P/E Multiple

A valuation ratio of a company's current share price compared to its per-

share earnings.

Calculated as: Market Value per Share/Earnings per Share

Also sometimes known as "price multiple" or "earnings multiple" or the

price multiplier

When we multiple P/E Ratio multiple by target company’s EPS, we get

estimated stock price

In general, a high P/E suggests that investors are expecting higher

earnings growth in the future compared to companies with a lower P/E.
Rules for Valuation, contd..
Rule # 4: Price/ Cash profit per share

In P/E ratio , EPS looks at the net income generated on a per share basis, for a given period.

In Price/ Cash profit per share, it takes into account the cash flow generated by a company
on a per share basis

Like EPS, higher the cash EPS, better it is considered.

Calculated as: Market Value per Share/Cash Earnings per Share

Cash EPS Calculated: Company's cash flow/Number of shares outstanding.

It is better than P/E ratio as Cash EPS adjusts for depreciation, amortization of goodwill and
other non-cash items such as intangibles.
Rules for Valuation, contd..
Rule # 4: EV/EBITDA

The EV/EBITDA ratio is a comparison of enterprise value and earnings before interest, taxes,
depreciation and amortization.

This ratio is also known as “enterprise multiple” and “EBITDA multiple”.

A lower enterprise multiple can be indicative of an undervaluation of a company.

The EV/EBITDA ratio is a better measure than the P/E ratio

• It is not affected by changes in the capital structure or companies with different capital structures.
• It removes the effect of non-cash expenses such as depreciation and amortization. These non-cash items are of less
significance to the investors because they are ultimately interested in the cash flows.
• It ignores the distorting effects of individual countries' taxation policies.

EV = MVE + MVD; if MVD is not available, take BVD as proxy for MVD
 Enterprise Value Example
• Company XYZ balance sheet
– Shares outstanding =10,00,000
– Current share price=$5
– Total Debt=$ 10,00,000
– Cash = $5,00, 000
• Enterprise value= Market Capitalization+ Net
Debt- Cash =($10,00,000*$5)+($10,00,000)-$
5, 00, 000)=$ 55,00, 000
 Why Enterprise Value matters?
Target Company ABC Ltd Target Company XYZ Ltd
• Market Capitalization=$ • Market Capitalization=$
50mn 50mn
• No debt • Debt=$10 mn
• Cash=$ 10 mn • No Cash
• Enterprise value=50+0- • Enterprise value=50+10-
10=$40 mn 0=$60 mn
• Cheaper to Acquire • Costly to Acquire
 Equity Value
• Enterprise value is the value of operations of
business available to everyone while Equity value
is the value of operations of business after the
non-equity claim holders and value of non
operating assets.
• e.g. Unlike Enterprise value, equity value
considers only equity interest not the entire value
of firm.
• Equity value= Don’t consider Net Debt
• Equity value = Market capitalization
 Enterprise Value vs. Equity Value
Example
Assets (in Crore) Liabilities (in Crore)
• Cash=Rs 100 (NOA)
• Account receivable = Rs 50 • Account Payable –Rs 50 (OL)
(OA) • Accrued Expenses=Rs 100
(OL)
• Plant and Equipment= Rs
• Debt=150 (NOL)
300 (OA)
Equity (in Crore)
 Equity-150

Enterprise value= Equity+ Debt-Cash= 150+150-100= Rs 200 Crore

Equity Value=Equity= Rs 150 Crore

 Rules for Valuation, contd..
Rule # 4: EV/EBIT multiple

It is a measurement to whether a share in a company is cheap

or expensive, relative to competing firms or the wider market.

EBIT as a measure of profitability eliminates the potential

distorting effects of differences in tax rates.

EV/EBIT normalizes for the effects of different capital structures.

A downside to this ratio is that it does not normalize for

depreciation and amortization costs.
 Rules for Valuation, contd..
– Discounted cash flow of the target firm
• DDM=P0=D1/(ke-g)
• FCFF (Free Cash Flow for Firm)
 FCFF = NOPAT + DEP&AMO +/- ΔNWC – Capex
» NOPAT = EBIT * (1 – T)
• FCFE (Free Cash Flow for Equityholders)
 FCFE = PAT + DEP&AMO – ΔNWC – Capex + Δdebt

Terminal value: The TV is the value that the business could be expected
to be sold for at the end of some specific forecast period.
 Dividend Discount Model
• P0=D1/(Ke-g)
• Where
– P0=Current market Price
– Ke=Cost of Equity or rate of return
– g=Growth rate
– D1=Expected Dividend
Example: If an investor have expected the share
price to grow at 5%, Ke=15%, Dividend= Rs 2 per
share, the value of share today is
P0=2/(.15-.05)=2/ 0.10= Rs 20/-
 Required Returns
• Minimum rate of return to induce an investor to purchase
firms equity?
• Cost of equity
• Estimation method??
• CAPM
• Formula
– Ke=Rf+β(Rm-Rf)
– Where
– Rf=risk free rate of return
– β = Beta
– Rm =Expected rate of return on equities
– (Rm-Rf)=Risk Premium
 FCFF-Enterprise Cash Flow
Example
• Background details
– From Operations=$ 15, 00,000
– Capital Expenditure=$ 5,00,000
– Working Capital increased by= $ 1,00,000
• FCFF= NOPAT+DEP&AMO+/- ΔNWC –Capex
where NOPAT=EBIT*(1-t)
FCFF=15,00,000-1,00, 000-5,00,000=$13,00,000
(Free cash flow to Equity Investors)
Back ground details Formula
• EPS (Rs.) 4 – FCFE = PAT + DEP&AMO –
• Capital Expenditure (Rs.) 3 ΔNWC – Capex + Δdebt
• Depreciation per share (Rs.) • Here EPS since per share
2.5 value
• Change in working capital • Value per
(Rs.) 0.5 share=FCFE(1+g)/(r-g)
• Expected Growth (%) 9 Where,
• Beta Co-efficient 0.9 Cost of Equity=Rf+Beta(Rm-Rf)
• Risk free Rate of return (%) 8
• Market Risk Premium (%) 6
 Basis for FCFF and FCFE
Example

NOPAT (Operating Income) PAT (Net Income)

Background Information Background Information
Sales (Cash)=25,000 Sales (Cash) =25,000
Less: Expenses or COGS(Cash) =10,000 Less: Expenses or COGS(Cash) =10,000
EBITDA =15, 000 EBITDA =15, 000
Less: Dep&Amo =5000 Less: Dep&Amo =5000
EBIT=10,000
EBIT=10,000
Less : Tax (.35) =3500
Less : Interest =1000
NOPAT=6500
EBT=9000
Less: Tax (.35) =3150
PAT=5850
• NOPAT=EBIT*(1-t) • PAT=EBT*(1-t)
• Used in FCFF • Used in FCFE
 Rules for Valuation, contd..
• Rule #5: Exercise estimators of intrinsic value to find
key value drivers and bets
– Univariate and Bivariate sensitivity analysis
– Scenario analysis
– Breakeven analysis
• Rule # 6: Think critically; Triangulate carefully
– Scrutinize estimators
– Scrutinize data
– Scrutinize the spreadsheet model
 Overview of Classic Measures of Value
(reference: Bruner, 2004)

Approach Advantages Disadvantages

Book Value •Simple •Ignores some assets and liabilities
•Authoritative •Historical costs: backward looking
•Subject to accounting manipulation
Liquidation Value •Conservative •Ignores ‘going concern’ value
•Firms in financial •(Dis)orderly sale?
distress •Subjective estimates
Replacement value Valuable insights in •Replace what?
any high-inflation
setting
 Overview of Classic Measures of Value
(reference: Bruner, 2004), contd…
Approach Advantages Disadvantages
Multiples, earnings •Simple •“Earnings” subject to accounting
capitalization •Widely used manipulation
•Price/earnings •“Snapshot” estimate: may ignore
•Enterprise value/ cyclical, secular changes
EBITDA* •Depends on comparable firms:
•Value/EBIT ultimately just a measure of
•Price/Book relative, not absolute value

*EBITDA is like Alice in Fantasyland. It should be outlawed from securities analysis –

Quotation by Robert Olstein in “Ebitda: Never Trust Anything That You Can’t Pronounce” by
Herb Greenberg, Fortune, June 22, 1998, p.192.\
Discounted cash flow •Theoretically based •Time consuming
•FCF @ WACC •Rigorous •Risks “analysis paralysis”
•RCF or FCFE @Ke •Affords many analytical insights •Easy to abuse, misuse
•Cash focus •Tough to explain to novices
•Multi-period
•Reflects time value of money
 Valuation Multiples
• Industry Specific Multiples:
– Steel??
-EV/ Ton of Steel
– Electricity Generation
-EV/Kwh
– Cable TV:
-EV/subscribers
– Retailers
-EV/Square Foot
– Technology:
-EV/patents; EV/Scientists
The Valuation Matrix
 Price/ Sales Ratio: Definition
• The price/sales ratio is the ratio of the market value
of equity to the sales.
• Price/ Sales= Market Value of Equity
Total Revenues
• Consistency Tests
– The price/sales ratio is internally inconsistent, since the
market value of equity is divided by the total revenues of
the firm.
 A More Intuitive Approach
• As a general rule of thumb, the following table provides a way of picking a
multiple for a sector
Sector Multiple Used Rationale
Cyclical Manufacturing PE Often with normalized earnings
High Tech, High Growth PEG Big differences in growth across firms
High Growth/No Earnings PS, VS Assume future margins will be good
Heavy Infrastructure V/EBITDA Firms in sector have losses in early
years and reported earnings can vary
depending on depreciation method
REIT P/CF Generally no capex investments
from equity earnings
Financial Services PBV Book value often marked to market
Retailing PS If leverage is similar across firms
VS If leverage is different
 Expected Growth (for FCF models)

Expected Growth

Net Income Operating Income

Rete ntion Ra tio= Retu rn on Equity Reinvestment Retu rn on Capital =

1 - Dividends/Net X Net Income/Book Value of Rate = (Net Ca p X EBIT(1-t)/Book Value of
Income Equity Ex + Chg in Capital
WC/EBIT(1-t)
LAST RULE : WHEN IN DOUBT SEE RULE 0
 References:

• Applied Mergers and Acquisitions by Bruner, John

Wiley
• Financial Management by I M Pandey , Vikas
• Mergers, Acquisitions and Other Restructuring by
DePamphilis, Academic Press
• Corporate Finance – Theory and Practice, 2e,
Aswath Damodaran