Mergers and Acquisitions (M&A) – Valuation
In an M&A transaction, the valuation process is conducted by the acquirer, as well as the target.
The acquirer will want to purchase the target at the lowest price, while the target will want the
highest price.
Thus, valuation is an important part of mergers and acquisitions (M&A), as it guides the buyer
and seller to reach the final transaction price.
Below are three major valuation methods that are used to value the target:
A. Market based approach
1. Market capitalization
What is Market Capitalization?
Market Capitalization (Market Cap) is the most recent market value of a company’s outstanding
shares. Under this the investing community often uses market capitalization value to rank
companies and compare their relative sizes in a particular industry or sector. To determine a
company’s market capitalization, simply take its current market share price and multiply the
figure by the total number of shares outstanding.
Market Cap = Current Share Price * Total Number of Shares Outstanding
For example, if a company has 1,000 common shares outstanding and the closing price per share
is $100, its market capitalization is then $100,000. If the closing price per share rises to $110, the
market cap becomes $110,000. If it drops to $90 per share, the market cap falls to $90,000. This
is in contrast to mercantile pricing where purchase price, average price and sale price may differ
due to transaction costs.
Misconceptions About Market Capitalization
It’s important to know that a company’s market capitalization is the total value of its equity
only. A company’s Enterprise Value is the value of the entire business, including both equity
and debt capital. This means that if a house is worth $1,000,000 and has a $700,000 mortgage,
the equity value is $300,000. The same applies to a business. A company with a Market Cap
(equity value) of $10 billion and debt of $5 billion has an Enterprise Value of $15 billion.
2. Price earnings ratio
What is the Price Earnings Ratio?
The Price Earnings Ratio (P/E Ratio) is the relationship between a company’s stock price
and earnings per share (EPS). It is a popular ratio that gives investors a better sense of
the value of the company. The P/E ratio shows the expectations of the market and is the price
you must pay per unit of current earnings (or future earnings, as the case may be).
Earnings are important when valuing a company’s stock because investors want to know how
profitable a company is and how profitable it will be in the future. Furthermore, if the company
doesn’t grow and the current level of earnings remains constant, the P/E can be interpreted as the
number of years it will take for the company to pay back the amount paid for each share.
There are two types of P/E: trailing and forward. The former is based on previous periods of
earnings per share, while a leading or forward P/E ratio is when EPS calculations are based on
future estimates, which predicted numbers (often provided by management or equity analysts).
P/E = Stock Price Per Share / Earnings Per Share or
P/E = Market Capitalization / Total Net Earnings or
Justified P/E = Dividend Payout Ratio / R – G
where;
R = Required Rate of Return
G = Sustainable Growth Rate
Why we use the Price Earnings Ratio?
Investors want to buy financially sound companies that offer a good return on investment (ROI).
Among the many ratios, the P/E is part of the research process for selecting stocks because we
can figure out whether we are paying a fair price.
Similar companies within the same industry are grouped together for comparison, regardless of
the varying stock prices. Moreover, it’s quick and easy to use when we’re trying to value a
company using earnings. When a high or a low P/E is found, we can quickly assess what kind of
stock or company we are dealing with.
Conditions under high and low-price earnings ratio
High P/E
Companies with a high Price Earnings Ratio are often considered to be growth stocks. This
indicates a positive future performance, and investors have higher expectations for future
earnings growth and are willing to pay more for them.
The downside to this is that growth stocks are often higher in volatility, and this puts a lot of
pressure on companies to do more to justify their higher valuation. For this reason, investing in
growth stocks will more likely be seen as a risky investment. Stocks with high P/E ratios can also
be considered overvalued.
Low P/E
Companies with a low Price Earnings Ratio are often considered to be value stocks. It means
they are undervalued because their stock prices trade lower relative to their fundamentals. This
mispricing will be a great bargain and will prompt investors to buy the stock before the market
corrects it. And when it does, investors make a profit as a result of a higher stock price.
Examples of low P/E stocks can be found in mature industries that pay a steady rate
of dividends.
For example
If company A: has a current stock price of 50$ and its earning per share (EPS) is 5$ and
If company A: has a current stock price of 60$ and its earning per share (EPS) is 4$. The price
earnings ratio of the two company is calculated under in the following manner
For Company A: P/E ratio = Current stock price / EPS P/E ratio = 50$/5 P/E ratio = 10
For Company B: P/E ratio = Current stock price / EPS P/E ratio = 60$/4 P/E ratio = 15
Therefore, the P/E ratio for Company A is 10, while the P/E ratio for Company B is 15.
Based on the above calculation When we comparing the P/E ratios of two companies, a lower P/E
ratio generally indicates that a company may be undervalued or has a lower earnings growth
expectation compared to its stock price. On the other hand, a higher P/E ratio can suggest that a
company is either overvalued or has higher earnings growth expectations.
So, Company A is relatively cheaper compared to Company B.
3. What is the Q Ratio?
The Q Ratio, or Tobin’s Q Ratio, is a ratio between a physical asset’s market value and its
replacement value. The ratio was developed by James Tobin, a Nobel laureate in economics.
Tobin suggested a hypothesis that the combined market value of all companies on the stock
market should be about equal to their replacement costs. The ratio can be used for valuing a
single company and even the whole stock market.
The original formula for the Q Ratio is:
market value ofassets
Q ratio=
replacement cost of capital
However, in real life, it is very difficult to estimate the replacement costs of total assets. Thus,
there is a modification of the original formula, in which the replacement costs of the assets are
replaced with their book values.
equity market value+liabilities market value
Q ratio=
equity book value+liabilities market value
The Q Ratio can be calculated for the overall market:
total market value of firm
Q ratio=
total asset value of firm
Applications of the Q Ratio
The Q Ratio is widely used to determine the value of a company. If the ratio is greater than 1,
the market value of a company exceeds the value of its booked assets. The company is
overvalued as the market value reflects some unmeasured or unrecorded assets. A ratio greater
than 1 indicates that a company’s earnings higher than the assets’ replacement costs. This fact
can attract potential competitors who would try to re-create the business model to achieve some
of the profits.
When the ratio is lower than 1, the value of the company’s booked assets exceeds their market
value. It implies that for some reason, the market undervalues the company. In such a case, the
company may be attractive to potential purchasers who would be willing to buy the company
instead of creating a similar company.
The ideal scenario is when the Q Ratio equals 1. It suggests that the market fairly values the
company’s assets.
Example of How to Use the Q-Ratio
The formula for Tobin's Q ratio takes the total market value of the firm and divides it by the
total asset value of the firm. For example, assume that a company has $35 million in assets. It
also has 10 million shares outstanding that are trading for $4 a share. In this example, the
Tobin's Q ratio would be:
total market value of firm
Q ratio=
total asset value of firm
=$40,000,000divided by $35,000,000=1.14
Tobin’s Q Ratio= 1.14
Since the ratio is greater than 1.0, the market value exceeds the replacement value and so we
could say the firm is overvalued and might be a sale.
An undervalued company, one with a ratio of less than one, would be attractive to corporate
raiders or potential purchasers, as they may want to purchase the firm instead of creating a
similar company. This would likely result in increased interest in the company, which would
increase its stock price, which in turn increase its Tobin's Q ratio.
As for overvalued companies, those with a ratio higher than one, they may see increased
competition. A ratio higher than one indicates that a firm is earning a rate higher than its
replacement cost, which would cause individuals or other companies to create similar types of
businesses to capture some of the profits. This would lower the existing firm's market shares,
reduce its market price and cause its Tobin's Q ratio to fall.
B. Book value-plus models
Book value is a company’s equity value as reported in its financial statements. The book value
figure is typically viewed in relation to the company’s stock value (market capitalization) and is
determined by taking the total value of a company’s assets and subtracting any of the liabilities
the company still owes.
Book value (share capital + retained earnings) = total assets (current + non-current assets)
– total liabilities (current + non-current liabilities)
Importance of Book Value
Book value is considered important in terms of valuation because it represents a fair and accurate
picture of a company’s worth. The figure is determined using historical company data and isn’t
typically a subjective figure. It means that investors and market analysts get a reasonable idea of
the company’s worth.
Book value is primarily important for investors using a value investing strategy because it can
enable them to find bargain deals on stocks, especially if they suspect that a company is
undervalued and/or is poised to grow, and the stock is going to rise in price.
Stocks that trade below book value are often considered a steal because they are anticipated to
turn around and trade higher. Investors who can grab the stocks while costs are low in relation to
the company’s book value are in an ideal position to make a substantial profit and be in a good
trading position down the road. Therefore, based on above conditions let see the following
practical example
In a given economic condition ABC Corporation and XYZ Corporation are there and they are
using the book value-plus model. So, we will consider their respective net asset values (NAV)
based on the information from their balance sheets.
Here are the key figures from the statement of financial position (balance sheet) of both
companies:
I. ABC corporation:
Total Assets: $10,000,000:
Long−term Payables: $2,000,000 Short-term Payables: $1,000,000
To calculate ABC Corporation's Net Asset Value (NAV): Net Asset Value (NAV) = Total
Assets - Long-term Payables - Short-term Payables
= 10,000,000−10,000,000−2,000,000 - 1,000,000=1,000,000=7,000,000
So, ABC Corporation's Net Asset Value (NAV) or book value of net assets is $7,000,000.
II. XYZ Corporation:
Total Assets: $15,000,000
Long−term Payables: $3,500,000 Short-term Payables: $1,500,000
To calculate XYZ Corporation's Net Asset Value (NAV): Net Asset Value (NAV) = Total
Assets - Long-term Payables - Short-term Payables
= 15,000,000−15,000,000−3,500,000 - 1,500,000=1,500,000=10,000,000
So, XYZ Corporation's Net Asset Value (NAV) or book value of net assets is $10,000,000.
Comparing the two companies using the book value-plus model:
ABC Corporation has a Net Asset Value (NAV) of $7,000,000.
XYZ Corporation has a Net Asset Value (NAV) of $10,000,000.
Based on this comparison, XYZ Corporation has a higher Net Asset Value (NAV) than ABC
Corporation.
Limitation under book value model
This method of valuation technique does not consider factors such as future earnings, growth
potential, or intangible assets, which are essential for a comprehensive analysis of a company's
value.
C. Free cash flow model
Free Cash Flow valuation views the intrinsic value of a company as the present value of its
expected future cash flows.
Two methods to value a company using Free Cash Flow method are by valuing Free Cash Flow
to the Firm (FCFF) and Free Cash Flow to Equity (FCFE).
I. Free Cash Flow to the Firm (FCFF)
Free Cash Flow to Firm, is the cash flow available to all funding providers (debt
holders, preferred stockholders, common stockholders, convertible bond investors, etc.). This can
also be referred to as unlevered free cash flow, and it represents the surplus cash flow available
to a business if it was debt-free.
Calculating free cash flow to the firm (FCFF)
FCFF=NI+NC+(I*(1-TR))-LI-IWC
where:
NI=Net income
NC=non-cash charges
I=Interest
TR=Tax Rate
LI=Long-term Investments
IWC=Investments in Working Capital
Free cash flow to the firm can also be calculated using other formulations. Other formulations of
the above equation include:
FCFF=CFO+(IE×(1−TR)) −CAPEX
where:
CFO=Cash flow from operations
IE=Interest Expense
CAPEX=Capital expenditures
If we look at Exxon's statement of cash flows, we see that the company had $8.519 billion
in operating cash flow in 2018. The company also invested in new plant and equipment,
purchasing $3.349 billion in assets (in blue). The purchase is a capital expenditure
(CAPEX) cash outlay. During the same period, Exxon paid $300 million in interest, subject to a
30% tax rate.
Therefore, FCFF=CFO+(IE×(1−TR)) −CAPEX
FCFF=CFO+(IE×(1−TR)) −CAPEX
In the above example, FCFF would be calculated as follows:
FCFF= $8,519 Million+($300 Million× (1−.30)) − $3,349 Million= $5.38 Billion
FCFF=$8,519 million + ($300 Million× (1−.30)) − $3,349 Million
=$5.38 Billion
II. Free cash flow to equity (FCFE)
Free cash flow to equity (FCFE) is the amount of cash a business generates that is available to be
potentially distributed to shareholders. It is calculated as Cash from Operations less Capital
Expenditures plus net debt issued.
FCFE = Cash from Operating Activities – Capital Expenditures + Net Debt Issued
(Repaid)
FCFE Example
Below is a screenshot of Amazon’s 2016 annual report and statement of cash flows, which can
be used to calculate free cash flow to equity for years 2014 – 2016.
As we can see in the image above, the calculation for each year is as follows:
2014: 6,842 – 4,893 + 6,359 – 513 = 7,795
2015: 11,920 – 4,589 + 353 – 1,652 = 6,032
2016: 16,443 – 6,737 + 621 – 354 = 9,973
FCFE vs FCFF
FCFF stands for Free Cash Flow to the Firm and represents the cash flow that’s available to all
investors in the business (both debt and equity).
The only real difference between the two is interest expense and their impact on taxes. Assuming
a company has some debt, its FCFF will be higher than FCFE by the after-tax cost of debt
amount.
Example of stock purchase
Let's say Company A wants to acquire Company B. Company A offers to purchase all outstanding
shares of Company B from its shareholders. The agreed-upon deal is that for each share of
Company B, the shareholders will receive $50 in cash and 0.5 shares of Company A's stock. -
Company B has 1,000,000 shares outstanding. - Company A's stock is currently trading at $100 per
share.
In this scenario, Company A will pay cash and issue shares to the shareholders of Company B.
therefore, Company A agrees to acquire Company B.
Shareholders of Company B will receive $50 in cash and 0.5 shares of Company A's stock for
each share of Company B.
Company B has 1,000,000 shares outstanding.
Company A's stock is currently trading at $100 per share.
As a result of the acquisition, Company B shareholders will receive $50,000,000 in cash
(50,000,000 in cash (50 * 1,000,000 shares) and 500,000 shares of Company A's stock (0.5
shares * 1,000,000 shares) as per the agreed terms.
Asset purchased
Let's say Company A wants to purchase certain assets from Company B. Company B agrees to
sell the following assets to Company A:
Equipment: Company B owns manufacturing equipment worth $500,000.
Licenses: Company B holds exclusive licenses for a patented technology, valued at $200,000.
Goodwill: Company B has established a strong brand reputation, which is estimated to have a
goodwill value of $300,000.
Customer Lists: Company B has a database of loyal customers, valued at $100,000.
Inventory: Company B's current inventory consisting of raw materials and finished goods is
valued at $400,000.
In this scenario, Company A will acquire these specific assets from Company B while Company
B will retain legal ownership of the entity.
The total consideration for the asset purchase would be the sum of the individual asset values:
Total Consideration = Equipment + Licenses + Goodwill + Customer Lists + Inventory Total
Consideration = 500,000+200,000 +300,000+100,000 + 400,000=
Total Consideration=1,500,000
Therefore, Company A will purchase these assets from Company B for a total consideration of
$1,500,000.
