The small matter of price

Francisco López Lubián. Professor. IE Business School

31 October 2006

The mergers and acquisition boom is a worldwide phenomena, but these deals are not always successful. One of the greatest challenges is to estimate the value of the companies involved.

According to information published by Thomson Venture Economics, over the last three years, leading US institutional investors have spent $500 billion on buying out companies. If 60% is an acceptable level of financial leverage, then these investors have a purchasing power of over $1 trillion. Moreover, the merger and acquisition (M&A) boom is not only happening in America: According to figures issued by the British Venture Capital Association, companies owned by firms specialising in leveraged acquisitions in the UK provide 18% of jobs in the private sector. Low interest rates have helped boost turnover in the global M & A market to $1.93 trillion in the first half of this year, from $1.4 trillion in the first half of 2005, according to figures provided by the market research company Dealogic. If corporate buyouts continue at the same pace, they could reach $4 trillion worldwide in 2006, breaking the previous record set in 2000.

Although certain sectors, such as the American health-care industry, have suffered a downturn in M&A activity in recent months, most companies continue to enjoy a surplus of cash. Consequently, in an economic scenario where investors demand increasingly higher yields, M&A activity is expected to continue to play a key role in managers´ growth strategies in the coming years.

There are many reasons for a company to acquire another and the economic logic is very simple: company A wants to buy company B because A believes that by managing B it can give the resulting combination of A & B greater value than the current total value of both firms.

We all know that the real world is full of sure-fire synergies that don’t turn out as planned. Numerous studies also show that an inflated price is one of the key factors in the failure of these types of transactions. Overpayment can occur because the acquiring company fails to assess properly the target´s intrinsic value, or because it has unrealistic expectations of synergies. So how do you calculate the right price for an acquisition? Which key factors determine the price? What pitfalls must be avoided? How does the financing of the transaction affect the final price? For the price to be considered reasonable, the economic value on which it is based must also be reasonable.

There are essentially two types of economic value: the extrinsic or relative value and the intrinsic or fundamental value. The relative value is based on external perimeters. For example, the market value of a company-- independently of whether it is within a regulated market (a listed company) or within the private market (using comparables)--is the value a company is given during an M&A process. Other examples of extrinsic value include the liquidation value, the replacement value and the legal value. Insofar as the market is considered a reliable mechanism for determining the price, an asset’s extrinsic value is an appropriate reflection of its economic value.

Of course, the market does not always work this way. Hence, the intrinsic value--based on more telling characteristics of the business--can better indicate its economic value. If the potential buyer is interested in accounting metrics, he can use the adjusted book value, employing market or replacement value for adjustments. If, however, the potential buyer considers that the book value of the assets does not reflect the true economic value, then he must estimate the expected future cash flows that the target company will generate and discount them at a rate that correctly reflects the opportunity cost and the associated risks.

Relative and fundamental values are actually complementary. The difference between the two should serve to show the economic value of a controlling stake in the company.

Price and relative value

Whatever the case, it is important to make sure that the markets on which a comparison is based are comparable, when establishing a reasonable price using the relative value.

In the case of listed companies, not all capital markets have the same levels of efficiency, size and depth. If the company is not listed and calculations are made on a like-for-like basis, it is important to make sure that the value reference used is consistent with the purpose of the valuation. For cross-border valuations, it is not usually enough to use figures from transactions carried out by companies operating in the same sector or in a similar type of business. Consistency in terms of comparison can be analysed using indicators that include: profitability, measured by the ROCE (Return on Capital Employed), the company’s sustainable growth rate, the company’s size, measured by turnover and the company’s presence, measured by the level of diversification. Other practices that ensure consistency in the terms of comparison include the use of recent figures, the elimination of non-recurrent income, the adjustment of the value if non-operative results are produced and the use of figures drawn up using comparable accounting principles

Moreover, earnings per share (EPS) are often employed in valuations using comparables. Again, it is a good idea to ensure the figures are comparable, especially when they are taken from companies involved in high-volume asset sales and acquisitions. In these cases, it is important to distinguish the earnings derived from ordinary or recurrent transactions from those that are the result of a non-recurrent operations.

For example, when General Electric (GE) announced the sale of its Japanese insurance subsidiary, GE Edison Life, in mid 2003, the company did not report the atypical earnings associated with the sale, which totalled more than $2 billion. Analysts estimated possible after-tax earnings at $250 million, which represented approximately $0.025 per share. Bearing in mind that the consensus figure on GE’s EPS was $0.42, the impact of these atypical earnings was 6%.

In order to calculate the correct ratio between price and value, it is essential to consider what is being bought and how it is being bought. For example, a controlling stake in a public company is not the same as a non-controlling stake in a private company. Similarly, cash offers are more attractive than all paper deals. Money makes it possible to buy new securities, and at times it is better to sell shares on the market than to accept a tender offer.

Once the value of the company is determined, based on an open scenario, the process should include the examination of real factors, such as possible limitations to the distribution of cash flows among those supplying the funds. In short, all valuations must be tested against time. Insofar as a valuation is an opinion about the future, the real test of how accurate that valuation proves to be is whether it holds up through time. That explains why financial markets punish companies that fail to meet expectations and why companies must handle correctly all external and internal communications. Economic value is based on the fulfilment of expectations, which in turn translates into credibility.


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