Valuing the Assets
Let us assume the worst. The balance sheet is based on HCA convention with few notes or qualifications. A professional analyst would advise the following adjustments.
(a) Fixed Tangible Assets
Whether property prices are rising or not, it is always wise to have land and buildings revalued, irrespective of any professional valuation revealed by the accounts. Items such as plant and machinery, motor vehicles, fixtures and fittings that are shown at their net book value, rather than current cost, may require uplift. Depreciation rates employed during the period of review must also be questioned as evidence of the relationship between net book values and current values. These rates may be quite arbitrary and not produce either a value in use (net replacement cost) for operating assets, or value in exchange (realizable value) if assets are surplus to requirements.
Listed shares and securities should be valued at their mid-market price for the year but unlisted shares must be the subject of a secondary valuation using methods similar to those used in the main valuation.
It is also important to distinguish between investments that are necessary for the earnings capacity of the business (e.g. trade investments and investments in subsidiaries) which are long-term holdings and those investments that are really "spare cash" items. Although earning interest, the latter should be regarded as "surplus" assets.
(c) Current Assets
If inventory and debtor turnover ratios are rapid, their balance sheet values may be taken without extensive revision. However, some adjustment to current cost may become apparent when the trading results are reviewed, relating to HCA methods of stock valuation and the provision for bad debts.
(d) Intangible Assets
The value of the business beyond "tangible" balance sheet items must also be taken into account by the predator. The value given to "goodwill" will be discussed separately. Suffice it to say that whatever adds value by "trade or reputation" must enter into the asset calculation.
If items such as R and D, patents or brand names have either significant usable or saleable values, an independent expert valuation may be necessary and the amount added to the tangible assets.
(e) A Going Concern Value
After appropriate adjustments to balance sheet items it is finally necessary to arrange the assets into the following three groups and then add them together to arrive at a going concern value:
1) Tangible assets directly employed in the business that comprise:
a) Net fixed assets, i.e. fixed operating assets at net replacement cost, excluding fixed assets and investments not employed in the business for their earning power, minus long-term liabilities.
b) Net current assets, i.e. current assets at their market value, less surplus investments, minus current liabilities.
2) Tangible assets and financial investments not directly employed in the business, whether fixed or current. These must be included in the final value of the target company at their realizable value because their acquisition and subsequent sale will produce income that is independent of the company's earnings from its trading operations. Excess, idle or "surplus" assets may aid cash flow in the future, either for new investment, working capital or distribution.
3) Intangible assets, represented by the value given to the business over and above the sum of the tangible assets, plus other investments.
How to Value Goodwill
To summarise our position so far:
A going-concern valuation based on a company's net assets may be defined as its net tangible assets (including excess or idle assets) plus intangible assets incorporating goodwill.
Whilst the derivation of the tangible component is not too problematical, the figure for goodwill has concerned analysts for many years, not least because its "real" value is so uncertain and easily destroyed. Ultimately, the price paid for goodwill may be a compromise between buyer and seller, or even ignored altogether. Moreover, the methods for evaluating goodwill are not particularly inspiring, even those standardized by the accounting profession. They are usually a variation of the right-hand term in the following net asset equation (continuing our numbering from Part Two).
V = going concern value of the business
A = value of net tangible assets
P = expected profits per annum
r = normal rate of return
P - rA = super profit
m = capitalisation rate of super profit
(P - rA ) / m = value of goodwill
Super profit is the profit attributable to goodwill. It is the difference between the total expected profit (P) post-takeover and what economists term "normal" profit, defined as the average return on the net assets (rA) in perpetuity for the industry in question.
The inequality (m>r) reflects the intangible nature of super profit, relative to normal profit. The higher capitalisation rate for m relates to that proportion of anticipated profit attributable to goodwill. It reflects the increased risk associated with its fragility because goodwill can easily evaporate through inept corporate management or a loss of identity after an acquisition.
The value term for goodwill can also be rewritten from a conventional accounting perspective in terms of its useful life.
(1 /m) = a number of years purchase of super profit the rationale being that the shorter the term (i.e. the higher the capitalisation rate) the less permanent (more risky) the goodwill.
To illustrate the application of Equations (23) and (24) consider Oasis plc, a target company with tangible assets of £100 million and expected profits of £19 million per annum.
Using assumed values of your choice for m and r (subject to the proviso that m > r) calculate goodwill and going concern values for Oasis.
a) If a reasonable return on capital is 10 percent, then normal economic profit would be £10 million and the super profit £9 million. Assuming the latter is capitalized at 20 percent, equivalent to a five years purchase of goodwill, we can define:
b) If a lower return on the intangible assets is expected because of less risk (say 15 percent) the goodwill would be more valuable (i.e. more permanent) lasting in excess of six years. Thus, the going concern value would be higher:
c) We can also introduce the time value of money into our calculations. Since the purchase of a number of years super profits is similar to a fixed term annuity, its value can be derived using present value (PV) analysis. Assuming a five year purchase, i.e. a discount rate of 20 percent.
Proponents of a going concern valuation incorporating a separate goodwill calculation argue that the method recognizes that tangible assets can be sold separately and unlike goodwill are reasonably permanent. However, this may not be true. A piecemeal asset valuation is more appropriate in the event of "asset stripping" and a firm's liquidation, rather than its takeover as a going concern. Moreover, the method cuts across the concept of valuing a business as an entity in favour of its component parts. A further practical criticism is that two appropriate rates of return (m and r) have to be assumed. One capitalisation rate may be arbitrary enough. Two may defeat the object of the whole exercise and widen the margin of error.
Despite these defects, the goodwill methodology may produce a valuation that is mutually agreeable to the buyer and seller. Returning to our example, the fact is that Oasis is very profitable and may be more valuable than its total assets of £100 million. This suggests a compromise solution to the valuation of goodwill, which is equivalent to capitalizing a perpetual annuity but avoids a separate super profit calculation.
Assuming that a rate of return of 10 percent is expected from investment in the company, which earns £19 million per annum, it follows that:
If the goodwill is deemed to be fragile, a lower figure may then be placed upon Oasis. For example, a simple approach could be to use a mean value. Thus, we have:
Needless to say, even these methods do not necessarily give an intrinsic valuation for the business but rather suggest a figure for the purposes of negotiation between the predator and its target. Besides, as we shall discover in Chapter Eleven we can dispense with a goodwill computation altogether.
There is more to financial analysis than the interpretation of historical data contained in company accounts. Accountants, auditors, the tax authorities and even management may defend such information by proclaiming that the price paid for assets and the income they generate are accountable facts. In this sense, accounting statements are objective. They are composed of "real" figures, which purport to represent a "true and fair" view. Whether such data has utility for investors, however, is questionable.
Suppose Osbourne plc, with a turnover of €25 million and profits of €5 million, records the following figures in its latest balance sheet for which you have additional information (in parenthesis).
For the purpose of a takeover valuation, evaluate this data.
Summary and Conclusions
Most data published by companies in financial accounts throughout the world is subjective. Invariably, the figures are biased toward GAAP concepts and conventions that comprise a regulatory framework. Even factual historical costs that fail to reflect current economic reality are dependent on forecasts. For example, net book values and by definition profits depend upon estimates of the useful lives of assets, appropriate methods of depreciation and residual values.
From the table above, at least four significant points emerge:
1. Each item in the list is factual (a record of transactions, which have actually taken place). Every one represents actual money, or money paid and receivable. Except to the extent that there might been fraud or error (for example, equipment might have been bought and charged against current revenue, thus reducing profit and the asset figure below total cost) the list is a factual statement of assets owned and prices paid.
2) However, the total of €151 million has no real meaning. It is a summation of euro's at different values (now, five years ago, three months hence, and so on) that equals the nominal value of authorized and issued share capital plus the historical cost of reserves, loan stocks and other liabilities. It says nothing about market value and has about as much validity as saying that four apples and three pears equal seven fruit.
3) Even if the figures were adjusted for inflation (an average price change) the list of assets provides no indication of their specific worth. The land might be in a development area and saleable for €50 million. The specific cost of replacing the buildings and equipment in their present form might be €250 million. Moreover, the assets might have a high or low current market value compared with a year ago. As a consequence, a significant disparity may exist between the nominal and market value of equity plus reserves, as well as debt. Yet none of this is revealed by the accounts.
4) Similarly, but to opposite effect, the €5 million profit is an accrual-based subtraction of various historical costs from current revenue which does not correspond to the net inflow of cash (to the extent that goods and services have been bought and sold on credit and the figure also includes depreciation which is a non-cash expense).
In the long run, a company's wealth is the amount it can first earn and subsequently distribute. However, if we adopt this criterion of value as a basis for takeover, there is a conflict between a tangible asset figure, net of all liabilities (even based on current cost) and either a profitability or a dividend valuation that reflect the market price of equity based on discounted revenue theory. The former ignores intangible items that incorporate goodwill and brand names. The latter are forward looking and embrace the whole structure of the firm based upon present value (PV) analyses of projected cash flows, relative to a company's desired rate of return (which may bear no relation to the return on capital employed derived from the accounts).