The various approaches to takeover valuation using published financial data can be summarized as follows:
- Balance sheet values (relating to net assets).
- Expectations (relating to accounting income) in the form of:
(i) A going concern value using a normal rate of return on net assets, plus a goodwill calculation based on the capitalisation of super profits.
(ii) A profitability valuation using a P/E ratio applied to post-tax earnings.
(iii) A capitalized dividend valuation based upon dividend yield.
(iv) A present value (PV) calculation using a cash flow yield.
No one method is necessarily correct; rather they should be used when appropriate to provide a range of values for the purposes of negotiation. So, as a final illustration, let us evaluate a range of bid prices per share using the following information prepared by Blur plc for the acquisition of Gallagher plc.
(i) Future profits after tax are estimated at $200 million
(ii) Future dividends cannot fall below $120 million per annum.
(iii) The normal rate of return on net operating assets for the industry is 12.5 percent.
(iv) Goodwill, if any, should be assimilated within four years.
(v) The market price of shares in companies doing an equally uncertain trade, financed by ordinary share capital (common stock) suggests that an appropriate P/E ratio is 7 (which is equivalent to a 14.5 percent return) and that dividend yield is 10 percent.
If we assume that the acquisition is premised on a rational strategic maneuver based on long-term profitability, a range of prices per share offered for Gallagher depends on four factors researched by Blur's management. Note that we have no cash flow data
- The minimum purchase price for the net tangible assets
- Evidence of goodwill
- Future profitability
- Dividend policy
1. Minimum valuation (net assets)
Net assets: $1,600 million minus $550 million = $1,050 million
Per share valuation: $1,050 million / 80 million = $13.125
(a) Going concern (goodwill)
Using Equation (23) from Chapter Ten where V = A + [(P - rA) / m] subject to m > r
(b) Profitability (P/E ratio)
Gallagher's anticipated post-tax profits are $200 million per annum and the expected P/E ratio is 7. If Blur's management assume that profits are constant in perpetuity, value may be defined using the following equations from Chapter Eleven.
(25) V = n(1 - t) x P/E = Profits after tax x P/E ratio = Total market capitalisation
= $200 million x 7 = $1,400 million
Per share valuation: $1,400 million / 80 million = $17.50
(c) Dividend Policy (yield)
If expected dividends are $120 million and the maintainable yield is 10%, then using the formula for capitalizing a perpetual annuity:
Per share valuation: $1,200 million / 80 million = $15.00
Recalling Activity 2 in Chapter Eleven, however, it is important to note that if the bid price per share is to accord with an earnings valuation of $1,400 million based on the Modigliani Miller (MM) law of one price, then the actual dividend after takeover should be $140 million with a corresponding uplift to the per share valuation. This is confirmed by solving for D in the following equation
Per share valuation: $1,400 million / 80 million = $17.50
Since this dividend uplift is still covered by after-tax profits it shouldn't be problematic, provided that Blur has adequate funding for future reinvestment post-takeover.
3. A Risk Assessment
The predator company has certainly done its research. There is an ideal "domino effect" that should minimise risk. Gallagher's earnings valuation exceeds its goodwill valuation, which is higher than the asset revaluation. As we discovered in Chapter Eleven, the assets are an important benchmark in any risk assessment since they can be sold-off piecemeal if the acquisition proves to be uneconomic. The risk associated with takeover can be measured by:
The purchase value of the tangible assets relative to the profitability valuation (asset backing) termed cover.
(28) Cover = Net asset valuation /Profitability valuation = $1,050 million / $1,400 million = 0.75
Or alternatively, the reciprocal of cover, using the valuation ratio
(29) Valuation ratio = Profitability valuation / Net asset valuation = 1.33
The tangible net asset value provides substantial cover (asset backing) for the company as a profitable going concern. Likewise, its profit earning capacity exceeds the asset valuation, which confirms the existence of goodwill, evidenced by the valuation ratio.
Blur plc should make an initial bid of around $13.20 for Gallagher's shares based upon a minimum net tangible asset value. A fairer price might be $17.00, reflecting an allowance for goodwill, dividend policy and the earning power of the assets capitalized at a reasonable rate of return, as evidenced by appropriate P/E ratios. In order to ensure success, particularly in the event of a competitive bid (when price might rise further) a maximum offer of $17.50 would seem realistic.
Finally, whilst Blur's original analysis excluded actual cash flow data, as a parting shot consider the following information.
If surplus assets with an immediate realizable value of $150 million had also been identified, over and above the net operating assets of $1,050 million, you may care to verify that the previous going concern values and share prices would have to be uplifted as follows:
What this also reaffirms is that the sale of excess or idle assets (which provides a once-only benefit) can only enter into the calculation after annually recurring operating profits or dividends have been capitalized. And needless to say, if realization is delayed, the eventual proceeds from the sale would have to be discounted back to a present value at an appropriate rate of return, in order to bring it in line with the main valuation date.