Exercise 7.2: A "Promising" Takeover Valuation
Riding on the back of domestic economic growth, the Mantra Company is an Indian cash-rich conglomerate that wishes to expand its global operations with European facilities.
Through inept management, the highly regarded Rock Company based in the north of England with mining operations throughout the Europe has recently suffered a reversal of fortune. Share price has plummeted, so much so, that Mantra regards their takeover as a perfect fit for its existing activities.
The Balance Sheet for Rock reveals the following: (£million)
Share Capital: £1.00 ordinary shares 1,200
CAPITAL EMPLOYED 7,632
Mining property 4,200
Distribution Facilities 900
As a basis for acquisition, Mantra believes that Rock's post-takeover turnover and profits should be in the region of £33,000 million and £1,500 million, respectively. The company has also prepared the following data relating to the acquisition.
- A 15 per cent incremental return on any new asset investment.
- A five year assimilation of goodwill, equivalent to a 20 per cent return on superprofits.
Rationalization policies £million
Sale of equipment 1,263
Sale of investments at market value 1,122
Annual cost savings from sale of equipment 207
New construction costs 630
1. Prepare a series of bid prices per share, using any assumptions you care to make, based on the information available and the following valuation techniques.
- Tangible assets
2. Provide a risk assessment of your valuations.
3. Summarize your bid strategy
An Indicative Outline Solution
1. A Range of Bid Prices per Share
Going concern valuation: V = A + (P - r. A ) / m
V = £7,767m + (£1,500m - £1,165m) / 0.2 = £9,442 million
With 1,200 million shares in issue we can derive the following bid price:
£9,442m / 1,200m £7.90 per share (say)
(iii) Profitability Valuation: (capitalisation of future earnings)
Forecast profit per annum 1,500 Given
Cost saving per annum 207 Given
Forecast profit per annum 1,707
Capitalised at 15% 11,380 Incremental return
Add: Sale of equipment 1,263 Given
Sale of investments 1,122 Given
Less: New build (630) Given
Total Profitability Valuation 13,135
So, dividing by the 1,200 million shares in issue, we can derive the following bid price: £13,135m / 1,200m £10.95 per share (say)
2. Risk Assessment
Although we have no precise information on the current market price for Rock, its mediocre stock market performance explains Mantra's predatory interest. Our range of bid prices per share also reveals an ideal "domino" effect.
The profitability valuation exceeds the going concern valuation (incorporating any remaining goodwill), which is higher than the current market valuation of assets. The latter also exceeds the total Balance Sheet value of assets
However, if profits do not materialize, or the residue of goodwill evaporates post-acquisition, then Mantra may have a problem. Their return on investment will be no more than the realization of Rock's assets.
To assess the risk of a worst-case scenario using the information available, we can compare the purchase value of net tangible assets in relation to a profitability valuation. What is termed asset backing can be measured in one of two ways, using either market capitalisation (total value) or bid price per share.
Cover = Net asset valuation /Profitability valuation
Valuation ratio = Profitability valuation / Net Asset valuation
Remember from your previous Exercise that the valuation ratio is the simply the reciprocal of the cover. So, we can define (with rounding) the two equations, either in aggregate, or on a per share basis, as follows.
- Market Capitalisation
Cover: Net Asset Valuation/Profitability Valuation = £7,767m / 13,135m = 60%
Valuation Ratio: Profitability Valuation/Net Asset Valuation = £13,135m / £7,767m = 1.7
- Bid Price
Cover: Net Asset Valuation/Profitability Valuation = £6.50 / £10.95 = 60%
Valuation Ratio: Profitability Valuation/Net Asset Valuation = 1 / Cover = 1.7
The purchase value of Rock's net tangible assets (asset backing) only supports sixty per cent of Mantra's profitability valuation. But to access a new market that complements existing activities premised on global growth is a rational strategic maneuver, particularly if the target company's shares are a bargain buy.
3. A Bid Strategy
Mantra could make an initial bid of £6.50 but a fairer price might be £8.00, if only to flush out other predators. In the event of a "bidding war", price might go higher still. Mantra can bide its time, and progressively up its offer to £11.00. Beyond this, much depends on the strength of its objective, strategic pre-planning, attitude toward risk and how the market values Rock's shares