Consider the following facts. Over the last three years, in the US, leading institutional investors have spent $500bn on buying out companies, according to data published by Thomson Venture Economics. If 60 per cent is an acceptable level of financial leverage, then these investors have a purchasing power of over $1,000bn.
On a global scale, low interest rates fuelled a turnover of $1,930bn in the M&A market in the first half of this year in comparison with $1,400bn in the first half of 2005, according to market research company Dealogic. If corporate buyouts continue at the same pace, they could reach $4,000bn in 2006, breaking the previous record set in 2000.
A company might choose to acquire another for a wide range of reasons. Some aim to increase their market share or eliminate a troublesome competitor, while others seek the supposedly limitless advantages that the buyer can implement once it has acquired the target business. The economic logic is simple: company A wants to buy company B because A believes that by managing B, it can give the resulting combination of A and B greater value than the current total value of both companies.
We all know that the real world is full of seemingly certain synergies that never happen, either because the acquiring company overestimated the positive effects or because it underestimated the problems that have always been part of the implementation of change in any organisation. Numerous studies have shown that overpayment is one of the key factors in the failure of this kind of operation, and that paying over the odds is due to the failure to rigorously assess the target’s intrinsic value or to unrealistic expectations of synergies.
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?
As in any negotiation process, a good price for an M&A transaction is the result of reaching a reasonable agreement on the economic value of the company being acquired. For the price to be reasonable, the economic value on which it is based must be as well.
When we speak of economic value, we need to define what we mean. There are essentially two types of economic value: the relative, or extrinsic, value; and the intrinsic, or fundamental, value.
■ Relative value Relative, or extrinsic, value is based on external references. For example, the market value of a company, which is the value it is given during an M&A process, whether it takes place in a regulated market (a listed company) or in a private market (using comparables). 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 allocating prices, an asset’s extrinsic value is an appropriate reflection of its economic value.
■ Intrinsic value Of course, the market does not always work that way. Hence, the intrinsic value, based on the more telling characteristics of the business, can provide a more reliable measurement of economic value. If the potential purchaser is interested in accounting metrics, it can use the adjusted book value, employing market or replacement value for adjustments. If, however, the potential buyer believes that the asset value provided by the books does not reflect the true economic value of the business, then it 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 risk associated with the above cash flows.
Contrary to common belief, relative/extrinsic and intrinsic/fundamental values are not incompatible, and are actually complementary. The difference between the two should serve to show the economic value of a controlling interest in the company.
Price and relative value
To establish a reasonable price using relative value, it is important to make sure that the markets on which the comparison is based are comparable. In the case of listed companies, not all capital markets have the same levels of efficiency, size and depth. For example, generally speaking, share prices provided by the financial markets of developing or emerging countries can not always be relied on as a genuine reflection of the economic value of the companies in question and their use is, therefore, limited.
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 the following:
■ profitability, measured by the return on capital employed;
■ the company’s sustainable growth rate;
■ the company’s size, measured by turnover;
■ the company’s presence, measured by the level of diversification;
■ use of recent figures;
■ elimination of non-recurrent events;
■ adjustment of the value if non- operative results are produced;
■ use of figures drawn up using comparable accounting principles.
Earnings per share (eps) are often employed in valuations using comparables. Again, it is a good idea to ensure the consistency of the figures, especially when they are taken from companies involved in high-volume asset sales and purchases.
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 transaction.
For example, when General Electric (GE) announced the sale of its Japanese insurance subsidiary, GE Edison Life, in 2003, the company did not report the atypical earnings associated with the sale, which were worth more than $2bn. Analysts estimated possible after-tax earnings at $250m, 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 equivalent to 6 per cent of the company’s overall value.
Price and fundamental value
To obtain a reasonable price using the intrinsic value it is essential to understand the valuation model used, the business being valued, and how they adapt to each other. Accordingly, determining what a differential cash flow and an appropriate discount rate are and how they size up against each other depends on the position from which the valuation is being made.
For example, if we were to try to determine the intrinsic value of a company, which we shall call, “A”, in an acquisition by another company, which we shall call, “B”, A’s value will depend on the why, for whom and circumstances of the valuation, which can bring about significant changes in the price. Table 1 shows some of the possible solutions that could serve in this case.
Consider the case of Spanish fast food company Telepizza. In February 2006, the Ballvé brothers, who controlled the company with a 20.5 per cent holding, announced a tender to purchase 100 per cent of the capital at a price of euro 2.15 per share, which represented a premium of 14.36 per cent on the share price at the last market close. When Telepizza’s board of directors recommended that shareholders accept the offer, their advice was considered reasonable by all concerned.
On May 5, however, the Portuguese group Ibersol announced an offer to buy 100 per cent in cash and at euro 2.41 per share, which led to a modification of the initial offer made by the current owners, raising the Telepizza share price to euro 3.21 per share.
This series of events raises several questions. What had changed at the company between February and June for its value, in the opinion of its current owners, to increase by almost 50 per cent? And to what extent can it be said that the company’s board of directors’ recommendation created value for shareholders?
In order to obtain the correct ratio between price and value it is essential to consider what is being bought and how it is being bought. For example, it is not the same to buy a controlling interest in a public company as it is to buy a non-controlling interest in a private company. Similarly, cash tenders are more attractive than tenders based on shares. 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 to purchase.
Moreover, there is always the risk that the transaction will not take place and if the share value has increased considerably because of the potential transaction, investors can consider selling their securities and pocketing the cash. This is particularly attractive when there are obstacles to the tender, such as legal regulations, competitors, politics and so on, or when there is a possibility of the transaction being delayed, a situation currently encountered by a number of companies, including steel producer Arcelor, Endesa, the energy provider, and property group Metrovacesa.
Once the value of the company has been made based on an open scenario, the process should be rounded off by examining real factors, such as possible limitations to the distribution of cash flows among those supplying the funds (capital and liabilities). These adjustments are particularly important when valuing M&A transactions in a multinational context, and must include analysis of possible fiscal differences resulting from different rates of taxation between the two countries, the financing of the foreign company by the parent company once it has been acquired, and the alternatives available for repatriation of monetary flows to investors through various dividend share-out mechanisms.
The importance of finding a reasonable price in the M&A processes is self-evident. But it is also important not to fall into the traps that invariably appear when analysing the price for this type of transaction. Below are some of the common pitfalls that managers and companies need to consider.
■ Valuation should be left entirely to valuation experts. A valuation process does, of course, require help from experts. But it also involves much more. All those involved in a valuation process must understand the model being used, the assumptions on which it is based and its limitations and expectations, regardless of the fact that technical aspects may be commissioned to experts.
■ Failure to analyse the quality of the information. In his last official meeting as chairman of the Securities and Exchange Commission, Arthur Levitt pointed out that “a chat room is nothing but graffiti. If you are dumb enough to invest in what you see on a bathroom wall, you deserve what you get.” This is not likely the case with most managers, but this reflection by such a senior figure illustrates the importance of understanding information as a basis for valuation processes.
■ Failure to understand the context of the valuation. A valuation process also involves a why, for whom and in what circumstances that have a marked effect on the final result. The answers to each of these questions must be clearly established. The subjective component of any economic valuation can only be based on said answers.
■ Failure to provide the right follow-up processes. In 1994, German automaker BMW bought UK manufacturer Rover for approximately £8m. Between 1995 and the end of 1999, including provision for future losses, it invested a further £2bn in Rover. During this time, Rover’s share of the British car market fell from 13 per cent to 5 per cent. In May 2000, it was sold for less than £60m. At the time, BMW’s president, Joachim Milberg, commented: “We have learned that mergers can be paralysing in certain circumstances”.
In short, all valuations and the resulting price must be contrasted with the results. Insofar as a valuation is merely an opinion about the future, the basis for determining how realistic it is rests in the capacity to put the chosen scenario into practice. This is why financial markets penalise the non-fulfilment of expectations very heavily indeed, and why companies need to handle all external and internal communications correctly. Economic value is based on the fulfilment of expectations which, in turn, translates into credibility.
Francisco J López Lubián is director of the finance department at Instituto de Empresa Business School.