Mergers and Acquisitions (M&A) is a buzz word in current business environment. It refers to that area of corporate strategy which deals with buying, selling, combining, splitting, restructuring, etc. of an enterprise to enhance shareholder value.
In India, the liberalisation process which started in early nineties provided the impetus for M&A transactions involving large businesses. In the initial years, the transactions were domestic but in last couple of years cross border transaction activity has increased. One of the first such large transactions was acquisition of Tetley by Tata Group. Barring last one year, M&A activity has shown constant growth over last many years. It is observed that M&A activities are at a peak in boom period. In the down-turn, such activities take back seat though it is probable that M&A in a downturn may yield higher returns to shareholders. At the same time, one cannot forget that risk attached to M&A activities is also very high during downturn.
M&A activity may be carried out through mergers, demergers, acquisitions, sale of business, spin offs, etc. Any transaction to get finally consummated needs to be settled by flow of consideration from the acquirer to the seller. The consideration may be discharged by actual payment or through any other financial instrument. The determination of consideration carries more weight as stakeholders would like to ensure that the transaction is done in most fair and transparent manner.
In any M&A transaction, valuation of the business being transferred becomes very critical from all angles. In view of this, the current article covers certain basic features of financial valuations along with practical issues connected thereto.
The importance and purpose of valuation:
The stakeholders will always ask following questions on valuation when a business or an asset is transacted:
What is the value at which it is sold?
Is it a fair value?
What are the principles applied to determine the fair value?
The professional who is carrying out the valuation needs to keep purpose of valuation constantly in mind. The methodology of valuation may differ according to the purpose. For example, in case of valuation for merger, relative valuation of the companies involved is more relevant than the absolute valuation. As against this, in case of valuation for sale of business, absolute value of the company / business is more relevant.
The date of the valuation is also very relevant. A valuation done today may not be valid after passage of time as underlying factors such as price earning multiple, market price of the share, the return expectation, etc. may change from time to time. It is always advisable that the valuation is finalised near to the date of the transaction; otherwise the conclusions may undergo a material change.
Business Value would also differ from the point of view of the Buyer and that of the Seller, depending on one’s own perception, vision, strategy and future projections made by each of them independently.
Some of the purposes for which valuation may be required are as follows:
Determining the Portfolio Value of Investments by Venture Funds or Private Equity Funds:
In the current environment, when funds are deployed in investee company through private equity or venture capital funds, it becomes important that at regular interval the basket of investments held by such funds is valued and reported to the concerned forum (investment committee or trustees) so that performance of the fund managers as well as return generated for the investors can be determined.
Determining the consideration for Acquisition/Sale of Business or for Purchase/Sale of Equity stake:
When a business or shares are proposed to be divested, valuation becomes very relevant as the consideration has to change hands between buyer and seller based on agreed valuation. It is general practice that both buyer as well seller undertakes the valuation exercise which becomes base for the negotiation process. Only in very few instances it is observed that a common valuer is appointed by both the parties to arrive at the fair value.
Determining the swap ratio for Merger:
In case of merger of two companies the role of valuer is to recommend fair exchange ratio (number of shares of Transferee Company to be issued to the shareholders of the transferor company). If the companies involved are listed on the stock exchanges, it is required that the valuation is also followed by a fairness opinion by a category I merchant banker. It is required that valuation of both the companies involved is carried out on a like to like basis to the extent applicable. It may be inappropriate to use asset-based valuation for company A and earnings-based valuation for company B, unless there are justifiable reasons to follow such different methodologies.
Determining the swap ratio for Demerger :
There is misconception that every demerger requires valuation of the division being demerged. In case of vanilla demerger where beneficial ownership of the two entities post-demerger remains with the same set of shareholders, valuation may not be required as both the companies will be held by the same shareholders in the same inter se proportion as they were owning the company prior to the demerger. (Example: Demerger of Reliance Industries Limited.) As against this, when a division is demerged from a company into an operating company with a different set of shareholders, valuation of the division as well as the company to which the division is being transferred are required to be carried out. (Example: Demerger of farm input division of E.I.D.-Parry (India) Limited into Coromandel Fertilisers Limited. Demerger of scheduled airlines business of Kingfisher Airlines Limited into Deccan
Aviation Limited)
Determining the Fair value of ESOPs as per the ESOP guidelines:
Generally such valuation is carried out using Black Scholes model for ‘option Valuation.
Determining the value offamily owned business and assets in case of Family Separation:
This is generally required when family members decide to part ways. Here the valuation exercise becomes sensitive as one of the parties involved will always feel that fair treatment is not given. There are instances where valuers are dragged to court of law in case of valuation for family separation.
Sale/purchase of Intangible assets including brands, patents, copyrights, trademarks, rights:
In case of acquisition of a business for a lumpsum price, the identification and valuation of intangible assets becomes a requirement. In recent times, many transactions of intangibles are carried out. (Example sale of certain brands by Pfizer to Jhonson and Jhonson)
Liquidation of company:
When a company is liquidated valuation of each and every asset and liability is carried out and cost required to be incurred for closure is reduced from such values.
Determining the fair value of shares for Listing on the Stock Exchange:
when a company decides to offer its security for public participation, an estimation of the fair valuation of the security is required to guide the promoters and merchant bankers to decide the offer price. There are instances where shares are issued at a discount to the fair value to encourage public at large to invest.
Other reasons:
Many times valuations are required for litigation, buyback of shares, raising of funds, open offer in case of takeover, approval under the FEMA regulations, etc.
The above list is not exhaustive but only indicative of the purposes for which valuation is attempted.
Methods of valuation:
As discussed earlier that the value changes with the change in the purpose holds true also for the use of methodologies of Valuation. A valuer may use different methods to value the Shares of a Company / Business. In practice, however, the valuer normally uses different methodologies of valuation and arrives at a fair value for the entire business by combining the values arrived, using various methods and giving appropriate weights to the values so arrived to opine on fair value.
Each method proceeds on different fundamental assumptions, which have greater or less relevance, and at times even no relevance to a given situation. Thus, the methods to be adopted for a particular valuation must be judiciously chosen.
Commonly used methods of valuation are as under:
A. Asset Based Approach:
i. Net Assets Method:
Valuation of net assets is calculated with reference to the historical cost of the assets owned by the company. Such value usually represents the minimum value or a support value. of a going concern. It is also necessary to make adjustments for market value of non operating assets, contingent liabilities likely to materialise, outstanding warrants, appreciation/ diminution in the value of investments, etc. This method is mainly applicable for investment companies or companies which are yet to commence their operations. For a manufacturing concern the value under this method is a floor value below which a transaction may not be carried out.
ii. Net Realisable Value Method:
Where the business of the company is being liquidated, its assets have to be valued as if they were individually sold and not on a going concern basis. This method is generally used in case of liquidation. One has to take a note of liabilities that would arise on account of closure, tax implications, and dividend distribution tax, etc.
iii. Remainder Replacement Value Method:
Under this method, the replacement value of assets and not the book value is captured. Net replacement value of the assets indicates the value of an asset similar to the original asset whose life is equal to the residual life of the existing asset. The term replacement cost refers to the amount that a company would have to pay, at the present time, to replace anyone of its existing assets.
B. Earnings-based Approach:
i. Profit Earning Capitalisation Value Method (PECV) :
Earnings-based methods are generally regarded as more appropriate in case of ‘going concern’ valuation. Capitalisation of future maintainable earnings on a post tax basis is carried out under Earnings Approach. For this purpose past profitability generally gives the indication. However, for a company where past profits are not representative of future maintainable earnings then, future expected profitability may be used after taking into account present value of future expected profits. Any extraordinary item of income/ expenditure is adjusted for arriving at future maintainable profit. The most common example of such adjustments are profit/loss on sale of assets/investments, impact of VRS, one time write off of stocks / debtors, loss on account of natu-ral calamities, etc. The price earning multiple is to be carefully chosen taking into account multiples enjoyed by similar quoted companies.
ii. Discounted Cash flow Method (DCF) :
DCF method considers cash flow and not the profits of the business. The DCF method values the business by discounting its free cash flows for the explicit forecast period and the perpetuity value thereafter. The free cash flows represent the cash available for distribution to both the owners and the creditors of the business. The cash flows are considered keeping in mind the projections, horizon period, growth rate, and the residual value. Discounting is done taking into account the weighted average cost of capital which is based on the cost of equity and cost of capital and after taking into account the proportion of debt and equity used to fund the business.
iii. EBITDA Multiple Method:
The EBITDA multiple is the ratio of Enterprise value to EBITDA. It involves determination of maintainable EBITDA.
This method ensures that the valuation is not affected by the pattern of funding adopted by the company or comparable companies. One has to keep in mind that value of debt is reduced from the enterprise value to arrive at the equity value.
iv. Sales Multiple Method:
Sales multiple may be used to arrive at the enterprise value particularly if the business is not making profits. The information needed is annual sales and an industry multiplier, which will depend on industry. The industry multiplier can be obtained from public sources including data relating to listed comparables. This method is easy to understand and use. However, this method is generally used to cross check the values arrived at under other methods of valuation.
C. Market-based Approach:
Market Price Method :
The Market Price Method takes into consideration prices quoted on the stock exchange. Average of quoted price is considered as indicative of the value perception of the company by investors operating under free market conditions. Adjustments have to be made for issue of bonus shares or right shares during the period. Regulatory bodies often consider market value as important basis – Preferential allotment, Buyback, Open offer price calculation under the Takeover Code. Market Price Method is not relevant where the shares are not listed or are thinly traded etc.
Market comparables :
This method is generally applied in case of unlisted entities. This method estimates value by relating the same to underlying elements of similar companies. It is based on market multiples of ‘comparable companies’. e.g.
- Earnings/Revenue Multiples (Valuation of Pharmaceutical Brands)
- Book Value Multiples (Valuation of Financial Institution or Banks)
- Industry-Specific Multiples (Valuation of cement companies based on Production capacities, Valuation of BPO companies based on number of seats)
- Multiples from Recent M&A Transactions.
Though this method is easy to understand and quick to compute, it may not capture the intrinsic value and may give a distorted picture in case of short term volatility in the markets. There may often be difficulty in identifying the comparable companies or comparable transactions.
Data used to carry out valuations :
Valuation starts with collection of relevant and optimal information required for valuing Share or Business of a company. Such information can be obtained from one or more of the following sources:
Historical results:
Annual Reports for atleast 3 years of the Company are required for valuation exercise. Apart from review of detailed financials, it is necessary to
carefully consider the Directors Report, Management Discussions, Corporate Governance Reports, Auditors’ Report and Notes to accounts. A detailed analysis of the past performance is starting point in any valuation exercise. From the past results various important aspects can be worked out such as one time non-recurring income, expenditure, change in Government/Tax regulations affecting business, tax benefits enjoyed, etc.
Projections:
Future expected Profitability, Balance Sheet and Cash Flows along with detailed assumptions underlying the projections are required. The projections considered for valuation should not be at variance with the outlook discussed in the Annual Report. It is important to cover the period which will comprise the entire cycle of the business. In certain industry even 3 year period will cover the cycle whereas in certain industries like heavy engineering or cement, a longer period of 5 to 7 years may capture the cycle. It is impossible to predict the future in a precise way particularly considering the dynamic nature of the economy. One should ensure that the assumption behind the future projections is reasonable at a point of time when they are prepared. A few common mistakes which are found in the projections are: assuming production much higher than the capacities without capturing additional capital cost, showing unreasonable changes in selling price of the final products or of raw materials, showing unreasonable change in the working capital movements, capturing tax benefits even after sunset clause under the Tax laws, unreasonable changes in manpower cost, etc.
Discussions with the Management:
Discussions with management may sometimes reveal issues that may drive the valuation. It is very important that open, fair and detailed discussions are carried out between the valuer and the management. The discussions should not be restricted to only representatives of Finance Department but involve other key functional heads.
It is advisable to obtain written confirmation of the inputs provided by the Management. This helps the valuer in defending the valuation in the eventuality of its being challenged by any Authority.
Market surveys, other publicly available data:
A valuer carries out market surveys and obtains publicly available information. It may pertain to the industry as well as the Company being valued. Due to technology advancement, most 6£ these data are available on the net. Various newspaper reports are also available on the subject. It is advisable to double check the accuracy of these data before relying on such data. Various software packages that have the relevant data are available. It should be ensured that updated version of such data is used.
Data on comparable companies:
Review of data on comparable companies is an important feature in any valuation exercise. Area of operations and the extent of the market share also play an important role in considering the comparable companies. It is possible that geographically the companies are located in different areas because of which there are substantial differences in the operational cost. For example cement companies located near to limestone reserve and those which are located far off are not strictly comparable. Further, different funding pattern of two companies and investment also makes them non-comparable.
Steps in valuation:
Obtaining information:
It is always experienced that the time available to carry out the valuation is short as the parties want to complete the transaction as fast as possible. In view of this, it is very critical that one seeks relevant information. Obtaining and processing unrelated data may take away precious time without obtaining desired result. For example if the transaction is only for an intangible asset, processing the data for working capital of the business may not be required. At the same time there should not be compromise on obtaining critical data on the ground of shortage of time. It goes without saying that this stage comes only after appropriate Engagement letter setting out scope of work, time lines and fees is in place.
Reviewing data provided:
Having obtained the relevant information, next step is to process the same. Some of the items on which extra emphasis should be given are analysis of various ratios, comparison with comparable companies, current Regulatory environment, future plans, contingent liabilities, surplus assets, outstanding warrants, etc. Use of technologies and other software will be maximum during this stage of valuation.
Review of underlying assumptions of projections:
Depending on the facts of the case, one can decide whether projections should be used or not. If one is using the future projections, review of underlying assumption for various critical items such as growth in turnover, raw material consumption, inflation rate, foreign exchange rate, working capital movement, capital expenditure needs, etc. will be important. One should always keep in mind the requirement of the Institute of Chartered Accountants of India while dealing with future projections.
Selecting method(s) :
Having obtained and processed the data, the valuer will have to decide on methods to be used for valuation. There is no fixed rule or principle regarding methods to be used for valuation. It is more dependent on valuer as to which method is relevant in a particular case. The selection of method(s) may differ from valuer to valuer as it a very subjective issue. The valuer should be in a position to justify the method(s) used as well as factors considered in case the valuation is challenged by any Authority. If multiple methods are used for a particular valuation, it is a common practice to assign weights to different methods to arrive at the fair value. Guidance may be taken from past decided case laws as to the selection of methods and weights.
Reporting:
Once the valuer concludes on his opinion as to the fair value, the next step will be Report of valuation. The typical contents of the report should be purpose of valuation, date of valuation, background of the Company, sources of information, methods of valuation used alongwith major adjustments, conclusions and disclaimers. There are some valuers who attach entire workings with the report where as some valuers just mention the final value.
Conclusion:
It may be relevant to mention that valuation is not at all a rocket science. It is always seen as a very specialised field. However it is more an application of common sense. The more you practise a particular work, more conversant and proficient you become. It is always seen that the easiest target in any transaction to get challenged is valuation. The reason is that valuation is very subjective. The discount rate, the price earnings multiple, the selection of methods, determination of maintainable profits, etc. will differ from one individual to other. There is no single correct answer to any valuation. That is why it is considered more an art and not an exact science.
