Acquisition Pricing and Accounting Data
Let us assume that a company has completed an objective analysis of its strategic capabilities based on shareholder welfare outlined in Figure 10.1. It has also identified a potential acquisition as the most viable means of achieving its goals. The question now arises as to the most appropriate method of valuation and from where the data should be sourced.
Figure 10.1: Objective Managerial Motives for Acquisition or Takeover
The various going concern valuations available to management (some more sophisticated than others) can be summarized as follows:
1) A net asset valuation incorporating goodwill
2) Income expectations:
(i) a profitability valuation using P/E ratios
(ii) a dividend valuation based upon dividend policy
(iii) a cash flow valuation based on DCF techniques
As we shall discover, no one method is necessarily correct. Rather, they should be used when appropriate to provide a "range" of values for the purposes of negotiation.
To determine a takeover valuation, management must pay careful attention to the past history and present background of the target company. Financial details should be prepared in respect of its latest asset position at the valuation date disclosed by the latest published accounts, together with a review of trading and profit and loss results over a period of years. Equally, the firm's recent stock market performance (yield, cover and the P/E) must be scrutinized, if only to ensure that dividend expectations can be satisfied post-takeover. The worst case scenario is that the target's shares are infrequently traded. There is a history of losses, or erratic profits. Distributions too, may be extremely variable or non-existent. So, there is no reliable basis for deriving a bid price based on market data.
And this is where an asset valuation kicks in.
Takeover Valuation: The Case for Net Assets
The problem of an asset valuation is its evidence of earning power. An acquisition at the market value of assets, let alone their book value based on historical cost accounting (HCA) techniques, may be interpreted as a "bargain buy". But as a going concern the firm may be worth more "dead than alive". For companies with a stock exchange listing (price) that produces a low market capitalisation of equity relative to the book value of net assets (i.e. low valuation ratio) the takeover may appear attractive, particularly for venture capitalists if the shares have been neglected by the market. But if an acquisition is not part of a carefully conceived corporate plan, reflecting factors other than earnings (for example asset stripping) the predator may inherit a negligible return on investment that is not dissimilar to takeovers premised upon the subjective managerial goals of growth, prestige and security outlined in the previous Chapter. The merger may also elicit rising expectations on the part of existing shareholders, as well as potential investors. But if these are not fulfilled after the takeover, confidence can evaporate rapidly and equity prices will tumble.
However, we cannot dismiss an asset valuation altogether. Reference to a company's assets is justifiable, if only as a "benchmark" in relation to its current market capitalisation of equity, since their earning power must have a profound effect on share price.
As a basis for takeover, your accounting skills are employed to determine a "going concern" valuation using a record of the latest asset position disclosed by the published financial accounts of a target company.
What adjustments to the data do you envisage making?