Acquisition Pricing Policy
In Part Three we explained how private investors and financial institutions analyse share price listings based on valuation theories that encompass dividends (the yield and cover) and earnings (the P/E ratio) to implement their trading decisions (i.e." buy, sell or hold").
Part Four began by applying these dynamics to the corporate sector and the specific case of a firm seeking a stock exchange listing and market valuation. We shall now analyse the most important trading decision undertaken by a listed company: namely the takeover of one firm by another.
Based on your reading of Chapters' Ten to Twelve of CVT and its referenced research, the objectives of our final Exercises are to:
- Illustrate why the commercial rationale for takeover activity should be based on wealth maximisation criteria, measured by a significant improvement in long-term earnings after an acquisition.
- Derive a going-concern valuation for one company (the "target") by another (the "predator") as a basis for acquisition.
- Demonstrate why the target company's going-concern capitalisation of future earnings (and bid price per share) prepared by the predatory company should exceed a corresponding current valuation of the target's net assets (which in turn should exceed its Balance Sheet figures).
- Explain why the difference between the two valuations and the price paid for "goodwill" should not be so highly valued (risky) as to invalidate the takeover.
Exercise 7.1: A "Suspect" Takeover Valuation
W. Stripes plc has completed an objective analysis of its strategic capabilities and decided upon a potential acquisition as the most viable means of achieving its goal, namely diversification. The chosen "target" is a "blue chip" company, Ozzy plc, whose background data you are already familiar with from Chapter Five. This company currently earns a "normal" return for its sector, although its current share price has been adversely affected by a recent "profit warning" and the wider economic recession.
For simplicity, we shall assume that Stripes' motivation for the takeover is not only rational but also cash based. So, borrowing (leverage) is not an issue.
The acquisition investment profile prepared by Stripes is summarized as follows:
Target Data (pre-acquisition): Predatory Data (post-acquisition):
The pre-acquisition data conforms to the table you were asked to derive at the end of Chapter Five for future reference.
Having read Part Four of the CVT text, prepare a financial report for Stripes that contains:
1. A summary of the objective and subjective motivational factors that underpin takeover activity.
2. A range of bid prices per share for Ozzy plc as a going concern, with reference to a:
- Net asset valuation
- Goodwill valuation
- Profitability valuation
3. A brief commentary on your findings
4. A risk assessment based on your valuations
5. Any recommendations
An Indicative Outline Solution
1. Motivational Factors
An objective analysis of any prospective acquisition should be based on rational managerial objectives underpinned by shareholder wealth maximisation criteria. Hopefully, these will be confirmed subsequently, by a significant improvement in the predator company's long-term earnings post-acquisition. Chapter Nine of CVT explains how this requires a comprehensive valuation based on the following strategic considerations prior to take-over activity.
Business Resource Influence
However, all too often, the agency principle breaks down because subjective managerial motives associated with an acquisition take precedence over commercial objectives, notably management's pursuit of:
Growth Prestige Security
And as we observed in CVT (Chapter Nine) the history of corporate takeovers revealed by the academic literature illustrates the extent to which these policies lead to financial disaster.
With regard to Stripes strategy, diversification can vary its activities. It is always sensible to avoid "putting all your eggs in one basket". But will this add value and create shareholder wealth?
If you have read the bookboon text "Portfolio Theory and Financial Analyses" (2010) or any others by the author on the subject (see the references at the end of this Chapter) you will be aware that diversification can help management in one of two ways.
Academic studies reveal that diversification has the potential to provide:
- The same return on investment as before, but with less risk.
- Higher returns than before, for the same risk.
Unfortunately, diversification isn't simply a question of investors buying more shares to add to their portfolio, or of one company acquiring another. "Efficient" diversification arises from researching individual shares, or companies, with different returns from different business activities that perform well at different points in the economic cycle.
The key to profitable risk- return diversification requires genuinely different sources of income. Hopefully, Stripes has researched this?
2. A Bid Price per Share
An offer for Ozzy's shares, currently trading at 75 pence (25 pence below nominal value because of a profit warning and recession), depends on three factors researched by Stripes:
- The minimum purchase price of net tangible assets,
- Evidence of goodwill,
- The total profitability of the business.
Using equations with the same numbering from CVT (Chapters Ten and Eleven) where appropriate, the corresponding valuations are calculated as follows
(i) Minimum Valuation (net tangible assets)
With 100 million shares in issue and a net tangible asset revaluation of £200 million we can derive a bid price of: £200m /100m = £2.00 per share
(ii) Goodwill Valuation (capitalisation of super profits)
From Chapter Ten, the value of goodwill is represented by the right-hand term in the following going concern equation
(23) V = A + [(P - rA) / m] Subject to m > r
V = going concern value of the business
A = value of net tangible assets
P = expected profits per annum
r = normal rate of return
P - rA = super profit
m = capitalisation rate of surper profit
(P - rA ) / m = value of goodwill
The value term for goodwill can also be rewritten from a conventional accounting perspective in terms of its useful life.
(1/m)= a number of years purchase of super profit Using the acquisition investment profile prepared by Stripes, we can therefore derive: Goodwill computation: (P - r A) / m
Post-acquisition profit: 10% on £200m £20.0 m
Less normal profit (given) £ 5.0 m
Super profit £15.0 m
Capitalised at 20% (i.e. 5 years purchase) £75.0 m
Going concern valuation: V = A + (P - r. A ) / m
V = £200m + (£20m - £5m) / 0.2 = £275 million
With 100 million shares in issue we can derive the following bid price:
£275m /100m = £2.75 per share
(iii) Profitability Valuation: (capitalisation of future earnings)
If we assume that profits are constant in perpetuity, the going-concern value of a target company can be defined using two equations from Chapter Eleven, depending on the data available:
V = going concern value of the business
n = expected profits at the valuation date t = rate of corporation tax
P/E = price-earnings ratio Ke = earnings yield
If profits grow at a constant rate in perpetuity (g) we can also rewrite Equation (26) using the constant growth formula explained in Part Two, based on anticipated post-tax earnings one year after takeover:
subject to the proviso that Ke > g for V to be finite.
Using the information prepared by Stripes, which ignores growth, we can therefore apply Equation (26) to capitalize post-acquisition profit at 10% as follows
V = n (1 - t) / Ke = £20 m / 0.10 = £200m
And dividing by the 100 million shares in issue, we can derive the following bid price:
£200m /100m = £2.00 per share
Ozzy's mediocre stock market performance (confirmed by the £25 million shortfall between the market capitalisation of equity and nominal value) may explain why the asset revaluation prepared by Stripes, not only exceeds the market capitalisation, but also equals the profitability valuation. But why does the going concern value (using net assets plus "goodwill") exceed the profitability valuation (which is based on the assets' earning power capitalised at the post-acquisition rate of return)?
Moreover, what is so special about the company's intangible assets to justify their acquisition at such a high-risk price? Note that the capitalisation rate of superprofit (m = 20 per cent) is twice the normal rate of return (r = 10 per cent).
4. A Risk Analysis
The tangible assets are important in any managerial risk assessment of corporate takeover. If the net assets divided by the market capitalisation of profits "cover" the price of investment significantly (i.e. the asset backing is high) or its reciprocal (the valuation ratio) is greater than one, this may compensate for corporate failure post-acquisition if the assets need to be sold off.
You will recall from CVT (Chapter Eleven) that the purchase value of tangible assets relative to a profitability valuation (asset backing) is measured by the following equation:
(28) Cover = Net asset valuation /Profitability valuation
The acquisition can also be assessed by the reciprocal of cover, using the valuation ratio
(29) Valuation ratio = Profitability valuation / Net asset valuation
Using the target data, we can evaluate the asset cover and valuation ratio if Stripes is willing to pay a capitalised profit figure of £200m for assets valued at £200m as follows:
- Cover = Net asset valuation /Profitability valuation = 1.0
- Valuation ratio = Profitability valuation / Net asset valuation = 1.0
The value of the tangible assets (asset backing) completely covers the profitability valuation
The acquisition can also be justified (but only just) since the profit earning capacity of the business equals the net assets as evidenced by the reciprocal of the cover: namely the valuation ratio.
As mentioned earlier, if a profit valuation equals a net asset valuation, the question predatory management must answer is where is the goodwill? We suggested earlier in this text (see the Summary and Conclusions to Chapter Five) that perhaps Ozzy plc is worth more "dead than alive" and only ripe for asset stripping.
Stripes could definitely make an initial bid that flatters the current share price of 75 pence, moving up to a profitability valuation of £2.00 covered by the assets with little risk. However, beyond this figure, any going concern valuation that incorporates goodwill suggests that the purchase of say a brand name, unsupported by profits, requires:
A radical reassessment of the forecast acquisition data, an allowance for growth, or alternatively a better company to complement Stripes' existing activities