CIMA F3 Syllabus D. Business valuation - Potential post-transaction value - Notes 1 / 3
Valuation of mergers and takeovers
Shareholders of both of the companies involved in a merger or acquisition
will be aware of the effect on share prices and earning per share (EPS).
The market values of the companies' shares during a takeover bid
Share prices can be very important during a takeover bid.
Suppose that Cow decides to make a takeover bid of Calf.
Calf shares are currently quoted on the market at $3 each.
Cow shares are quoted at $6.50 and Cow offers one of its shares for every two shares in Calf, thus making an offer at current market values worth $3.25 (= $6.50 / 2) per share in Calf.
This is only the value of the bid so long as Cow's shares remain valued at $6.50.
If their value falls, the bid will become less attractive.
E.g. if the the value is $5.80 so the offer would mean ($5.80 / 2 = $2.90) which is less than $3.00
Companies that make takeover bids with a share exchange offer
are thus always concerned that the market value of their shares should not fall during the takeover negotiations, before the target company's shareholders have decided whether to accept the bid.
If the market price of the target company's shares rises above the offer price during the course of a takeover bid, the bid price will seem too low, and shareholders in the target company might refuse to sell their shares to the bidder.
EPS before and after a takeover
If one company acquires another by issuing shares, its EPS will go up or down according to the P/E ratio at which the target company has been bought.
If the target company's shares are bought at a higher P/E ratio than the predator company's shares, the predator company's shareholders will suffer a fall in EPS.
If the target company's shares are valued at a lower P/E ratio, the predator company's shareholders will benefit from a rise in EPS.
Illustration 1: Share for share exchanges
P acquired 80% of S shares via a 2 for 1 share exchange.
At the date of acquisition, the following balances were in the books of P and S:
| P | S | |
| Share Capital | $400 | ($0.50) $400 |
| Share Premium | $100 | $50 |
How much is the Cash of investment?
P acquired 80% of S’s shares.
The shares had a value of $400 but a nominal value of $0.50.
This means S has 800 shares in total. P acquired 80% x 800 = 640 shares
The share for share deal was 2 for 1.
So P gives 1,280 of its shares in return for 640 of S’s shares.
P’s shares have a MV of $2 at this date so the “cost of investment is 1,280 x $2 = $2,560
Illustration 2: Share for share exchanges (2 for 1)
Cow takes over Calf by offering two shares in Cow for one share in Calf.
Details about each company are as follows.
| Cow | Calf | |
|---|---|---|
| Number of shares | 3,000,000 | 100,000 |
| Market value per share | $5 | - |
| Annual earnings | $750,000 | $100,000 |
| EPS | 25p | $1 |
| P/E ratio | 20 |
By offering two shares in Cow
worth $5 each for one share in Calf, the valuation placed on each Calf share is $10, and with Calf's EPS of $1, this implies that Calf would be acquired on a P/E ratio of 10.
This is lower than the P/E ratio of Cow, which is 20.
If the acquisition produces no synergy, and there is no growth in the earnings of either Cow or its new subsidiary Calf, then the EPS of Cow would still be higher than before, because Calf was bought on a lower P/E ratio.
The combined group's results would be as follows:
| Cow group | |
|---|---|
| Number of shares (3,000,000 + 200,000) | 3,200,000 |
| Annual earnings (750,000 + 100,000) | 850,000 |
| EPS | 26.56p |
Illustration 3: Buying companies on a higher P/E ratio but with profit growth (2 for 3)
Buying companies on a higher P/E ratio will result in a fall in EPS unless there is profit growth to offset this fall.
For example, suppose that Cow acquires Calf, by offering two shares in Cow for three shares in Calf.
Details of each company are as follows.
| Cow | Calf | |
|---|---|---|
| Number of shares | 7,500,000 | 6,000,000 |
| Value per share | $8 | $6 |
| Annual earnings | ||
| Current | $3,000,000 | $1,200,000 |
| Next year | $3,200,000 | $2,000,000 |
| EPS | 40p | 20p |
| P/E ratio | 20 | 30 |
Cow is acquiring Calf on a higher P/E ratio, and it is only the profit growth in the acquired subsidiary that gives the enlarged Cow group its growth in EPS.
| Cow group | |
|---|---|
| Number of shares (7,500,000 + 4,000,000) | 11,500,000 |
| Earnings | |
| If no profit growth (3,000,000 + 1,200,000) = $4,200,000 | EPS would have been 36.52p |
| With profit growth (3,200,000 + 2,000,000) = $5,200,000 | EPS will be 45.22p |
If an acquisition strategy involves buying companies on a higher P/E ratio, it is therefore essential for continuing EPS growth that the acquired companies offer prospects of strong profit growth.
Valuation using post-merger dividends or cash flows
An alternative method to using the P/E ratios, is to consider the dividends or cash flows of the merged company.
Dividend method
The steps are as follows:
Estimate the initial dividends of the combined company and the dividend growth rate
Estimate the new cost of capital; if the cost of the two old companies differs significantly, some sort of weighted average method wilI be required
Calculate the value of the combined company using the dividend valuation model
Compare the value of the combined company with the pre-merger value of the acquiror.
The excess is the value of the target
Cash flow method
The steps here are as follows:
Estimate the cash flows of the combined company, including the acquired's, the acquiror's and the additional cash flows arising from the beneficial effects of the merger
Estimate the new cost of capital
Calculate the net present value of the combined cash flows
Compare the value of the combined cash flows with the acquiror's cash flows if no merger took place.
The excess is the value of the target.