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11. Acquisition Pricing-Profitability, Dividend Policy and Cash Flow

Introduction

If analysts could successfully measure the value of a business using data drawn directly from its published accounts, the valuation of one company by another would present little difficulty. However, we have observed that beyond their stewardship function (providing a historical record of transactions which have actually taken place) published financial statements are "not fit for purpose".

The limitations of company accounts (even those based on current cost) arise because of the necessity for up to date information that relate the income of the firm to annual reporting periods; a "snapshot" which rarely conforms to the cycle of its operations. If all inputs into the productive process were converted into output and sold within a single accounting period, there would be no problem. The only asset held by the firm would be cash. Since business is a continuous process, however, at the end of each period there are normally significant amounts of input. Each at various stages of conversion into output, all of which need to be valued. It is this "piecemeal" approach to asset valuation that poses the greatest problem when valuing a company as a going concern. How do we place an entity value on a company as a "whole" as evidenced by its future earning power?

Fortunately, alternative approaches to corporate valuation are available to predator companies, which are not asset based but driven by income expectations. These utilize discounted revenue theory and the capitalisation of a perpetual annuity (using earnings, dividends, or cash flows) that can be made operational through a series of investment yields (capitalisation rates) namely:

- A capitalized earnings valuation using a P/E ratio applied to post-tax earnings

- A capitalized dividend valuation based on dividend policy

- A present value (PV) calculation using a cash flow yield

11.1. Takeover Valuation: The Profitability Basis

If we adopt an entity view, takeover valuations can be derived from the capitalisation of a company's post-tax accounting profits, rather than the sum of its net tangible assets and an allowance for goodwill. Of course, great care should still be taken to ensure that the profit figure provides a realistic basis for capitalisation. Allowance must be made for all charges (including tax) and retention policy, because what should motivate the purchaser is the amount earned by leaving the business in at least the same position as it was prior to takeover. Note that the after tax profit figure is unlikely to be the same as the dividend payout, because an allowance for ploughback may produce a different valuation (a point to be discussed later).

Items that should be given particular attention in the target's accounts are:

a) Managerial remuneration, which might be artificially high, not only in a bonus culture, but also to avoid corporation tax.

b) Transactions that are not at "arms length" and therefore unavailable to the prospective purchaser.

c) Cost of sales, which should be in current terms.

d) Adequacy of depreciation in order to provide funds for the replacement cost of assets. Note that depreciation rates could also be used to keep cash in the business in order to maintain a dividend distribution at the expense of reinvestment (as the following example reveals).

Watts plc ($ m)

Wyman plc ($ m)

Balance Sheet for Year One

Balance Sheet for Year One

Share Capital 100 Assets

100

Share Capital 100 Assets

100

Profits before depreciation = 20 p.a.

Profits before depreciation = 20 p.a.

Depreciation over 5 years

Depreciation over 10 years

Balance Sheet for Year Five

Balance Sheet for Year Five

Share Capital 100 Assets (cost)

100

Share Capital 100 Assets (cost)

100

Depreciation

_80

Depreciation

40

Net book value

20

Net book value

60

_ Cash

80

_ Cash

40

100

100

100

100

No dividends

Dividends $40

e) The correct treatment of R and D as either revenue or capital.

f) The impact of future repairs and maintenance on profitability.

g) The inclusion of any non-recurring income or profits, such as those arising from the sale of excess or idle assets.

h) Provision for bad debts.

After making adjustments to post-tax profit, the predator company must then ascertain whether it is possible to use the figure as an estimator for maintainable earnings at the valuation date. This may be problematic if there are fluctuations in past profits. Even where steady growth is evident, there is also the question of whether this will continue. However, having arrived at an acceptable figure, this must now be capitalized by reference to an appropriate P/E ratio (or desired earnings yield) that relates to the investment's risk.

If we assume that profits are constant in perpetuity, the going-concern value of the target company may be defined as follows:

Or alternatively:

Where:

V = going concern value of the business

n = expected profits at the valuation date

t = rate of corporation tax

P/E = 1 / K

Ke = earnings yield

If profits grow at a constant rate in perpetuity (g) we can rewrite Equation (26) using the constant growth formula explained in Part Two, based on anticipated post-tax earnings one year after takeover:

In the absence of a suitable P/E ratio relating to the target itself (or similar companies in a similar industry) we can assume the minimum yield to be sought by a prospective purchaser is the rate of return obtained from risk-free government securities (gilt-edged stocks). To this yield a premium must be added for the risk of acquiring the company. The amount of risk depends very much on the individual circumstances for takeover and the attitude of the predator. For example, will management continue to function well in the purchased company? Does technical expertise reside with individuals, rather than the nature of the business itself? In fact, will the nature of the business change post-acquisition?

The assets are also important in any risk assessment. If the net assets divided by the market capitalisation of profits "cover" the price of the investment significantly (i.e. the asset backing is high) or its reciprocal (the valuation ratio) is only slightly greater than one, this may compensate for corporate failure post-takeover if the assets need to be sold off piecemeal.

Activity 1

Using the following target data (£m) evaluate the asset cover and valuation ratio for a company willing to pay a capitalized profit figure of £120 million for an acquisition.

The purchase value of the tangible assets relative to the profitability valuation (asset backing) is measured by:

(28) Cover = Net asset valuation / Profitability valuation = 0.83

The acquisition can also be assessed by the reciprocal of cover, using the valuation ratio

(29) Valuation ratio = Profitability valuation / Net Asset valuation = 1.20

If the purchaser pays £120 million for the business because of strong earnings then the cover is £100 million divided by £120 million. In other words, the asset backing is 0.83, which is substantial. Conversely, this corresponds to a valuation ratio of 1.20 (£120 million divided by £100 million) which is reasonable. The net assets relative to future profitability minimise the risk of investment. If the former were higher than the latter, the target firm would obviously be "worth more dead than alive" and ripe for asset stripping.

Share capital 50

Retained earnings 50

Net assets at valuation 100

As a basis for valuation, distinction should also be drawn between the P/E ratio (and its reciprocal the earnings yield) and the dividend yield. The former is more important to investors wishing to acquire control of a company. This is not to say that predatory companies can ignore how earnings are packaged for distribution. On the contrary, a dividend valuation contributes to a "range" of bid prices underpinned by a benchmark net asset valuation. Adequate dividend yields are necessary to attract investors, now as well as in the future, who seek regular income (as we shall discover). But this should not be at the expense of reinvestment policy.

Consider the following target companies:

£m

Bilbo

Frodo

Pippin

Purchase price: V

1,000

1,000

1,000

Profitability: P/E ratio

8.3

11.1

16.7

Earnings yield

12%

9%

6%

Earnings before tax

160

120

80

Tax at 25%

40

30

20

Profits after tax

120

90

60

Dividend yield (5%)

50

50

50

Retained earnings

70

40

10

Ploughback %

58%

45%

16%

Whilst the dividend yield for each company is identical, Bilbo's ploughback of 58 percent clearly offers the best prospects for growth and capital gains.

The capitalisation of net maintainable earnings using an appropriate P/E ratio should produce a going concern figure in excess of the total net asset value employed in the business. To this value we may have to add excess or idle assets that are surplus to requirements post-acquisition at a realizable valuation (i.e. assets whose income has not been included in the net maintainable earnings figure).

Thus:

(30) V = Going concern valuation = capitalized earnings, plus surplus assets at realizable value

This going concern valuation (the total market capitalisation) divided by the number of shares then provides a bid price per share:

(31) P = Bid price per share = market capitalisation / number of shares

 
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