Introduction
A company can increase its worth by using modern strategies of acquisition this ensures that one always maintains that competitive edge over its peers (Thinking Managers, 2005).
This paper is about evaluating the sources of valuation and their limitations. It also gives some of the justifications companies use when taking over other firms. It also gives some of the developments through the past five years.
Critical evaluation of Sources and Limitations in Valuation
The discount Cash Flow method seeks to establish the worth of the companies or firms in question by comparing their present cash flows and the life of the firms. They then make an assumption that the life of the firm is infinite and this leads to the division of the analysis into two sessions. The first is the forecast period and the second is the terminal value (Jensen, 1986).
In the forecast period, the negotiators concentrate on establishing the costs economically speaking of the transactions and the profit or gain the company will achieve in going ahead with the deal. This is done of the interval that the firm is expected to be experiencing the higher returns than expected or needed, the peak of the business per se. A standard period of 5-10 years into the past of the firm is usually maintained (Jensen, 1986).
The terminal value picks up from the last year of the five years to the present and puts into account future cash flows. After the cash flows of the business are determined what happens is that the Weighted Average Cost of Capital (WCC) is calculated. This helps to make a discount on the value achieved to estimate the present value of the respective firm. It is also known as the enterprise value.
Some essential formulas in calculating the values according to the Graduate School of Business, University of Virginia
Cash flows
The expression for free cash flow is:
Free Cash Flow = EBIT (1- T) + Depreciation – CAPEX – DNWC, where:
- EBIT is earnings before interest and taxes.
- T is the marginal cash (not average) tax rate, which should be inclusive of federal,
State and local, and foreign jurisdictional taxes.
- Depreciation is noncash operating charges including depreciation, depletion, and
Amortization recognized for tax purposes.
- CAPEX is capital expenditures for fixed assets.
- DNWC is the change in net working capital.2
Calculating Discount rates
WACC = Wd kd(1-T) + We ke , where:
- k d is the interest rate on new debt.
- ke is the cost of equity capital (see below).
- Wd, We are target percentages of debt and equity (using market values of debt and equity.)
- T is the marginal tax rate.
In determining the WACC one needs to calculate the debt and equity values. This is achieved by getting the Capital Asset Pricing Model (CAPM).
Capital Asset Pricing Model (CAPM)
ke = Rf + Ăź (Rm – Rf), where:
- Rf is the expected return on risk-free securities over a time horizon consistent with the investment horizon. Generally use the ten-year government bond rate.
- Rm – Rf is the historic risk premium for common stocks over government bonds (6.0 percent.)
- ß is beta, a measure of the systematic risk of a firm’s common stock. The beta of common stock includes compensation for business and financial risk (Bayrak, n.d).
It is considered the most reliable in Mergers and Acquisitions setting because it focuses on the future and does not need past record to determine value. It dwells on the working cash and not the profit margins and helps one note the incoming cash and the charges that are not monetary. It creates visible demarcations between the finances coming in and the money leaving the business for investments. It clearly puts into consideration the time value of cash in the firm. One can actually make adjustments and add personal touches of information, be in control of the process and tailor it. One is also free to incorporate strategy they deem necessary. It adequately caters for the assets that are intangible and costs incurred in carrying out the operations (Bradley, Anand & Han, 1983).
Some of the limitations of this method are the assumptions that are made. First is the assumption that the life of a company is infinite. The second is in deriving the terminal value, here there is an assumption that the firm is operating in a plateau mode where there is no opportunity for growth or even that the returns experienced are equl to those needed and expected by the firm.
Method of valuation
The other method of valuation includes the use of books. This means going into the records of both the acquirer and the target and analyzing to know the status (financially) of the firms. This is appropriate for the organizations that have stability in their procedures, and who deal with products and not services. This has some struggles to it for instance the methods of accounting are most definitely unique to all firms so it becomes tiresome when using this method because a lot of analysis will have to be done, this wastes a lot of time.
The other limitation is that it leaves out tangible possessions of a firm like experience in the business, patents and knowledge in handling technical procedures. It also leaves out analysis of abnormal increase in cash flow due to good business or other causes like inflation. it does not clarify or give a clear definition between a debt and equity in the categorization of liabilities. It focuses so much on the past and not the present or future accomplishments or profits of the firm (Lawyers, 2008).
Some companies choose to use the liquidation value. Here the company sells all that it owns in assets. It is appropriate for companies that are not getting any headway in business and have no clear prospects whatsoever. This method depends on what the valuator will decide as the value of the assets, one cannot get people’s opinions on such, and he or she has monopoly of decision. One has to think critically how to do the disintegration of the company or entity. The value of the assets will be determined by where a person is at a time and not how long the owners have had them in possession. The method like the book value may also leave out other assets that might be valuable to the owner that are intangible (Brown, Geraghty, Willough & Hogan, 2010).
The replacement cost value entails buying a business that one wants to start than starting one. They state that it is cheaper to do it that way. It was common in the 1970’s and the 1980’s. it greatly explains the merger boom of the late eighteenth century and early nineteenth century. This was because replacement costs were higher than the stocks. Some of the limitations in that kind of thinking was that the comparison ignore important aspects like inflation and overcapacity or even high interest rates. That these costs were determined or governed by very simple rules and were not fully reliable. Most estimators dismiss the figures derived most of the time (Bryer,2001).
The stocks-market value method advises one to price their assets according to the market price. It is very advantageous if the market prices are good or favorable and if the person is active in monitoring the stocks in the first place. The market also hat to be providing viable and essential information that is helpful for the industry in question. Merger negotiators choose their prices mostly above the market rarely do they settle for lower. This means 30% above the price and in some cases even as high as 100% above. The method discriminates against upcoming companies and those that are not big enough to have stocks; it also leaves out the privately owned ones (Graduate School of Business Administration University of Virginia. n.d.)
Trading multiples of peer firms: This next method is where peer firms choose to trade. Ratios of the price earnings are made or it can be done by comparing the market value to the book value. One of its limitations is that it requires a one-year forecast of the earnings of the firm.
Previous earnings cannot work because it takes account future occurrences in terms of performance. It needs one to do a careful research in determining the other firms in the market that are potential targets apart from the chosen one. It is different for every accounting technique and so the type of accounting methods used by a firm determines the earnings of the particular company. The method assumes that the growth rate is the same or steady. It could also omit critical variations in the profit margins and the rate of cash flow. It might be a challenge when analyzing the changes in finances in this one since it does not differentiate the investments and the finances coming in. It also disregards the fact that money has time value.
Justifications for actions
Some companies out of experience in the market or from advice from professionals locate other companies in their fields, which they recognize are struggling with undervaluation. They say that these companies are being undervalued by markets in the financial sector in comparison to their true value. Most companies that propose a merger rationalize this way most of the time (Damodaran, n.d, 3).
One of the other justifications is the need to maximize and increase profits by diversification. They claim they need to grow or to help the other company and that the impact will be greater if the two or more companies come together (Mergers and Acquisitons, 2009). They further go on to defend their motives by adding that it would help the companies make their earnings more stable and be able to cushion them better by reducing the burden of risks. This usually raises questions especially by the company being approached. It raises controversies (Martynova & Renneboog, 2008).
The other common reason is for the purpose of synergy. This the added value that comes from combining two companies either from a financial basis or for operational reasons altogether. There are two types of synergy involved here as a result, the operational which is from a higher level of growth or lower expenditures. Financial synergy is from taxes, an increase in debt capacity and a delay in cash flow. Here the companies try to minimize losses and reduce expenses by increasing the productivity of the normal working operations (Debra & McConnell, 1986).
When a company locates another that they analyze and conclude that it is under poor management, they may decide to take it over (Bradley & Han,1983).They do this by coming up with a completely new system of and production. They buy the company and give it a new structure because they believe in the potentiality of the firm.
Some managers may just develop an interest in a certain company or firm and decide to take it over. They may not have a necessarily valid reason.
The year 2005 saw the affluent banks known for practices such as M&A pull back from the scene in trading and commercial banking. This happened in the first half of the year. They noticed they were making more money in other businesses than in banking. For example, the Goldman Sachs got $ 2.3 billion form banking trading which was peanuts compared to the $ 800 it garnered from advices it offered to customers and consulting entities. In the same year buyers and sellers in the M & A, business consolidated their associations with the companies dealing in technology since they discovered they had a lot of cash. For example at that time, Microsoft had $37.6 billion leading followed by Intel, Dell and IBM with $12.6, $ 9 and $ 8.7 billion respectively (Davidwanetick, 2005).
The main boosters for M&A activity in 2006 were the opportunities that opened up for the firms to invest, the rise in the market shares and the synergies that were available to the buyers and sellers at the time. The people in business could control the supply chain with a little more ease than before. Then more than ever before companies were eager to diversify (James & Uhrig, 2007, 6), so diversify they did.
The case in the year 2007 was not the same as in as in the past, prospects were good at least for the better part of the first half of the year. Then came the credit crunch in the summer of the same year and it was disaster. The favorable conditions in terms of finances were no more (Brown, et al., 2007).
In 2008, the sellers and buyers were under financial pressure since due to the credit crunch of 2007 the financiers were keener on who gets funding (M&A top ten trends in 2008). They made the process elongated so not many transactions took place as such. During the same year many private entities and funding agencies worked more closely. Many organizations and even property owners were looking for new ways to invest and the fact that they were private companies was not really an obstacle (Brown, et al., 2007, 2&4).
Most countries were under had the need to expand and develop their infrastructure, so the editors predicted that the government would be under such immense financial burden to rebuild it would require more resources. This is where the private sectors would come in and that would be where M&A also plug in (Brown, et al., 2007, 12). Another compeller for business in the same year they predicted was the increase in foreign buyers in many countries this being in the United States. Countries like Russia and India had been very active in Canada and other states so their interest was expected to rise (10). Some more focus was also on the media sector in the same year (Merger and acquisition trends in 2008, 2007).
The current market is favoring any buyer who will dare to indulge and exploit the opportunities presented by the economy (Lunkes, 2009, 50). He further advises the company directors that the M&A is in a cycle and the trends are positive.
He goes on further to say that most companies are restructuring at this time of the economy. That most are not indulging in corporate development much because of the market right now. That means that the stocks are controlling people’s decisions to either sell or acquire (Coffee, 1999).
He says that the older entrepreneurs in the business are quickly weakening and so are being pressured to make liquid investments they are forced to sell in the process to survive in the market. Therefore, this becomes their reason to sell (Lunkes, 2009, 51). In explaining himself he gave an example of the Houlihan Smith & company (Analytical Method Inc.) that dealt in providing software for outer space locomotives, which was recently bought by the Israel Aerospace Industries.
The companies that were seeking to buy were approaching the targets to close are doing that with a little more wisdom than before (Ernst &Young, 2008). They present the financial aspects and make sure they give them positions that are competitive so that eventually, they do not become irrelevant.
The sellers were more careful and were under pressure from all means not to sell because of the conditions, this decision was mostly based on values that are intrinsic to their organizations. There was no drive. Lunkes (2009, 51) says that this did not last for long since the weakened firms were soon going to be seeking suitable sellers for their assets.
According to analysis in the next two or three years the prospects to buy or sell will be much favorable (Lunkes, 2009, 51). This is a good pointer for those in the business though they also have to apply strategy when deciding to sell or buy.
The buyers are going green in the year 2010, everyone cares for the environment and is more conscious to keep it that way. The governments will be focusing on generating renewable sources of energy, which will in turn mean they will need funding. That is where M&A comes in. the demand for the energy will lead to more funding requirements to meet these demands (Hill & Pickersgill, 2009, 2).
The activist trends that were prevalent by the shareholders in the year 2009 are bound to stay longer in 2010 (M&A Top ten trends in 2010,2009). They are protesting economic crisis that is prevalent right now. This means restructuring and reallocation of resources to avoid risks (Koval & Walch-Watson, 2009, 6).
When in the M & A business on has to be careful in the choice of valuation methods be it the use of books which dwells on the past or monitoring stocks that one may not be keen enough to benefit. Alternatively, even liquidation of assets, which leads to losses in value, and lack of valuation of intangible assets or replacement of stocks methods are all more of wrong choices. One should be aware of all the negatives that come with the above choices, the discount cash flow has been considered the most reliable and includes all the elements that the rest of the methods omit (Martynova & Renneboog, 2008).
The reasons that have been put forward to explain reasons for selling and buying of companies have been undervaluation, diversification, creating synergy, claims of poor management and an interest by the management. Undervaluation means that the target company is in a state that the buyer presumes to be critical and that they could make better in terms of value in the stock market and the general production of the entity.
As explained, diversification helps companies to increase profits and to reduce business risks (Jan and Lang, n.d.). Synergy means the coming together of two firms on the basis of operational benefits (e.g. reduced costs) or financial benefits (e.g. reduced taxes). The claims of poor management could be an expression of interest because a company requires such a business and they do not wish to start from scratch. The management of the interested buyer might just have an interest in a particular industry and choose to buy the firm.
Conclusion
There has been a slow, gradual but sure change in the interests of buyers and sellers over the past five years, this has stretched from interest in technology companies like Microsoft to gaining control on in supply chains or rather vertical integration to pulling back from business due to the credit crunch in the United States (Acemoglu, et al., 2009). In 2008, there was the need to improve infrastructure, which drove the industry. In 2009, the activists also influenced with business with their protests on the economic crisis. This year companies are more concerned about the renewable sources of energy and how to maintain a constant supply, all investments are being made in the same direction. They are going green!
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