VALUATION METHODS: SCIENCE OR ART?

The methods and data considered in the valuation of businesses vary widely. In some respects,
business valuation is as much an art as it is a science. It is exact and scientific in that there are
standard methods and hard data to consider in the formulation of valuation. However, several
different methods may be employed in a given evaluation. The methods may provide different
business values and thus give the impression that the general methodology lacks systematic
rigor.

What is a Discounted Cash Flow (DCF)

Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment
based on its future cash flows. DCF analysis finds the present value of expected future cash
flows using a discount rate. A present value estimate is then used to evaluate a potential
investment. If the value calculated through DCF is higher than the current cost of the
investment, the opportunity should be considered.

DCF is calculated as follows:

What is the Dividend Discount Model - DDM

The dividend discount model (DDM) is a quantitative method used for predicting the price of
a company's stock based on the theory that its present day price is worth the sum of all of its
future dividend payments, when discounted back to their present value. It attempts to calculate
the fair value of a stock irrespective of the prevailing market conditions, and takes into
consideration the dividend payout factors and the market expected returns. If the value obtained
from the DDM is higher than the current trading price of shares, then the stock is undervalued
and qualifies for a buy, and vice versa.

Free Cash Flow Theory of Mergers, Acquisitions, and Leveraged Buyouts

Some researchers believe that a firm’s amount of free cash flows may determine whether it is
going to engage in takeovers. The theory implies that managers of firms that have unused
borrowing capacity and ample free cash flows are more likely to engage in takeovers. Managers
use the cash resources to acquire other firms instead of paying the monies to stockholders in
the form of higher dividends.

DESIRABLE FINANCIAL CHARACTERISTICS OF TARGETS

 Rapidly growing cash flows and earnings.

 Low price relative to earnings.

 Market value less than book value.

 High liquidity.

 Low leverage.

What is the Multiples Approach

The multiples approach is a valuation theory based on the idea that similar assets sell at similar
prices. This assumes that a ratio comparing value to some firm-specific variable (operating
margins, cash flow, etc.) is the same across similar firms.

The multiples approach is also referred to as the “multiples analysis” or “valuation multiples.”

Cost of Capital and the Discount Rate

One guide to selecting the proper discount rate is to consider the cost of capital. This measure
is useful in capital budgeting because only one firm is involved. The cost of capital for a given
company can be generally derived through:

CC ¼X n i¼1

wiki ð14:7Þ

where: CC¼the firm’s cost of capital

wi¼theweightassignedtotheparticularki.Thisweightisthepercentageofthetotal capital mix of the
firm that this source of capital accounts for. ki¼the rate for this source of capital Let us consider
a simple example of a firm whose capital structure is composed of 50%
debtand50%equity.Theweightsforeachsourceare0.50.Ifthedebtrateis9%andtherate of return on
equity is 15%, the cost of capital can be computed as follows: CC ¼
0:50ð0:09Þþ0:50ð0:15Þþ0:045þ0:075 ¼ 0:12 or 12% ð14:8Þ
How to calculate synergies in M&A

A corporate merger is a combination of assets and liabilities of two firms which form a single
business entity. When the senior management decides to buy another company, it is mostly
focused on increasing the value of a new company.

The synergy effect is expected to be the core driver to improve sales, profit margins and the
market positioning of the company. Excluding any synergies resulting from the merger, the
total post-merger value of the two firms is equal to the pre-merger value.

Nevertheless, synergies do exist.

Often the value creation is the motive for an acquisition. And it can result in several ways from
the transaction’s synergy.

What is Control Premium?

Control premium refers to an amount that a buyer is willing to pay in excess of the fair market
value of shares in order to gain a controlling ownership interest in a publicly traded
company. A buyer that pays a control premium gains access to the firm’s cash flows, day-to-
day operations, and control of the firm’s strategy. Determining how much to offer as a takeover
premium is a major consideration in mergers and acquisitions.

Control premiums are popular during takeover bids, where large companies acquire a large
number of shares in order to gain ownership control of the target. Typically, control premiums
can be in the 20%-30% range of the target’s current share price, and can sometimes go up to
70%.

Reasons for a Control Premium

Stockholders that own a large portion of the company’s stocks can determine the direction of
the company, with the minority stockholders exercising minimal influence on the company’s
activities. Some of the decisions that the majority stockholders make include:

 Select management and set their compensation

 Register stock for a public offering
 Liquidate, sell, or merge the company
  Buy, sell, and pledge assets
 Declare dividends
 Make capital distributions
 Enter and control contracts

When the market perceives that a public company’s profitability is not being maximized, the
capital structure is not optimal, and the value of the target can be enhanced, the acquirer may
be willing to pay a premium above the price currently established by the market participants.
The premium paid to acquire an entity may be substantial if the target owns assets such as
intellectual property or real estate that the acquirer wants.

However, if the business is on a downward trend and faces the risk of bankruptcy, paying a
control premium would be unwise because the acquirer would need to invest lots of funds to
turn around the target’s business operations.

DEFINITION of Stock-For-Stock
1. In the context of mergers and acquisitions, the exchange of an acquiring company's stock for
the stock of the acquired company at a predetermined rate. Usually, only a portion of a merger
is completed with a stock-for-stock transaction, with the rest of the expenses being covered
with cash or other payment methods.

2. A method of satisfying the option price in an employee stock option compensation scheme.
Under these compensation programs, employees are granted stock options but must pay the
company the option price before they are given the grant. By exchanging mature stock (stock
that has been held for a required holding period), the grantee can receive his/her options without
having to pay for them. After a given time period, grantees are given back the stock they used
to pay for their options.