Valuation of acquisitions (Part 1)

This is the first part of my acquisition series where I show the methods on how to value companies. Starting with the basics, the first type of acquisition does not change the business or financial risk of the acquiring entity.

The three main valuation models for this type of acquisition:
- Book value-plus model
- Market relative models (including P/E, Tobin`s Q ratio)
- Cash flow models (including free-cash flows, EVA, MVA)

1) Book value-plus model
The book value plus model is an asset based method that uses the Statement of Financial Position as the starting point. The assets are summed up and long and short-term debt are deducted. This method does not take into account the value of intangible assets.

Example:

Total value of assets                                             xxx          
Less: Goodwill (Intangible asset)                          (xxx)
Total value of tangible assets                                 xx
Less: Debt                                                              (x)
Net asset value of equity                                         xx

To find out the value per share, divide the net asset value of equity by the number of shares issues. The number of shares issued can be computed from the Statement of Changes in Equity.


2) Market relative model (P/E ratio)
This is a common method that appears frequently in research reports.

Since P/E ratio essentially is the share price divided by earnings per share (EPS), the projected share price after an acquisition can be calculated from the estimated earnings after the acquisition.

Example:

Initially, the P/E ratio of company A = Market value of share/ EPS
Project the earnings benefit from the acquisition. Next, by playing around with the equation, the new market value per share is simply new EPS multiplied by the P/E.


3) Market to book ratio model
This is another ratio method, based on Tobin`s Q ratio.

The market value of a company = market to book ratio x book value of assets

The formula sounds simple but the tricky bit is the Q ratio,
where Q = Market value of capital/ Replacement cost of capital


4) Free-cash flows (FCF) model
Although more commonly used in investment appraisal, the free-cash flow model can be used for equity.

There are two approaches and the underlying difference is the effect of interest.

Approach (i): Free-cash flows (before interest) 
The free-cash flows of a company is the after-tax operating profits (pre-interest) minus net investment in assets.
The net present value of this value is obtained by discounting FCF at the weighted-average cost of capital (WACC) rate.
Hence, the value of the company is the net present value of FCF minus debt.

Approach (ii) Free-cash flows to equity (after interest)
Free-cash flows to equity (FCFE) is the FCF minus net interest paid.
Since this is equity alone, to obtain the present value, discount the FCFE at the cost of equity.
The net present value of FCFE is the value of the company.


5) Economic value added (EVA)
This method of valuation is based on the economic profits of a company. According to BPP, "it can be used as a means of measuring managerial performance".

EVA = Net operating profit after tax (NOPAT) - (WACC x book value of capital employed)
or
EVA = Book value of capital employed x (Return on invested capital - WACC)

Note that the NOPAT value cannot be derived from the financial statements. Adjustments are needed before it can be used in the EVA formula.


6) Market value added (MVA)
Market value is related to EVA as it is the present value of EVA.

MVA= Market value of (debt + equity) - Book value of (debt +equity)