Chapter 8 Valuation of Acquisitions and Mergers



Chapter 8 Valuation of Acquisitions and Mergers

|LEARNING OBJECTIVES |

| |

|1. Discuss the problem of overvaluation. |

|2. Estimate the potential near-term and continuing growth levels of a corporation’s earnings using both internal and external |

|measures. |

|3. Assess the impact of an acquisition or merger upon the risk profile of the acquirer distinguishing: |

|(a) Type I acquisitions that do not disturb the acquirer’s exposure to financial or business risk. |

|(b) Type II acquisitions that impact upon the acquirer’s exposure to financial risk. |

|(c) Type III acquisitions that impact upon the acquirer’s exposure to both financial and business risk. |

|4. Advise on the valuation of a type I acquisition of both quoted and unquoted entities using: |

|(a) Book value-plus models |

|(b) Market based models |

|(c) Cash flow models, including EVA, MVA |

|5. Advise on the valuation of type II acquisitions using the APV value model. |

|6. Advise on the valuation of type III acquisitions using iterative revaluation procedures. |

|7. Demonstrate an understanding of the procedure for valuing high growth start-ups. |

[pic]

1. The Overvaluation Problem

1.1 Market efficiency

1.1.1 Empirical evidence suggests that stock markets are semi-strong efficient, i.e. equity prices reflect all publicly available information. However, this does not necessarily mean that the shares will be fairly valued.

1.1.2 If the market does not fully understand the information available – as was the case in the late 1990s and early 2000s with some high-tech, telecommunications, and internet ventures – it tends to overestimate the potential returns and so overvalue the equity.

1.1.3 The price of overvalued equity may not be corrected by the market if:

(a) the data provided by managers is deliberately misleading;

(b) there is collusion by gatekeepers including investment and commercial banks, and audit and law firms.

1.2 Management responses to overvaluation

1.2.1 Managers may be reluctant to correct the markets’ mistaken perceptions. This can lead to :

(a) the use of creative accounting to produce the results the city is expecting.

(b) poor business decisions aimed at giving the impression of success.

(c) poor acquisitions made using inflated equity to finance the purchase.

1.3 The impact of overvaluation on reported earnings

1.3.1 Since managers may manipulate reported earnings to produce more favourable results, the financial data they supply should be treated with caution. When valuing a company the financial statements should first be analysed and adjusted as necessary.

2. Estimation of the Growth Levels of a Firm’s Earnings

2.1 The growth rate of a company’s earnings is the most important factor in the value of the company.

2.2 There are three ways to estimate the growth rate of earnings of a company.

(a) By extrapolating past values

(b) By relying on analysts’ forecasts – Analysts regularly produced forecasts on the growth of a company and these estimates can be the base for forming a view of the possible growth prospects for the company.

(c) Looking at the fundamentals of the company – it can be estimated by earnings retention model (refer to Chapter 4).

|Example 1 – By extrapolating past values |

|Year |

|EPS |

| |

| |

|$ |

| |

|2014 |

|0.53 |

| |

|2013 |

|0.43 |

| |

|2012 |

|0.37 |

| |

|2011 |

|0.26 |

| |

|2010 |

|0.25 |

| |

|2009 |

|0.18 |

| |

| |

|The average growth rate, g, may be calculated as follows. |

|0.18 × (1 + g)5 = 0.53 |

|g = 0.241 or 24.1% |

| |

|There are some problems associated with historical estimates: |

|(a) A decision needs to be made regarding the length of the estimation period. Too long a period may reflect conditions that are no |

|longer relevant for the future. |

|(b) Even if the same conditions prevail, the average value estimated may not be relevant for the near term especially if growth rates |

|are volatile. An average value may be close to the expected future growth rate over the medium terms. |

3. Valuation of a Type I Acquisition of Both Quoted and Unquoted Entities

3.1 Introduction

3.1.1 A type I acquisition does not affect the acquiring company’s exposure to business or financial risk.

3.1.2 Type I acquisitions may be valued using one of the following valuation methods:

(a) Book value-plus models

(b) Market relative models

(c) Cash flow models, including EVA, MVA

3.2 Book value-plus models (asset-based methods)

(Jun 15)

3.2.1 Book value or asset-based methods of company valuation use the statement of financial position as the starting point in the valuation process.

|Example 1 |

|The summary statement of financial position of ABC Co is as follows. |

|Non-current assets |

|$ |

|$ |

| |

|Land and buildings |

| |

|160,000 |

| |

|Plant and machinery |

| |

|80,000 |

| |

|Motor vehicles |

| |

|20,000 |

| |

| |

| |

|260,000 |

| |

|Goodwill |

| |

|20,000 |

| |

|Current assets |

| |

| |

| |

|Inventory |

|80,000 |

| |

| |

|Receivables |

|60,000 |

| |

| |

|Short-term investments |

|15,000 |

| |

| |

|Cash |

|5,000 |

|160,000 |

| |

|Total assets |

| |

|440,000 |

| |

| |

| |

| |

| |

|Equity and liabilities |

| |

| |

| |

|Equity |

| |

| |

| |

|Ordinary shares of $1 |

| |

|80,000 |

| |

|Reserves |

| |

|140,000 |

| |

|4.9% preference shares of $1 |

| |

|50,000 |

| |

| |

| |

|270,000 |

| |

|Non-current liabilities |

| |

| |

| |

|12% loan notes |

|60,000 |

| |

| |

|Deferred taxation |

|10,000 |

|70,000 |

| |

| |

| |

| |

| |

|Current liabilities |

| |

| |

| |

|Payables |

|60,000 |

| |

| |

|Taxation |

|20,000 |

| |

| |

|Proposed ordinary dividend |

|20,000 |

|100,000 |

| |

| |

| |

|440,000 |

| |

| |

|What is the value of an ordinary share using the net assets basis of valuation? |

| |

|Solution: |

| |

|If the figures given for asset values are not questioned, the valuation would be as follows. |

| |

| |

|$ |

|$ |

| |

|Total value of assets less current liabilities |

| |

|340,000 |

| |

|Less: Intangible asset (goodwill) |

| |

|20,000 |

| |

|Total value of assets less current liabilities |

| |

|320,000 |

| |

|Less: Preference shares |

|50,000 |

| |

| |

|Loan notes |

|60,000 |

| |

| |

|Deferred taxation |

|10,000 |

|120,000 |

| |

|Net asset value of equity |

| |

|200,000 |

| |

| |

| |

| |

| |

|No. of ordinary shares |

| |

|80,000 |

| |

|Value per share |

| |

|$2.50 |

| |

3.3 Market value models (P/E ratio)

(Jun 12, Jun 14, Dec 15)

3.3.1 The P/E method is a very simple method of valuation. It is the most commonly used method in practice.

3.3.2 Value of company = Total post-tax earnings × P/E ratio

Value per share = EPS × P/E ratio

3.4 Market to book ratio – based on Tobin’s Q ratio

|3.4.1 |Tobin’s market to book ratio |

| |Market value of target company = Market to book ratio × book value of target company’s asset |

| | |

| |Where market to book ratio = Market capitalization / Book value of assets for a comparator company (or take industry |

| |average) |

3.4.2 This method assumes a constant relationship between market value of the equity and the book value of the firm.

|Example 2 |

|The industry sector average Market to Book ratio for the industry of X plc is 4.024. |

| |

|The book value of X plc is $3,706m and it has 1,500m shares in issue. |

| |

|Required: |

| |

|Calculate the predicted share price. |

| |

|Solution: |

| |

|Predicted value of X plc = $3,706 × 4.024 = $14,912.94m |

| |

|Predicted share price = $14,912.94m / 1,500m = 994.2c |

3.5 Free cash flow models

(Jun 11, Jun 12, Dec 13, Jun 14, Dec 15)

3.5.1 The free cash flow approach has been explained in detail in Chapter 5. The procedure for valuing a target company on the basis of its predicted cash flow is the same.

|Free cash flow = |EBIT |

| |– Tax on EBIT |

| |+ Non cash charges (e.g. depreciation) |

| |– Capital expenditure |

| |– Net working capital increases |

| |+ Net working capital decreases |

| |+ Salvage value received |

|Free cash flow to equity = |Free cash flow ± net borrowing – net interest paid |

3.5.2 There are two approaches to valuing a company using the free cash flow basis.

|Approach 1 |Approach 2 |

|1 Identify the free cash flows of the target company (before |1 Identify the free cash flow to equity of the target company |

|interest) |(after interest) |

|2 Discount FCF at WACC to obtain NPV |2 Discount FCFE at cost of equity (Ke) to obtain NPV |

|3 Value of target = NPV of company – debt |3 Value of target = NPV |

|Example 3 |

|ABC Inc is planning on making a bid to take over BBC Inc which is in the same industry. Both companies have similar gearing level of |

|18%. |

| |

|ABC Inc has estimated that the takeover will increase its annual cash flows over the next few years by the following amounts. |

| |

|Year |

|After-tax (but before interest) cash flows |

| |

| |

|$m |

| |

|2011 |

|14.00 |

| |

|2012 |

|18.50 |

| |

|2013 |

|20.75 |

| |

|2014 onwards |

|30.25 |

| |

| |

|BBC Inc has 6.5% irredeemable debentures of $37.5 million trading at par. |

| |

|The risk-free rate is 6.5% and the market rate is 12%. ABC Inc’s equity beta is 2.450 and the corporation tax rate is 28%. |

| |

|Required: |

| |

|If ABC Inc was prepared to bid $100 million for the entire share capital of BBC Inc, would the acquisition increase shareholder wealth?|

|Use both approaches given above to illustrate your answer. |

| |

|Solution: |

| |

|Ke (using CAPM) = 6.5% + 2.45 × (12% – 6.5%) = 19.98% (say 20%) |

|Kd = [pic] |

|WACC = 20% × 0.82 + 4.68% × 0.18 = 17.2%, say 17% |

| |

|Approach 1 |

|[pic] |

| |

| |

| |

| |

| |

| |

| |

|Approach 2 |

|[pic] |

| |

|Under both approaches, as value of equity > the proposed bid, the shareholders’ wealth would increase if the target was acquired. |

3.6 EVA approach

(Dec 07, Dec 09, Jun 13, Dec 14)

3.6.1 EVA is an estimate of economic profit. It can be used as a means of measuring managerial performance, by addressing the NPV of revenues (profits) less resources used (capital employed).

3.6.2 EVA is calculated as follows:

|EVA = Net operating profit after tax (NOPAT) – (WACC × book value of capital employed) |

3.6.3 Note that NOPAT cannot simply be lifted from the financial statements. There are numerous adjustments that may have to be made such as:

(a) Intangibles (for example, advertising, research and development, training). These are viewed as investments and are added to the statement of financial position.

(b) Goodwill written off and accounting depreciation. These are replaced by economic depreciation, which is a measure of the actual decline in the market value of the assets.

(c) Net interest on debt capital – debt is included in capital employed and the cost of debt is included in the WACC.

|Example 4 |

|ABC plc has a NOPAT as adjusted for EVA purposes of $562.98 million. It currently has invested capital of $5,609.48 million and a WACC |

|of 7.25%. The company has total debt of $1,500 million. |

| |

|Find the EVA for ABC plc, the value of the firm and the value of the firm’s equity. |

| |

|Solution: |

| |

|EVA = NOPAT – (WACC × Capital employed) |

|EVA = $562.98m – (7.25% × $5,609.48) = $156.30m |

| |

|Firm value = Capital employed + EVA / WACC |

|Firm value = $5,609.48 + $156.30m / 7.25% = $7,765.34m |

| |

|Equity = Firm value – value of debt |

|Equity = $7,765.34m – $1,500m = $6,265.34m |

3.7 Market value added approach

3.7.1 The market value added (MVA) of a company is defined as:

|MVA = Market value of debt + Market value of equity – Book value of equity – Book value of debt |

3.7.2 The MVA shows how much the management of a company has added to the value of the capital contributed by the capital providers.

3.7.3 The MVA is related to EVA because MVA is simply the PV of the future EVA of the company. In terms of the notation used in the previous section:

|MVA = PV of EVA |

3.7.4 If the market value and the book value of debt is the same, then the MVA simply measures the difference between the market value of common stock and the equity capital of the firm.

3.8 Dividend valuation basis

(Jun 08, Jun 15)

|3.8.1 |Dividend Valuation Model |

| |The dividend valuation model is based on the theory that an equilibrium price for any share on a stock market is: |

| |(a) The future expected stream of income from the security. |

| |(b) Discounted at a suitable cost of capital. |

| | |

| |Equilibrium market price is thus a present value of a future expected income stream. The annual income stream for a share |

| |is the expected dividend every year in perpetuity. |

| | |

| |The basic dividend-based formula for the market value of shares is expressed in the DVM (assume no growth) as follows: |

| | |

| |Market value (ex div)[pic] |

| | |

| |If the dividend has constant growth, dividend growth model can be applied: |

| |[pic] |

| |Where: D0 = Current year’s dividend |

| |g = Growth rate in earnings and dividends |

| |D0(1+g) = D1 = Expected dividend in one year’s time |

| |Ke = Shareholders’ required rate of return |

| |P0 = Market value excluding any dividend currently payable |

4. Valuation of Type II Acquisitions Using the APV Model

4.1 A type II acquisition affect the acquiring company’s exposure to financial risk only – it does not affect exposure to business risk.

4.2 The theory behind the APV has been explained in Chapter 4. An acquisition is valued by discounting free cash flows to the firm by the ungeared cost of equity and then adding the PV of the tax shield.

4.3 The approach used in valuation can be summarized as follows:

|Step 1 |Calculate the NPV as if ungeared – that is, Ke |

|Step 2 |Add the PV of the tax saved as a result of the debt used in the project |

|Step 3 |Deduct the debt of the target company to obtain the value of equity and then deduct the proposed|

| |cost of the acquisition |

|Example 5 |

|ABC Co is considering the acquisition of BBC Co, an unquoted company. The shareholders of BBC Co are hoping to receive $75 million for |

|the sale of their shares. |

| |

|The ungeared (asset) beta factor for BBC Co is 1.20, the risk free rate of interest is 3% and the market risk premium is 5.8%. |

| |

|Forecast free cash flows for BBC Co are as follows: |

| |

|Year |

|1 |

|2 |

|3 |

|4 |

| |

| |

|$m |

|$m |

|$m |

|$m |

| |

|Free cash flow |

|10.3 |

|11.5 |

|13.8 |

|14.9 |

| |

| |

|Annual cash flows after year 4 are expected to stay constant into perpetuity. |

| |

|BBC Co has $50 million of 6% debt, repayable in 4 years. The tax rate is 30%. |

| |

|Required: |

| |

|Using the APV method of valuation, calculate whether ABC Co should be prepared to pay the $75 million required by the shareholders of |

|BBC Co. |

| |

| |

|Solution: |

| |

|Ungeared cost of equity = 3% + 1.2 × 5.8% = 9.96%, say 10% |

|[pic] |

|PV of tax relief on debt interest: |

| |

| |

|$m |

| |

|Debt amount |

|50.0 |

| |

| |

| |

| |

|Annual tax relief (50m × 6% × 30%) |

|0.9 |

| |

|Annuity factor (6%) for 4 years |

|× 3.465 |

| |

|PV of tax shield |

|3.12 |

| |

| |

|APV calculation |

| |

|$m |

| |

|Base case NPV |

|141.12 |

| |

|Add: PV of tax shield |

|3.12 |

| |

| |

|144.24 |

| |

|Less: Debt |

|(50.00) |

| |

|Equity value |

|94.24 |

| |

| |

|This is significantly more than the $75 million that the shareholders are hoping fro, so ABC Co should pay the $75 million and take |

|over BBC Co. |

5. Valuation of Type III Acquisitions Using Iterative Revaluation Procedures

(Jun 13, Dec 13, Dec 15)

5.1 A type III acquisition affects both financial and business risk exposure of the acquiring company.

|5.2 |Type III acquisitions |

| |In practice, valuing a type III acquisition is a complex process requiring the iterative procedures. |

| | |

| |For exam purposes, we often simplify the method as follows: |

| |Step 1: Calculate the asset beta of both companies. |

| |Step 2: Calculate the average asset beta for the new combined company after the acquisition. |

| |Step 3: Regear this beta to reflect the post-acquisition gearing of the new combined company. |

| |Step 4: Calculate the combined company’s WACC. |

| |Step 5: Discount the post-acquisition free cash flows using the WACC. |

| |Step 6: Calculate the NPV and discount the value of debt to give the combined company’s value of equity. |

|Example 6 |

|Anderson Co is planning to take over Webb Co, a company in a different business sector, with a different level of risk. Anderson Co’s |

|free cash flows are forecast to be $50m per annum in perpetuity, Webb Co’s free cash flows are forecast to be $10m per annum in |

|perpetuity and there are expected to be annual post-tax cash synergies of $5m if the acquisition goes ahead. |

| |

|The combined company will pay tax at 30% and will have a pre-tax cost of debt of 5%. The risk free rate is 3% and the equity risk |

|premium is 5.8%. |

| |

|Currently, Anderson Co has an asset beta of 1.25 and Webb Co has an asset beta of 1.60. Assume that the beta of debt is zero. |

| |

|The current financing of the two companies is: |

| |

| |

| |

| |

|Debt |

|Equity |

| |

| |

|$m |

|$m |

| |

|Anderson Co |

|50 |

|450 |

| |

|Webb Co |

|20 |

|80 |

| |

| |

|Anderson Co is planning to make a cash offer of $80m to buy 100% of the shares of Webb Co. The cash offer will be funded by additional |

|borrowing. |

| |

|Required: |

| |

|Calculate the gain in wealth for Anderson Co’s shareholders if the acquisition goes ahead. |

| |

|Solution: |

| |

|Step 1: Calculate the asset beta of both companies |

|Anderson’s asset beta = 1.25 |

|Webb’s asset beta = 1.60 |

| |

|Step 2: Calculate the average asset beta |

|The asset beta of the combined company |

|= [pic] |

| |

|Step 3: Regear this beta to reflect the post-acquisition gearing of the new combined company |

|[pic] |

|[pic] |

| |

|Hence, using CAPM, the cost of equity Ke = 3% + 1.57 × 5.8% = 12.1% |

| |

|Step 4: Calculate the combined company’s WACC |

|WACC = [pic] |

| |

|Step 5: Discount the post-acquisition free cash flows using this WACC |

|Discounted free cash flows = [pic] |

| |

|Step 6: Calculate the value of equity |

|Value of equity = $637m – $150m = $487m |

| |

|Hence the shareholder wealth of the Anderson Co shareholders has increased from $450m to $487m as a consequence of the acquisition. |

|Question 1 |

|ABC Inc is considering making a bid for 100% of BBC Inc, a company in a completely different industry. The bid of $200 million, which |

|is expected to be accepted, will be financed entirely by new debt with a post-tax cost of debt of 7%. |

| |

|Pre-acquisition information |

|ABC Inc |

|ABC has debt finance totaling $60 million at a pre-tax rate of 7.5%. There are 50 million equity shares with a current market value of|

|$22 each and an equity beta of 1.37. |

| |

|Post-tax operating cash flows are as follows. |

| |

|Year 1 |

|Year 2 |

|Year 3 |

|Year 4 |

|Year 5 |

| |

|$m |

|$m |

|$m |

|$m |

|$m |

| |

|60.3 |

|63.9 |

|67.8 |

|71.8 |

|76.1 |

| |

| |

|BBC Inc |

|BBC has an equity beta of 2.5 and 65 million shares with a total current market value of $156 million. Current debt – which will also |

|be taken over by ABC – is $12.5 million. |

| |

|Post-acquisition information |

|Land with a value of $14 million will be sold. |

| |

|Post-tax operating cash flows of BBC’s current business will be |

| |

|Year 1 |

|Year 2 |

|Year 3 |

|Year 4 |

|Year 5 |

| |

|$m |

|$m |

|$m |

|$m |

|$m |

| |

|15.2 |

|15.8 |

|16.4 |

|17.1 |

|17.8 |

| |

| |

|If the acquisition goes ahead, ABC will experience an improvement in its credit rating and all existing debt will be charged at a rate|

|of 7%. |

| |

|Cash flows after year 5 will be grow at a rate of 1.5% per annum. |

| |

|General information |

|The risk-free rate is 5.2% and the market risk premium is 3%. Corporation tax rate is 28%. Debt beta is 0. |

| |

|Required: |

| |

|Should ABC Inc go ahead with the acquisition of BBC Inc? Give reasons for your answer. |

|Question 2 |

|Mercury Training was established in 1999 and since that time it has developed rapidly. The directors are considering either a |

|flotation or an outright sale of the company. |

| |

|The company provides training for companies in the computer and telecommunications sectors. It offers a variety of courses ranging |

|from short intensive courses in office software to high level risk management courses using advanced modelling techniques. Mercury |

|employs a number of in-house experts who provide technical materials and other support for the teams that service individual client |

|requirements. In recent years, Mercury has diversified into the financial services sector and now also provides computer simulation |

|systems to companies for valuing acquisitions. This business now accounts for one third of the company’s total revenue. |

| |

|Mercury currently has 10 million, 50c shares in issue. Jupiter is one of the few competitors in Mercury’s line of business. However, |

|Jupiter is only involved in the training business. Jupiter is listed on a small company investment market and has an estimated beta of|

|1.5. Jupiter has 50 million shares in issue with a market price of 580c. The average beta for the financial services sector is 0.9. |

|Average market gearing (debt to total market value) in the financial services sector is estimated at 25%. |

| |

|Other summary statistics for both companies for the year ended 31 December 2007 are as follows: |

| |

| |

|Mercury |

|Jupiter |

| |

|Net assets at book value ($m) |

|65 |

|45 |

| |

|EPS (cents) |

|100 |

|50 |

| |

|DPS (cents) |

|25 |

|25 |

| |

|Gearing (debt to total market value) |

|30% |

|12% |

| |

|Five year historic earnings growth (annual) |

|12% |

|8% |

| |

| |

|Analysts forecast revenue growth in the training side of Mercury’s business to be 6% per annum, but the financial services sector is |

|expected to grow at just 4%. |

| |

|Background information: |

|The equity risk premium is 3.5% and the rate of return on short-dated government stock is 4·5%. |

|Both companies can raise debt at 2.5% above the risk free rate. |

|Tax on corporate profits is 40%. |

| |

|Required: |

| |

|(a) Estimate the cost of equity capital and the WACC for Mercury Training. |

|(8 marks) |

|(b) Advise the owners of Mercury Training on a range of likely issue prices for the company. (10 marks) |

|(c) Discuss the advantages and disadvantages, to the directors of Mercury Training, of a public listing versus private equity finance |

|as a means of disposing of their interest in the company. (7 marks) |

|(Total 25 marks) |

|(Amended ACCA P4 Advanced Financial Management June 2008 Q1) |

6. Valuation of High Growth Start-ups

6.1 Characteristics of high growth start-ups (新創公司)

6.1.1 The valuation of start-ups presents a number of challenges for the methods that we have considered so far due to their unique characteristics which are summarized below:

(a) Most start-ups typically have no track record

(b) Ongoing losses

(c) Few revenues, untested products

(d) Unknown market acceptance, unknown product demand

(e) Unknown competition

(f) Unknown cost structures, unknown implementation timing

(g) High development or infrastructure costs

(h) Inexperienced management

6.2 Projecting economic performance

6.2.1 All valuation methods require reasonable projections to be made with regard to the key drivers of the business. The following steps should be undertaken with respect to the valuation of a high-growth start up company.

|Steps |Explanation |

|Identifying the drivers |Any market-based approach or discounted cash flow analysis depends on the reasonableness of |

| |financial projections. |

| |Projections must be analyzed in light of the market potential, resources of the business, |

| |management team, financial characteristics of the guideline public companies, and other factors. |

|Period of projection |Start-ups that do grow quickly usually have operating expenses and investment needs in excess of |

| |their revenues in the first years and experience losses until the growth starts to slow down. |

| |This means that long-term projections, all the way out to the time when the business has |

| |sustainable positive operating margins and cash flows, need to be prepared. These projections will|

| |depend on the assumptions made about growth. |

| |However, rarely is the forecast period less than seven years. |

|Forecasting growth |Forecasting growth in earnings can be accommodated in the framework we have already explained for |

| |the prediction of earnings. The growth in earnings will be: |

| | |

| |g = retention rate × Return on invested capital (ROIC) |

| |For most high growth start-ups retention rate = 1 as the company in order to achieve a high growth|

| |rate need to invest in research and development, expansion of distribution and manufacturing |

| |capacity, human resource development to attract new talent, and development of new markets, |

| |products, or techniques. |

6.3 Valuation methods

6.3.1 Once growth rates have been estimated, the next step is to consider which is the most appropriate of the valuation approaches we have considered so far: net-assets, market or discounted cash flows.

6.3.2 However, since the estimate of growth is so unpredictable and initial high growth can so easily stagnate or decline, valuation methods that rely on growth estimates are of little value.

7. Intangible Assets

7.1 Valuation of intangibles assets of an enterprise

7.1.1 The valuation of intangible assets and intellectual capital presents special problems. Various methods can be used to value them including the relief from royalties, premium profits and capitalization of earnings methods.

A. Market-to-book values

7.1.2 We covered this method earlier in the chapter. The value of a firm’s intellectual capital is defined as:

The difference between the book value of tangible assets and the market value of the firm

For example, if a company’s market value is $8 million and its book value is $5 million, the $3 million difference is taken to represent the value of the firm’s intangible (or intellectual) assets.

B. Calculated intangible values (CIV)

7.1.3 This method based on comparing (benchmarking) the return on assets earned by the company with:

(a) a similar company in the same industry or

(b) the industry average

7.1.4 The method is similar to the residual income technique. It calculates the company’s value spread or excess return – the profit it earns over the return on assets that would be expected for a firm in that business.

7.1.5 A step-by-step approach would be as follows:

|Steps |Explanation |

|Step 1: |Calculate average pre-tax earnings over a time period |

|Step 2: |Calculate average year end tangible assets over the time period using statement of financial |

| |position figures |

|Step 3: |Divide earnings by average assets to get the return on assets. |

|Step 4: |Find the industry’s return on assets |

|Step 5: |Multiply the industry’s return on asset by the entity’s average tangible asset. Subtract this |

| |from the entity’s pre-tax earnings to calculate the excess return |

|Step 6: |Calculate the average tax rate over the time period and multiply this by the excess return. |

| |Subtract this from the excess return to give the after-tax premium attributable to intangible |

| |assets. |

|Step 7: |Calculate the NPV of the premium by dividing it by the entity’s cost of capital |

|Example 7 – CIV method |

|ABC Inc is trying to value its intangible assets and has decided to use the CIV method. Details for ABC Inc over the last three years |

|are as follows. |

| |

| |

|2012 |

|2013 |

|2014 |

| |

| |

|$m |

|$m |

|$m |

| |

|Pre-tax earnings |

|350.0 |

|359.8 |

|370.6 |

| |

|Tangible assets |

|1,507.5 |

|1,528.9 |

|1,555.9 |

| |

| |

|The current return on assets ratio for the industry as a whole is 21%. ABC Inc’s WACC is 8%. |

| |

|Required: |

| |

|Calculate the fair value of ABC Inc’s intangible assets, assuming an average tax rate of 30%. |

| |

|Solution: |

| |

|Average pre-tax earnings = [pic] |

|Average tangible assets = [pic] |

|Return on assets = [pic] |

|Value spread or excess return = 360.13 – (21% × 1,530.77) = $38.67m |

|After-tax premium = 38.67 – (30% × 38.67) = $27.07m |

|NPV of premium = [pic] |

7.1.6 Problems with the CIV approach

(a) It uses average industry ROA as a basis for computing excess returns, which may be distorted by extreme values.

(b) The choice of discount rate to apply to the excess returns to value the intangible asset needs to be made with care. To ensure comparability between companies and industries, some sort of average cost of capital should perhaps be applied. This again has the potential problems of distortion.

C. Lev’s knowledge earnings method

7.1.7 An alternative method of valuing intangible assets involves isolating the earnings deemed to be related to intangible assets, and capitalizing them. However it is more complex than the CIV model in how it determines the return to intangibles and the future growth assumptions made.

7.1.8 In practice, this model does produce results that are close to the actual traded share price, suggesting that is a good valuation technique.

7.1.9 However, it is often criticized as over complex given that valuations are in the end dependent on negotiation between the parties.

7.2 Valuation of individual intangible assets

A. Relief from royalties method

7.2.1 This method involves trying to determine:

(a) The value obtainable from licensing out the right to exploit the intangible asset to a third party, or

(b) The royalties that the owner of the intangible asset is relieved from paying through being the owner rather than the licensee.

7.2.2 A notional royalty rate is estimated as a percentage of revenue expected to be generated by the intangible asset. The estimated royalty stream can then be capitalized, for example by discounting at a risk-free market rate, to find an estimated market value.

7.2.3 This relatively simple valuation method is easiest to apply if the intangible asset is already subject to licensing agreements. If they are not, the valuer might reach an appropriate figure from other comparable licensing arrangement.

B. Premium profits method

7.2.4 The premium profits method is often used for brands. It bases the valuation on capitalization of the extra profits generated by the brand or other intangible asset in excess of profits made by businesses lacking the intangible asset or brand.

7.2.5 The premium profits specifically attributable to the brand or other intangible asset may be estimated (for example) by comparing the price of branded products and unbranded products. The estimated premium profits can then be capitalised by discounting at a risk-adjusted market rate.

C. Capitalization of earnings method

7.2.6 With the capitalised earnings method, the maintainable earnings accruing to the intangible asset are estimated. An earnings multiple is then applied to the earnings, taking account of expected risks and rewards, including the prospects for future earnings growth and the risks involved. This method of valuation is often used to value publishing titles.

D. Comparison with market transactions method

7.2.7 This method looks at actual market transactions in similar intangible assets. A multiple of revenue or earnings from the intangible asset might then be derived from a similar market transaction.

7.2.8 A problem with this method is that many intangible assets are unique and it may therefore be difficult to identify 'similar' market transactions, although this might be done by examining acquisitions and disposals of businesses that include similar intangible assets.

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