discussion topics: mergers and acquisitions, JV, commercial transactions, and other interesting corporate issues
Part 1
Published on February 15, 2004 By thesuer In Business


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After identifying candidates that meet your criteria as potential targets and after answering questions like:


Does the initial valuation of the company meet your previously defined pricing criteria?
Does the company meet your acquisition criteria?
How much is always a question that is important and the determination of such value is one of the most difficult asks involved as businesses are unique.

Market value is normally established by using figures like historical earnings, cash flows, assets and the liabilities. What is at times more important and difficult to ascertain are the value of intangibles (know-how, brands, trade marks, patents, intellectual capital, management quality, leases?) Other factors like current market condition, industry performance, number of buyers and sellers, acquisition structure and tax issues makes valuation an estimate of numbers.

Value of a company does not have an exact relation to the selling price as the selling price of companies is the estimate of value plus minus premium, eagerness, accounting issues, tax issues, consideration in question, negotiations.

It is a commonly known fact that valuation of a company can always produce the valuation as determined and justified by the buyer and the seller. Using different methods different valuations are obtained according to the purpose of the valuation.

In the case of valuing privately held companies, a very informative book “Valuing a Business: The analysis and appraisal of closely held companies” sets out the following points that one should keep in mind:


The value of a business is the sum of the expected future economic benefits to its owners, each discounted back to a present value at an appropriate discount rate,
The discount rate is dependant on the market for capital and is the expected rate of return that would be required to attract capital to the investment as compared to the rate of return available on investments with comparable risks,
To project economic benefits and the discount rate is difficult. There are accepted methods of estimating value by using current or historical financial data. Normally adjustments are made to reflect impact of future expectation,
Financial variables used in valuation should be defined on a consistent basis between the guidelines and subject companies,Value of a share of stock can be more or less than a proportionate share of the underlying net asset value and sometimes bears little relationship to the underlying net asset value.

Valuation processes involves four key elements:


Gathering information about the target company and its industry,
Analyzing and recasting the historical financial statements,
Preparing prospective financial statements, and
Applying the appropriate valuation technology.
1. Gathering Company Information


From the 5 year financial statements with detailed notes as to the accounting methods and adjustments made, revenues, expenses, cash flows, off book liabilities if any,
Meetings with the management of the company,
Initial due diligence report about the company, its history, growth, operations, markets, and
Annual reports and other internal documents: management accounting reports and tools.

2. Gathering Industry Data


General economic outlook in the target location,
Specific industry information to understand market trends, strategies, and
Information about competitors, the same size as the target.

3. Recasting Historical Financial Statements

The objective of this exercise is to create a set of financial statements that allow for a clearer comparison between the target and its competitors in the market based on a common parameter. For example a company wanting to maximize current tax deductions in order to minimize corporate income taxes may have taken steps to mask its true earning power. Recasting historical financial statements is the process of normalizing such steps taken by companies.

To normalize operating results (EBIT, EBITDA, net income, or other measures of operating results) for business valuations the following recast adjustments could be made: Excessive management salary, bonuses, Excessive salaries paid to individuals that can be replaced for lower salaries, Excessive retirement and health packages, Excessive perquisites; company car, club memberships, Last in first out inventory adjustments, Legal expenses and other non recurring expenses and Accelerated depreciation charges used to reduce taxable income, etc

To normalize a balance sheet for business valuations the following recast adjustments could be made:Excess cash, Beneficial leases, Contingent liabilities, Fixed assets that have appreciated in value, Intangible assets that are not recorded in the financial statements and Last in first out reserves to adjust the inventory to current cost, etc

4. Evaluating Recast Financial Statements

So far so good now the analysis of the recast statements can be done. Finding absolute change in numbers, percentage change in key variables and financial ratios are techniques that help in spotting the strengths and weaknesses of the target company. It also gives you an idea of what is normal performance and allows you analyze budgets and forecasts made by the company. It is important to combine the financial results of the target with your own business as this gives you an absolute amount of the target size of business and the combined business size to understand the money value. To understand the components of operations the percentage changes in key variables year to year should be thoroughly examined to see the cost relates to change in revenue. Calculating the compound growth rates for key financial variables like revenue, EBIT, EBITDA, operating cash flows to understand the growth patterns of the target.

Ratios: 5

1. Return on equity: ROE; Dividing the annual net income by stockholders equity. ROE should be compared with industry wide averages and with investment alternatives. Other ratios like profit margin, asset turnover and financial leverage can be directly linked to ROE.

ROE = Profit margins (net income/sales)* Asset turnover (sales/Assets)* Financial leverage (assets/shareholders equity)

Return on Investment: ROI; Profit for a period divided by the amount of capital invested to earn that profit. Total invested capital includes only long term debt the interest on that debt should be included.

2. Profitability Ratios

Profit Margin = Net income/Sales

Gross Margin = Gross profit/ sales

3. Asset Turnover Ratios

Short term liquidity measures include:

Current Ratio = Current assets/current liabilities

Quick ratio or acid test = (cash + cash equivalents + marketable investments+ receivables)/current liabilities

Activity Ratios measures how companies use their assets effectively. These include ratios for the calculation of accounts receivables turnover, sales to net working capital and inventory turnover.

Sales to fixed assets (Sales/ fixed assets) and total assets (Sales/ total assets) show us how efficient a companies assets are at generating sales. Can be used to check the measure of productivity and care should be taken as when completely depreciated can make a company look more efficient when it should have been increasing its investments to improve productivity.

4. Financial Leverage Ratios measure long time solvency of the business and its ability to deal with opportunities and challenges that can arise in the future. Total liabilities/ total assets give us the debt to assets ratio that allows us to measure the long term adequacy of the company’s capital structure. Other ratios here are Equity to total assets, long term debt to total capital, equity to total capital and fixed assets to equity.

5. Risk Ratios are used to measure the degree of uncertainty in net income.

5. Comparison with the Industry

Using the financial tools mentioned above a comparison should be made with the target company’s operating results with other results of companies in the industry. There are some industries where specific industry related statistics are used. What are the statistics of the target company with its industry? Does it under perform or outperform its industry average? Is it gaining or losing market share? This analysis will give you an idea of whether you would have to pay a premium of negotiate a discount over the value of comparable companies.



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