Chapter4

 

Valuation Concepts & Standards 

 

Amajor challenge within the merger and acquisition process is due diligence. One of the more critical elements within due diligence is valuation of the Target Company. e need to assign a value or more specifically a range of values to the Target Company so that we can guide the merger and acquisition process. We need answers to several questions: How much should we pay for the target company, how much is the target worth, how does this compare to the current market value of the target company, etc.?

 

It should be noted that the valuation process is not intended to establish a selling price for the Target Company. In the end, the price paid is whatever the buyer and the seller agree to.

 

The valuation decision is treated as a capital budgeting decision using the Discounted Cash Flow (DCF) Model. The reason why we use the DCF Model for valuation is because:

 

• Discounted Cash Flow captures all of the elements important to valuation.
• Discounted Cash Flow is based on the concept that investments add value when returns exceed the cost of capital.
• Discounted Cash Flow has support from both research and within the marketplace.

 

The valuation computation includes the following steps:

 

1. Discounting the future expected cash flows over a forecast period.
2. Adding a terminal value to cover the period beyond the forecast period.
3. Adding investment income, excess cash, and other non-operating assets at their present values.
4. Subtracting out the fair market values of debt so that we can arrive at the value of equity.

 

Before we get into the valuation computation, we need to ask: What are we trying to value? Do we want to assign value to the equity of the target? Do we value the Target Company on a long-term basis or a short-term basis? For example, the valuation of a company expected to be liquidated is different from the valuation of a going concern.

 

Most mergers and acquisitions are directed at acquiring the equity of the Target Company. However, when you acquire ownership (equity) of the Target Company, you will assume the outstanding liabilities of the target. This will increase the purchase price of the Target Company.

 

For publicly traded companies, we can get some idea of the economic value of a company by looking at the stock market price. The value of the equity plus the value of the debt is the total market value of the Target Company.

 

A word of caution about relying on market values within the stock market; stocks rarely trade in large blocks similar to merger and acquisition transactions. Consequently, if the publicly traded target has low trading volumes, then prevailing market prices are not a reliable indicator of value.