Valuation of Target Companies

Methods of Valuation Assets based valuation approach, Relative valuation approach, Capitalization of earning approach, Cash flow based valuation approach

Assets based valuation approach, This approach assumes that the value of a company is sum of the value of its individual assets, The value of assets can be calculated either on the basis of book value or liquidation value, Book value means historical cost of assets and liabilities (at which they are recorded in books of accounts). The value of company can be determined by deducting book value of liabilities from book value of assets, Under liquidation approach the value of assets are determined by estimating market value of assets if sold in case of closer of business, However the asset based approach are not relevant in valuing target company as they do not reflect the true value of shares of target company.

Relative valuation approach This approach involves valuing a company by comparing it with the valuation of other companies in the same industry, This comparison is done using Comparison with industry averages approaches; – Under this the PE ratio of target company is compared with the respective industry, – If the PE ratio is less than industry average one can pay more than its current market price and vice-versa, To take an example, on July when SENSEX was around 13,500, the average PE ratio of paints industry was 23. the individual PE of Asian paints was 29, Nerolac 15.8, Berger paints 13.8, Shalimar 13.5 (sources; Capital Market, July , 2008), If one were to value Berger Paints or Shalimar Paints using industry average PE, one would project 70% rise in the share prices of these companies. So as to reach with industry average. The main flaw of this approach that if individual company PE moves up or down then the industry average will also moves and can not remain constant. Therefore it does not happen in real life.

Capitalization of earning approach Target company is valued on the basis of projected accounting earnings and PE ratio for next two to three years, Limitations; Accounting profit is calculated on the basis of accrual concept and not on cash concept, Focus on earning in short run, It ignores the factor of growth, It ignores additional capex, PE are so volatile,

Cash-Flow Based Valuation Approach Process to value target company; Business Projections; Define the time horizon which should not less than five years and more than ten years, Estimate growth rate which may be defined for each year separately or for small blocks of two or three years, Estimate change in working capital, Estimate CAPEX requirement, Prepare profit & Loss account and Balance Sheet, Cash Flow Projections; Convert P/L and BS in to cash flows, Find out funding gap, Decide how to fulfill funding gap, Weighted Average Cost of Capital; Estimate specific cost f various existing and proposed components f funding, Estimate WACC, Calculation of Present Value of projected cash flow,

Stages in Target Company’s Valuation Status quo Valuation, Valuation of control Premium, Valuation of synergy