© 2000 John Petroff
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© 2000 John Petroff |
F- Pricing an entire company
The value of an entire company, or total capitalization, is obtained by multiplying the price of the common stock by the number of shares outstanding. If the company has also issued some preferred shares then those are added to the company valuation base. This would be an appropriate way of evaluating an entire company if the purchaser remains an outside investor. But, that is hardly the case when an investor considers acquiring a controlling interest (which is further described in merger strategies in Chapter 4 Section H). Then, the company must be valued not from the point of view of a shareholder that is entitled to dividends, but from the point of view of management that will control all physical assets, human resources and future earnings opportunities. The valuation takes a discounted cash flows approach.
See review questions Q-3F.1 and Q-3F.2.
1)- Rate of return to be used in mergers and acquisitions
One of the first steps is to determine an appropriate discount rate to use. The most common approach is to use the weighted average cost of capital of the firm as it is. But, as will be demonstrated in Chapter 11 Section D-1, firms can achieve a minimum cost of capital that is different from the actual weighted actual cost of capital (shown most vividly in Graph G-11.6). An analyst must decide whether to use the actual average cost of capital or the potential minimum cost of capital. The decision will depend on the feasibility of changing the capital structure to achieve an optimum combination of funds. Another approach is to use the marginal cost of capital, i.e. the cost of raising new capital by the firm, because this rate reflects more accurately prevailing market conditions; it is the recommended rate to use when market rates are significantly changing. One may observe that both average and marginal cost of capital are lower than risk adjusted rate of return required by an outside investor because the latter adds projected capital appreciation to income from dividends, as specified in Chapter 2 Section F-1, whereas the former combine equity returns with lower cost debt, as explained in Chapter 11 Section 11D-1.
See review question Q-3F1.1.
2)- Cash flow valuation approach:
As introduced in the context of earnings multiple, when evaluating an entire company, the inclusion of all earnings is an improvement over a calculation of share price using dividends alone, because undistributed earnings generate company growth. But a company also generates growth (or at least renews its assets) with non-cash expense deductions from profits, such as depreciation, amortization and depletion. To capture this source of growth, one must use cash flows rather than net earnings.
With the assumption that there is no plan to close down the company, and that the company can keep going at least at its current level of operation indefinitely, the formula for company value V is direct extension of a present value of an infinite annuity or simply
V = CF / i
This approach requires some estimation which is not always easily performed by an outside financial analyst if the firm does not publish sufficiently detailed financial statements. Indeed, non-cash expenses can be buried in a general heading such as overhead expense. As usual, the valuation task should involve not just the company under study, but similar firms for comparative purposes. But conducting the valuation for several firms opens the doors to additional difficulties. Even in the case of adequate data, differences in operating strategy or types of equipment require complex adjustments.
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See review questions Q-3F2.1 and Q-3F2.2.
Cash flows are influenced to a some extent by accounting methods used by different companies (as touched upon in Chapter 6 Section 6D and Chapter 13 Section 13A-4). For instance, the cash flows can be manipulated by taking greater or smaller depreciation in given years. Analysts may want to rely on some more objective measure of performance. Since cash flows are generated by sales, the next approach is to compare share price to company sales. This is called sales multiple. A sale multiple can be calculated on the basis of a single share or total capitalization of a company. A sales multiple sm is calculated with the formula
sm = P / S
This approach is only appropriate for comparing firms within the same industry. Such companies face the same type of customers and technical challenges. The comparison reveals rapidly if a firm is potentially grossly underpriced or overpriced. It is then up to the analyst to look for reasons in marketing or operations, as well as in attitudes of consumers. To derive a company value V with this approach, one must obtain an average sales multiple for the industry smi and apply it to the company sales volume with the formula
V = S / smi
See review question Q-3F3.1.
See research assignment R-3.18.
For most companies, future sales growth is more important than current sales level. This is especially true for companies in growth industries, and those that seek - as they should - to grow by capitalizing on market opportunities, but that also face a competitive environment in which other products and other firms are likely to take away sources of revenues. An estimate of sales growth is necessary. This estimate is explicitly used in the formula of the discounted dividend model and implicitly present in the sales multiple approach. The basic methodology of sales growth forecasting is first introduced in Chapter 5 Section 5E and Section 5F. Its practical application is illustrated in Chapter 9 Section 9G and is found especially challenging because of industry consideration outlined in Chapter 14 section C-1.
5)- Valuation of a company based on company strategy and competitive threats
To conduct a realistic estimation of sales growth, an analysis of the industry as a whole must be undertaken by looking at long term and short term trends, with special attention to impact of business cycles on consumption and production patterns. Then, marketing strategies of each firm in the industry must be compared to determine which firm is a technology leader, which a price leader, and which firm is most likely to gain or lose market share. A discussion of how to give this recognition to competitors is presented in Chapter 14 Section C-1.
Identifying the market position of a firm within its industry and studying its strategy reveals how accurate sales growth projections are. Such assessment is especially crucial when an industry is concentrated and dominant competitors represent immediate threats. Then, an assessment of competitors' marketing strategies is unavoidable: this can show if the firm under study is about to loose market share to its competitors instead of achieving any aspired sales growth.
If the analysis is conducted for the purpose of firm acquisition, the strategy of the acquiring firm must be brought into the valuation process as it is discussed in Chapter 4 Section H.
See review questions Q-3F5.1.
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