Valuation Errors in Mergers and Acquisitions

We've noted many times that Value is Estimated, Price is Paid and that a main driver for creation or destruction of value is the price one pays up front.  Since estimated value is (hopefully) an upward bound on the price an acquiring firm will pay for a company it is instructive to investigate errors in calculating that value.  

A recent interesting article lists 119 common errors in valuation.  The article is authored by Pablo Fernandez and Andrada Bilan of  the University of Navarra - IESE Business School.  Their article provides a useful overview for organizing types of errors in valuation into six categories. 

Quoting from the article,

"1) Errors in the discount rate calculation and concerning the riskiness of the company;

2) Errors when calculating or forecasting the expected cash flows; 

3) Errors in the calculation of the residual value; 

4) Inconsistencies and conceptual errors; 

5) Errors when interpreting the valuation; and 

6) Organizational errors. "

We cover many of these in detail in our Acquisition Finance Course in Amsterdam.  I'll mention just a few clarifying comments here.  The categories above relate to:

1) Misjudging the risk of the acquiring company, errors in adjusting betas for leverage, etc.

2) Using hockey stick growth estimates that are not sustainable in the long run and incorrect projection of future cash flows.

3) Misestimating terminal value.  We've noted that 70-90 percent of a company's value is in the residual value.  It is important to get this right.  

4) Using incorrect cash flow estimates or inappropriate multiples.

5) Failure to recognize the strengths and weaknesses of various methods of estimation

6) Not adequately monitoring the valuation process

 The complete paper may be downloaded here.

All the best,

Ralph

The Price is Right?

Ralph and I have previously mentioned the difference between price as a fact and value as an opinion.  (See, for example, Value is Estimated, Price is Paid.)  Nonetheless, many remain rightfully confused by a firm whose stock is trading at $20 p/s receiving a takeover offer for $30 p/s.  Specifically, was the $20 price wrong or is the $30 offer a mistake? While it is possible for either the market price or offer to be wrong-it is also possible they are both right, but under different circumstances.

As an opinion, value is truly in the eyes of the beholder. Equally true, there is no one true intrinsic value based on a firm’s cash flows (magnitude and timing) and risk. Think of valuation as an attempt to price expected operating performance. This in turn depends on the firm’s market environment and the strategy and asset-liability combinations employed by management in the execution of their chosen strategy. Thus, different owner-manager teams can different results from the same firm.

Changes in the industry environment from technology and regulation shifts for example can render existing strategies obsolete. Existing management may be unable or reluctant to change, thinking the changes to be cyclical not structural. Performance under these conditions starts to decline and the firm’s stock price begins to decline as passive minority shareholders begin to vote with their feet by selling their shares. These selling shareholders have priced downward from say $30 p/s to $20 the firm’s expected operating performance based on its current strategies in a changed market. They no longer share management’s expectations.

The price decline attracts the attention of others who see profit opportunities from shifting to alternative higher value strategies, asset -liability combinations and improved management execution of the strategies. These investors are active control shareholders seeking to force a change. This in turn requires a significant ownership position or majority to implement their plans. These investors are prepared to obtain this position by offering a premium to existing shareholders of $30.  Their price is not based on the firm’s expected operating performance as currently configured. Rather, it reflects their view of operating performance under a new higher value strategy and management team.

This illustrates that firms trade in two different financial markets, and at two different prices. The first represents the passive minority interest market, for example, the firm’s current Bloomberg terminal price, based on existing strategies and management. The other is a potentially higher price to alternative owners employing different strategies and management; this price is available in the market for corporate control. Of course, the new investors can be wrong. They are, however, willing to back up their beliefs with real capital. Thus, their position can have more credibility than a simple existing management denial – a management who may be more interested in keeping their jobs than in creating shareholder value.

So next time before assuming the share price is right first make sure you specify which price you mean. The right price depends on the right combination of owners, strategies and management, and this combination changes over time.

J