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  • Berger, Thomas
     
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  • Consolidation and mergers of corporations
     
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  • Valuation
     
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  • Profit
     
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  • MSEM Thesis.
     
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    Comparing valuation methods in the acquisition process / by Thomas Berger.
    by Berger, Thomas
    Subjects
  • Consolidation and mergers of corporations
  •  
  • Valuation
  •  
  • Profit
  •  
  • MSEM Thesis.
  • Description: 
    viii, 79 leaves : ill. ; 29 cm.
    Contents: 
    Advisor: Cecil Head.
    Committee Members: Robert Hankes, Dr. Bruce Thompson.
    Acquisitions and mergers -- Reasons for acquisitions and mergers -- Business valuation -- Valuation methods -- Recommendations -- Conclusions.
    With greater pressure and demands coming for earnings growth, acquisitions and mergers have become a popular technique used by executives to improve a company's profitability. Their popularity, however, has varied throughout the years. Looking back from the late 1960's to the present, yearly acquisitions and mergers have ranged from a low of 1,877 in 1991 to a high of 7,800 in 1997.
    In 1969, there were over 6,000 acquisitions and mergers, so this strategy is nothing new. There are four general categories as to why a company may decide to acquire or merge with another business. The first, is to implement a growth strategy. Some examples of this are to obtain new products, to grow internationally, to obtain technical information, to increase market share, or to diversify a product line. A second motive for acquisitions is to capitalize on efficiency improvements.
    This can come in the form of vertical or horizontal integration, which can eliminate dependence on a supplier, or improve the distribution channel. Synergy is also a benefit of improved efficiency. A third reason a company may want to acquire or merge with another company is for tax purposes. A highly profitable company may look for a company with unused tax losses to benefit them. However, the IRS requires that such a merger have another benefit in addition to the tax advantage. And finally, a company may acquire another company as a defensive strategy.
    In-other-words, to stop a hostile takeover. Once a firm decides that it wants to acquire another company, it must determine what is fair compensation. This is called Business Valuation. It is the process of determining the worth of a business, taking into account the risks and the return. Business valuation is not an exact science. There are many techniques which range from being quite simple to very complicated. But despite this, good business valuation is a key to an acquisition success. There are four general categories of business valuation techniques.
    There are the Cost Approaches, the Income Approaches, the Market Approaches, and the Other Approaches. The cost approach bases the worth of a business on the value of its assets. Each asset and liability are reviewed separately and then added together. In general, these approaches are accounting in nature and are straightforward and easy to understand. The major disadvantage associated with this method is that it doesn’t take into account future earnings. The rate at which the earnings are discounted are dependent upon the risk associated with the business.
    Under this approach there are three principal methods: Earnings Capitalization, Excess Earnings, and Discounted Cash-Flow. The discounted cash-flow is the most popular of these methods. Its advantages are that it takes into account timing, future earnings, and risk. However, the results can be greatly affected by small changes in critical assumptions (sales volume, operating expenses, etc.), and in determining the continuing value of a firm. The market approach bases the worth of a company on financial information obtained from the open market.
    The three principle methods under this approach are: the stock and debt approach, the direct comparison approach, and the financial multiples approach. For these methods to be accurate, it is important that the market be efficient, and that there be several comparable firms (with regard) to the target company. If either of these elements is missing, then the accuracy of the results will suffer. The last category of valuation techniques include: rule-of-thumb, unit-capacity, and hybrid methods.
    Rule-of-thumb and unit-capacity methods are quick and simple, but they are based on 'typical' companies. This may, or may not, cause a problem. The hybrid method simply incorporates parts of different valuation techniques to create a new method. The possibilities are endless because of the number of techniques. This approach is used by companies which acquire businesses regularly, and usually evolves over several years. Although any of the methods discussed could be used to value a business, some methods are more accurate than others for certain circumstances. As a result, one method alone cannot be used for all valuations.
    To determine what valuation method should be used, the advantages, disadvantages, and limitations of each were reviewed and analyzed. Using this information, key characteristics of businesses which affect valuation approaches short-comings were identified. These characteristics were then used to determine the best approach to use and when. The key characteristics identified were: Type of earnings (standard or bankruptcy), Earnings sign (positive or negative), Type of business (manufacturing or service), Number of comparable firms (0-2 firms or 3 and over firms), and Amount of assets (high or low).
    Using the different key characteristics to identify different business situations, 24 different scenarios were identified. For each scenario, a primary and secondary valuation method was recommended. The discounted cash-flow (DCF) method is recommended as the primary approach in 14 instances, and is recommended as the secondary approach for the other 10. Direct comparison, adjusted book value, rule-of-thumb, and unit capacity were the other primary techniques.
    DCF is the preferred method because it takes into account cash-flows, timing, and risk. It can be tailored to work for most of the business scenarios. If a firm is in bankruptcy with a high amount of assets, DCF may have problems. Regardless of the situation, both the primary and secondary valuation methods should be used to calculate the value of a target company. If there are differences between the two results, an attempt to understand why must be made.
    For acquisitions to be successful, the valuation process must be accurate. The valuation techniques recommended here will not give an exact value. What they will do is give an estimate which is valid for that target company, at that point in time. Since external factors in the market place change on a regular basis, so must the data used in calculating a businesses worth. It is clear that each of the valuation approaches discussed in this paper, does have some sort of short-coming in certain situations. Therefore, there is not one single valuation method that will work accurately for all circumstances, and that is why the valuation selection tool was developed. It is also important that a minimum of two different techniques be used. The more information the better the valuation. And the better the valuation, the better chance of a successful merger or acquisition.
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