Presented by : RSM Nelson Wheeler Venue: Hong Kong Institute of CPAs, 27/F., Wu Chung House Date: 31 July CPD Series M&A Issues for Accountants

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1 Presented by : RSM Nelson Wheeler Venue: Hong Kong Institute of CPAs, 27/F., Wu Chung House Date: 31 July 2013 CPD Series M&A Issues for Accountants Valuation 31 July 2013

2 Welcome and Introduction By Samuel Y C Chan & Joe Yan Transaction and Valuation Advisory Services Samuel Y C Chan Principal Consultant Tel: (852) ycchan@rsmhk.com Joe Yan Manager Tel: (852) joeyan@rsmhk.com 2

3 Disclaimer The materials of this seminar / workshop / conference are intended to provide general information and guidance on the subject concerned. Examples and other materials in this seminar / workshop / conference are only for illustrative purposes and should not be relied upon for technical answers. The Hong Kong Institute of Certified Public Accountants (The Institute), the speaker(s) and the firm(s) that the speaker(s) is representing take no responsibility for any errors or omissions in, or for the loss incurred by individuals or companies due to the use of, the materials of this seminar / workshop / conference. No claims, action or legal proceedings in connection with this seminar/workshop/conference brought by any individuals or companies having reference to the materials on this seminar / workshop / conference will be entertained by the Institute, the speaker(s) and the firm(s) that the speaker(s) is representing. 3

4 Contents Part I General introduction to valuation Part II Overview of valuation concepts for M&A transactions Business Enterprise Valuation (BEV) and Purchase Price Allocation (PPA) Part III Common valuation methodologies in M&A transactions Income Approach, Market Approach and Cost Approach Part IV Example of Business Enterprise Valuation (BEV) 4

5 Part I General Introduction to Valuation 5

6 What is valuation? Value measurement Valuation methodologies Valuation Valuation assumptions Art / Science Objective / Subjective 6

7 Valuation Purpose Impairment assessment Business valuation Purchase price allocation Financial reporting Valuation purposes Tax reporting Corporate dissolution Estate planning Gift planning Charitable contributions Shareholder disputes Matrimonial disputes Fraudulent acts IP infringement Legal reporting Transaction reporting M&A Sales and divestitures Employee stock options 7

8 Valuation Process Valuation cycle Environmental change Valuation purpose Indicated value Valuation Valuation methodology Valuation process Valuation assumptions 8

9 Valuation Process Top down analysis approach Economic analysis Industry analysis Analysis factors Economic cycle Economic indicators Relevant environmental factors Industry cycle Porter five force model BCG matrix model Industry concentration ratio Valuation inputs Interest rate General cost of debt General cost of equity Probability of defaults etc Industry comparable companies/ transactions Industry cost of capital etc Target analysis Entity cycle Product cycle Financial ratio Entity culture and structure Entity management skills Cash flow forecasts Terminal value Growth rate Capital expenditures etc 9

10 Preparers: Different experts for different types of valuation Subject of the valuation Degree Designation Property Appraisal Property, land and building Surveying RICS, ASA Business Valuation Business, intangible asset, PPA Finance and Accounting ASA, CVA, CBA, AICPA/ABV Financial Instrument Valuation Option, CB, forward contract Financial Engineer, actuarial science FRM, CFA Report Standard Yes Yes No Yes Signature required Yes Yes No Yes Experience requirement 2 5 years 2 5 years 1 4 years or NA Mineral Appraisal Exploration and mining right Geology, Mining Engineer and Finance AusIMM, CMA 5 10 years 10

11 Preparers: qualifications of valuators Reputation of valuation firm History, development, brand name, firm size Qualifications of individual valuator Profile of the individual valuator Business title Relevant professional designations Relevant experience Examine the qualifications of valuator Check qualifications of individual valuator Visit valuation firm and chat with individual valuator Visit website of the valuation firm Valuation fee VS Valuation quality 11

12 Users: various potential parties Acquirer / Acquiree Auditors / Internal valuators Shareholders Tax office Management Users Court 12

13 Part II Overview of valuation concepts for M&A transactions BEV and PPA 13

14 Valuations involved during M&A process 14

15 Valuations involved during M&A process Pre-M&A valuation M&A Process Post-M&A valuation (A) Business Enterprise Valuation of: (i) Target for price negotiation (ii) Unlisted shares as a part of consideration PPA: (A) Business Enterprise Valuation of Target (B) Contingent Consideration (C) Convertible Bonds (D) Call & Put Options (E) Financial Guarantees (F) Intangibles (G) Executive Share Options 15

16 What is PPA? It is an application of acquisition method in business combination whereby the acquirer when purchasing a target, allocates the purchase price into various assets and liabilities acquired from the transaction. The allocation of purchase price is based on corresponding fair values at the acquisition date. The IFRS/HKFRS 3 requires business entity to perform Purchase Price Allocation (PPA) at the acquisition date. 16

17 Part III Common valuation methodologies in M&A transactions Income Approach, Market Approach and Cost Approach 17

18 Income approach Description Income approach provides an indication of value by converting future cash flows to a single current capital value. (IVS Framework 2011) - Absolute valuation - Going concern basis Valuation methods Discounted cash flow method Excess earning method Incremental income method Relief from royalty method Income approach Cost of capital Cost of equity Cost of debt Weighted average cost of capital (WACC) Projected financial information (PFI) Free cash flow to Firm (FCFF) Free cash flow to Equity (FCFE) Terminal value (TV) 18

19 Income approach Stage 1 Project prospective financial information (PFI) based on historical financials and future circumstances Stage 3 Construct discount rate (e.g. WACC) based on CAPM or build-up method with applicable premiums (e.g. size, company specific) Stage 2 Compute the applicable cash flows (e.g. FCFF, FCFE) from the PFI. Stage 4 Analyze value indications by discounting the prospective cash flows by discount rate 19

20 Income approach: Cash Flows Income approach More on control perspective Shareholder perspective (free cash flow to equity) Whole firm perspective (free cash flow to firm) Applicable to company with positive free cash flow Terminal value occupy substantial portion of estimated value Free cash flow Dividend cash flow More on minority perspective Shareholder perspective Applicable to stable dividend paying company Terminal value occupy substantial portion of estimated value 20

21 Market approach Description Market approach provides an indication of value by comparing the subject asset with identical or similar assets. (IVS Framework 2011) - Relative valuation - Going concern basis Valuation methods Guideline public company method Guideline M&A company method Guideline prior transaction method Market approach Valuation multiples P/E, P/B, P/S, and P/CF EV/E, EV/B, EV/S, and EV/CF Valuation multiples vendor data - Bloomberg - Public Stats TM - Mergerstat - BIZCOMPS 21

22 Market approach Stage 1 Search comparable transactions from vendor database (e.g. Bloomberg, Public Stats TM, Mergerstat ) Stage 3 Compare the financial and operational aspects of the comparable transaction to subject assets. Compute the valuation multiples (e.g. P/E, P/S) Stage 2 Verify accuracy of data and reflection of arm length transaction Stage 4 Analyze value indications to a single value from a range value 22

23 Market approach: Price Multiples Earning is generally: Problem of negative figure Volatile Easier to be distorted by different accounting treatment P/E P/B Book value is generally: Problem of negative figure More stable than earning Easier to be distorted by different accounting treatment Sales is generally: Always positive figure More stable than earning More difficult to be distorted by accounting treatment than earning P/S P/CF Cash flow is generally: Problem of negative figure More stable than earning More difficult to be distorted by accounting treatment than earning 23

24 Market approach: Examples Guideline public company method 24

25 Cost approach Description An indication of value using the economic principle that a buyer will pay no more for an asset than the cost to obtain an asset of equal utility, whether by purchase or by construction. (IVS Framework 2011) Cost approach Valuation methods Replacement cost method Reproduction cost method Historical cost method Intangible applications Used for intangibles that have no identifiable income benefits (e.g. assembled workforce, self-developed software) Absolute valuation More likely to be liquidation basis 25

26 Cost approach Primary and secondary valuation approach and method Weighting of valuation approach and method Guideline public company method Guideline M&A company method Prior transaction method Market approach Income approach Valuation approach Cost approach Discounted cash flow method Relief from royalty method Excess earning method Incremental income method Contingent cash flow method Replacement cost method Reproduction cost method Historical cost method Original cost method 26

27 Valuation Process of Purchase Price Allocation (PPA) Stage 1 Conduct Business Enterprise Valuation (BEV) based on prospective financials Stage 3 Identification and fair valuation of tangible, intangible and financial assets and liabilities Stage 2 Measurement of purchase consideration (e.g. shares, contingent considerations) Stage 4 Measurement of goodwill as the residual value of purchase price less net identifiable assets and liabilities 27

28 Part IV Example of Business Enterprise Valuation (BEV) 28

29 Business Enterprise Valuation (BEV): FCF Model Income approach Projected financial information 29

30 Business Enterprise Valuation (BEV): FCF Model Income approach Free cash flow to firm Terminal value WACC 30

31 Business Enterprise Valuation (BEV): WACC Income approach Capital Asset Pricing Model (CAPM) based on Sharpe (1964), Markowitz (1952) and Merton Miller (1958) Volatility of return of the firm s stock relative to the returns of a broad market portfolio. Unleveraged and re-leveraged process Company size risk premium and Company specific risk premium Cost of equity (r e ) = Risk free rate + Beta (Market risk premium) + Risk premiums (r f ) (β) (r MRP ) (r RP ) After tax cost of debt (r d ) Long term government bond yield (same currency denomination as target cash flows) = Long term borrowing cost X (1 tax rate) Return on equity market index over government bond yield in the same country, same time horizon Interest bearing cost of debts. E.g. Interest expense per interest bearing debts. E.g. Banker quoted borrowing rate for the firm 31

32 Business Enterprise Valuation (BEV): Cost of Equity/Debt Income approach Weighting based on market value of capital structure Weighting based on market value of capital structure WACC = Cost of + equity (r e ) Discount rate used for projected cash flow discounting (e.g. dividend cash flows, free cash flows) After tax cost of debt (r d ) 32

33 Business Enterprise Valuation (BEV): WACC Income approach (S.P. Pratt and R.J. Grabowski, 2010) Current capital structure Target capital structure Optimal capital structure Constant capital structure Variable capital structure Capital structure currently estimated and assume the company remain the current weighting in the long run. Capital structure set by the firm management which may or may not be the same as the long run industry capital structure. Capital structure which minimize the cost of captial of the firm in the mix of equity and debt financing. Assume it is reflected by the long run industry captial structure. Implies capital structure at market value remains unchanged over time. Debt components proportional increase with the firm capital size. Implies capital structure at market value change over time. More complicated and rely on more assumptions. 33

34 Business Enterprise Valuation (BEV): WACC Income approach WACC 34

35 Business Enterprise Valuation (BEV): Beta Beta 35

36 Business Enterprise Valuation (BEV): Risk-free rate and market risk premium Risk free rate Market risk premium 36

37 Discount for lack of marketability (DLOM) Valuation discounts and premiums What is Discount for Lack of Marketability (DLOM)? The CAPM used in the cost of equity computation generally assume liquidity of investments. Therefore, DLOM should be considered for valuation of private company. 37

38 Discount for lack of marketability (DLOM) Valuation discounts and premiums Approach European put option option Pre-IPO stock studies Restricted stock studies Rationale Put option represents the value of a right to sell a stock. Thus DLOM results from an inability to exercise a right to sell, this model measures DLOM by dividing the put option value by the current stock value. Price/share in an IPO is compared with a price in a private transaction sometime prior to the IPO when the company was not yet public. Publicly trading stock issues non-trading stock directly to an investor in a private placement. Due to SEC rules/agreement, these privately placed stock cannot be freely traded in public market for a period of time. (J.J. Stockdale 2011) 38

39 Reference A Reviewer's Handbook to Business Valuation, L.P. Hood and T.R. Lee, 2011, John Wiley & Sons. Business Valuation, Discounts and Premiums, 2 nd edition, S.P. Pratt, 2009, John Wiley & Sons. Business Valuation Review, Vol. 28. No.2, 2009, American Society of Appraisers. Cost of Capital, Applications and Examples, 4 th edition, S.P. Pratt and R.J. Grabowski, 2010, John Wiley & Sons. Discounts for Lack of Marketability, Theory, Evidence and Technique, 1 st edition, J.J. Stockdale, 2011, Business Valuation Resources. Guide to Fair Value under IFRS, J.P. Catty, 2010, John Wiley & Sons. International Valuation Standards Framework, IVSC, 2011 Options, Futures and Other Derivatives, 9 th edition, J.Hull, 2012, Pearson Valuation Handbook, Valuation Techniques from Today Top Professional, R., Thomas, and B.E. Gup, 2010, John Wiley & Sons. 39

40 Finished Q & A Session 40

41 Thank You! 41