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Thursday, Sep 23, 2004

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High-value knowledge of valuation for buys

D. Murali

BEAUTY is in the eyes of the beholder, but value rests in the hands of accountants. But to help, you'd need Enrique R. Arzac's Valuation for Mergers, Buyouts, and Restructuring, from Wiley ( The book is organised into three parts, viz. main methods in valuation, application of the methods, and recapitalisation/ restructuring analysis.

Value is the price investors would be willing to pay in a competitive capital market, defines the author. "Pricing an asset is done by comparing its FCFs (free cash flows) to those derived from other assets of similar risk available to investors."

Economists may protest, "There is no free lunch, so how can there be FCF?" Arzac explains that what accountants usually compute as cash flow (that is, "net income plus depreciation and other non-cash items") may not be available for reinvesting or financing future growth. FCF is "the cash available for distribution to investors after all planned capital investment and taxes."

Are you aware that a forecast is divided into two: One, "an initial period over which an explicit forecast is made", and two, "the estimation of the value of the going concern at the end of the period." The latter has different names such as horizon, terminal or continuation value. If there is a plan to sell the business at the end of the forecast period, it is called `exit value'.

You know DCF or discounted cash flow, but the author would advise you to break it into three: reproduction value that "measures the cost of entry into the business," and is "an estimate of the cost of the do-it-yourself alternative that can be compared to the asking price for the target"; present earning power, that is FCF in excess of reproduction value; and value of expected growth opportunities (that is, the difference between DCF value of the enterprise and its no-growth value).

A chapter is devoted to metrics and multiples. Multiples are estimated from the prices of other companies with characteristics comparable to the company being valued, explains the author, but cautions, "True comparables are not always available." Price-earnings (P/E) ratio is only too common, but remember, "differences in the amount of net debt can lead to differences in interest expense and earnings, and correcting for these differences can be laborious and yield unreliable results."

An alternative metric is the EBITDA multiple, a.k.a. `cash flow multiple'. "Another useful multiple is the price-to-book (P/B) ratio," notes the book. Use this to gauge the value of companies where "book value provides a reasonable estimate of the replacement value of the assets in place."

There are detailed examples throughout the book, and these include illustration of applying EVA (economic value added), APV (adjusted present value), recursive WACC and so on.

"What is the value of a firm that has negative cash flows and no revenue but offers the uncertain possibility of capturing market share into a potentially growing and profitable market sometime in the future?"

Who would want to even touch such firms even with a bargepole, you may ask. But wait, tech and biotech start-up fall in that category, "as well as a variety of platform investments undertaken by venture capitalists." These are called foothold investments.

There's lot more. Arzac will handhold to explain equity kickers and mezzanine financing, pre-packaged bankruptcy and pecking order, Brownian motion and carve outs, Curran Asian call formula and Majd-Pindyck time-to-build model, senior debt and walk-away rights.

Knowledge is of value, they say. So, how about some high-value knowledge of buy valuation?

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