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Valuation methods used in M&A

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Valuation methods used in M&A

The book value of a firm is based on the balance sheet value of owners equity or in other words Assets minus liabilities.

The book value of a firm is based on the balance sheet value of owners’ equity or in other words Assets minus liabilities.

  • It can be used as a starting point to be compared and complemented by other analysis.
  • Where large investment in fixed assets is required to generate earnings, the book value could be a critical factor especially where plant and equipment are relatively new.
  • The study of firms working capital is also necessary.

However, this method suffers from certain disadvantages:

  • It is based on historical cost of the asset which do not bear a relationship either to value of the firm or its ability to generate earnings.
  • Some entities may wish to sell only part of their business. In such case book value may fall flat.


For Example:

Balance sheet of A Ltd.

Equity share capitalof Rs 10 each

Plant & Machinery100000
General Reserve50000Stock40000
Tax Payable30000Cash in bank30000

Goodwill is worth nothing. Plant and machinery is valued at Rs 85000. Sundry debtors declared insolvent owed Rs 5000. Compute value per share.



Plant & Machinery85000
Cash in bank30000



Tax payable30000
Not worth (Rs.)110000
No. of shares10000
Value per share (Rs/share)11


There are two methods here. Capitalization of earnings and PE based value.

Capitalization of Earnings


Profit available for equity shareholders(Rs.)       =   225000

No of equity shares                                             =   10000

Earnings per share (Rs/share)                            =    22.5

Normal return on investment                               =    16%

Value per share (22.5/16%)                =   Rs 140.625/share

P/E based valuation

The market value of equity share is the product of “Earning per share (EPS) ” and the “Price Earnings Ratio”. According to this approach the value of the prospective acquisition depends on the impact of the merger on the EPS. There could either be positive impact or a dilutive impact. Prima facie, dilution of the EPS of the acquiring firm should be avoided. However, the fact that the merger immediately dilutes the current EPS need not necessarily make the transaction undesirable. However, the prevailing PE in the market may not always be feasible. Some aspects that will influence the valuers choice of PE ratio include:

  • Size of the target company
  • In case of unlisted companies, there would be restricted marketability and the PE multiple will tend to be lower than listed company
  • Gearing level
  • Reliability of past profit records, nature of assets, liquidity etc.


Earnings Based model – ROCE driven

A modified method of estimating value of the firm based on earnings is to use the market-return on assets as a benchmark. The steps are as follows:

  1. Compute the current Return on Capital Employed (ROCE)
    1. Assign weights to the past capital employed to arrive at weighted average capital employed
    2. Assign weights to the past profits to arrive at the weighted average profit after tax
    3. Average return on capital employed is then computed by dividing (b) by (a)
  2. Compute the latest capital employed
  3. Compute the Return by multiplying latest capital employed with ROCE
  4. Capitalize the value from above step at the market ROI to arrive at value of the firm.

It should be remembered that the ROCE is meaningful only when expressed in current cost figures. ROCE computed on current cost basis is more meaningful than historical cost basis.


Dividend Based valuation

Quite often, the amount of dividend paid is taken as the base for deriving the value of a share. The value on the basis of the dividend can be calculated as

No growth in Dividends

S = D1/Ke


S – Current share price

D1 – Dividend

Ke – cost of equity

Constant Growth in Dividends

S = [Do(1+g)] / (Ke-g)


Do – Dividend of last year

g – Expected growth rate


The Capital Asset pricing model can be used to value the shares. This method is useful when we need to estimate the price for initial listing in the stock exchange. The crux of this model is to arrive at the cost of the equity and then use it as the capitalization of dividend or earning to arrive at the value of share.

The formula is:

ke = Rf + beta of the firm (Rm-Rf)


Ke – cost of equity

Rf – Risk free rate of return

Rm – market rate of return.

Free cash flow model facilitates estimating the maximum worthwhile price that one may pay for a business. Free cash flow analysis utilizes the financial statements of the target-business, to determine the distributable cash surpluses, and takes into account not merely the additional investments required to maintain growth, but also the tie-up of funds needed to meet incremental working capital requirements. Under this model value of the firm is estimated by a three step procedure:

  • Determine the free future cash flows:

Net operating income + Depreciation – incremental investment in capital or current asset for each year separately.

  • Determine terminal cash flows, on the assumption that there would be constant growth, or no growth.
  • Present values these cash flows can then be compared with the price that we would pay for the acquisition.

However, while estimating future cash flows, the sensitivity of cash flows to various factors should also be considered.

As far as unlisted companies are concerned the price of shares of such company is not readily available, so we need to determine the value of shares of such companies, but this is not the case with the listed companies. The price of share of a listed company is already available on the stock market. Then why do we need to calculate the value of shares or business separately?

The reasons are:

  • The market price may not represent fair value.
  • There is no guarantee that the market price is not rigged or manipulated.

It’s hard for investors to know when a deal is worthwhile. The burden of proof should fall on the acquiring company. To find mergers that have a chance of success, investors should start by looking for some of these simple criteria:

  • Price-Earnings Ratio (P/E Ratio) – With the use of this ratio, an acquiring company makes an offer that is a multiple of the earnings of the target company. Looking at the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target’s P/E multiple should be.


Mergers are awfully hard to get right, so investors should look for acquiring companies with a healthy grasp of reality.

1. For unlisted companies, the price of shares of such companies are not readily available. So, we need to calculate the value of shares or business separately.

2. There are different methods of valuation. Some of the commonly used methods are: Asset based valuation, Earnings or dividend based valuation, CAPM based valuation and Valuation based on Present Value of free cash flows.

3. Asset Based valuation method is used when large investment in fixed assets is required to generate earnings.

4. The CAPM model can be used to value the shares. This method is useful when we need to estimate the price for initial listing in the stock exchange.