Calculating the value of an acquisition

This is a detailed example of calculating the fair value of an acquisition, using a logical step by step approach and realistic assumptions and determinations based on transaction and market data. Identifying and valuing intangible asset(s) is a broad endeavor and requires careful consideration of; factors specific to each business, the transaction structure, identifying the primary income generating asset, determining the discount rates, estimating the useful lives for identified intangibles. Examples of such intangibles include customer contracts, trademarks, brands, etc.

 

The DealFortune, Inc. acquired M&P Company on January 1, 2017. Consideration was $30 million cash plus additional contingent consideration, as follows:

EBITDA

  • Below 1 million: Nil
  • 1.5 – 2.0 million: 2 million
  • 2.0 – 2.5 million: 2.5 million
  • Above 2.5 million: 3.2 million
The Business
  • M&P is a leading contract developer and manufacturer of Active pharmaceutical ingredients (“API’s”)
  • The company has strong reputation throughout the pharmaceutical community with over 50 years of expertise.
  • It provides comprehensive range of development and manufacturing services with technical leadership on Highly potent APIs

Valuing an acquisition – THE APPROACH


Step 1 Gather company and transaction data

Gather the information with the help of preliminary checklist to establish a groundwork on which the base the additional details to be obtained that are relevant to the valuation assignment.

Review various sources of information. These could include internal and external sources of information as listed below:

Internal source

External source

Sales and Purchase Agreement (SPA) dated January 1, 2017 between Fortune Inc. and M&P Company

Information available on databases such as Standard and Poor’s Capital IQ and KtMine royalty database.

Historical financial statements of M&P for the years ended December 31, 2012 and December 31, 2017. and Balance sheet of M&P as at the valuation date

Publications such as Duff & Phelps 2016/2017/2018/2019 Handbook- Guide to cost of capital and Duff & Phelps 2016/2017/2018/2019 Valuation Handbook – Industry cost of capital (December quarterly update)

Projection of operations for the years ending December 31, 2017 through December 31, 2021 (“Prospective financial information – PFI”)

Publicly available sources such as the U.S. Federal Reserve and Department of Treasury, Moody’s website, and Bloomberg business week

Detailed breakdown of each component of projections. (“Prospective financial information- PFI”)

List of employees acquired as a part of the transaction along with their compensation details and estimates of their replacement costs.

Discussion with key management personnel


Step 2 Analyze information obtained

Assembly of required information and perform a thorough analysis to draw inferences that support valuation conclusion. Information received can be grouped under the different heads as summarised below :

The financial metrics were analysed based on following concerns:

  • Is the information complete?
  • Is the information consistent with the entity’s plans and expectations?
  • Is the information consistent with each other?
  • Would a person knowledgeable in the entity’s business and industry select materially similar assumption?

Step 3 Measure and recognize consideration transferred

Establish the fair value of the consideration given in the acquisition as given in the below equation:

The consideration transferred by the acquirer for the business does not include acquisition-related costs or other amounts transferred in transactions that are not part of the business combination.

Examples of consideration transferred include:
Cash, other assets, contingent consideration, a subsidiary or a business of the acquirer transferred to the seller, common or preferred equity instruments, options, warrants, and member interests of mutual entities

Cash

USD 30 million

+

Equity consideration

Nil

+

Contingent consideration

USD 2,117 million1

=

Consideration transferred

USD 32.117 million


Step 4 Evaluate prospective financial information (PFI)

Confirm the adaptability of PFI to market participants assumptions considering the following aspects:

The PFI is a key input in the valuation process and it is critical to understand the underlying assumptions. It should reflect market participant assumptions including only those synergies that would be available to other market participants and thus should be adjusted to remove entity-specific synergies.
  • Analyze the reasonableness of projections
  • Consider what market participants would consider in their analysis of the DCF.
  • Adjust the projections, if necessary, to match the probability-weighted projections used in the contingent consideration calculation.
  • Use market participant tax rates, WACC and net working capital.
  • Use the IRR in the calculation of the present value rate.


Step 5 Identify market participants

Apply the guidance under IFRS 13:23: Fair value measurements, and identify specific characteristics of market participants considering the following factors:

Analyse various sources of information to identify market participants including press releases, prior bid attempts, board of director presentations, due diligence documents, deal models, and lists of known bidders, comparable companies and so on.

Based on the entity specific characteristics the following market participants characteristics are identified to determine the entity’s assumptions are representative of the market participants assumptions.

Financial versus strategic buyers

National or regional competitors

Financial capacity

Acquisition strategy

Marketplace synergies

Market share

Complementary assets

Management

capabilities


Step 6 Recognise identifiable assets acquired, liabilities assumed

The process to recognise identifiable intangible assets is as follows:

In the example case the following intangible are recognised and measured:

Customer relationships
  • M&P has diverse customer base including many long-standing relationships with global pharma companies.
  • Customer relationships were identified as the primary asset due to their importance in the sales cycle.
Trade name
  • The “M&P” trade name is well recognized within its market and is registered with the Patent and Trademark Office.
  • Additionally, “M&P” has built quite a reputation for itself and is one of the strong players in the HPAPI market.
Assembled workforce
  • M&P have highly skilled employee base of 99 employees at various positions across the company and all of these would be retained by Fortune Inc. post-acquisition.

Identified intangible asset

Valuation methodology

Rationale
MPEEMRelief from royaltyWith orwithout
Reproduction cost
Customer relationships

V

  • Primary intangible
  • Independent direct cash flows are capable of being estimated and disaggregated from total cash flows
Trade name

V

  • Availability of comparable and observable royalties
Assembled workforce

V

  • Only acceptable method
  • No independent cash flows or observable mark

Step 7 Measure contingent consideration, if any Calculating the value of an acquisition

Recognize contingent consideration payments at fair value at both the acquisition date and future reporting dates with any changes in the fair value recorded in P&L. Measuring fair value involves the development of expected cash flows to be discounted as of acquisition date at an appropriately chosen discount rate using a suitable valuation technique.


Here is the example worked out with a probability weighting: Calculating the value of an acquisition


Step 8 Measure identifiable assets acquired, liabilities assumed

Determine the associated valuation methodologies and develop comprehensive asset valuation model depending both on the nature of the asset in question and the availability and reliability of the information available to apply the technique. Calculating the value of an acquisition
The three broad commonly applied approaches are summarised below:

Apply professional judgment to develop assumptions and estimates depending on the actual facts and circumstances of the transaction

  1. Revenues: Revenue growth rates for the period 2015 through 2019 are based on management’s expectations from contracts and subscriptions for various product/service lines. Beyond 2019, revenues growth is projected to reflect a gradual decline up to the point in time where the relevant product/service line would achieve a maintainable long term growth rate. The surviving revenue from acquired customers is estimated by applying a customer retention percentage to projected total revenues. Customer retention percentages are based on the management’s customer attrition estimates for each product/service line. Calculating the value of an acquisition
  2. Costs: COGS, operating costs and depreciation assumed to attribute to existing customer revenues on a pro rata basis with new customer revenues.
  3. S&M Costs: Compensation expenses for selling & marketing were reduced by 50 % based on discussions with the Management to reflect the adjustment for a lower effort required by the selling & marketing team to service existing customers.
  4. Contributoty asset charges: Calculating the value of an acquisition
    PLANT, PROPERTY, AND EQUIPMENT Calculating the value of an acquisition
    Fair return of PPE is based on 50 % debt and 50 % equity financing structure on the rationale that an equal proportion of plant, property, and equipment is being financed by equity.
    Fair return of PPE is assumed to be equivalent to annual depreciation
    WORKING CAPITAL
    A fair return on working capital is based on 90 % debt and 10 % equity financing structure on the rationale that the major proportion of working capital is being financed by debt. ASSEMBLED WORKFORCE Calculating the value of an acquisition
    A fair return on the assembled workforce is assumed at 15.78 % which is equal to the WACC. The return on the assembled workforce incorporates a growth investment which correlates with the annual increase in revenue. Calculating the value of an acquisition
  5. Discount rate: The risk profile of the cash flows to value the customer relationships are relatively less risky than the cash flows from the overall business. Therefore, the discount rate for estimating the fair value of existing customer relationships is adjusted by 100 basis points to arrive at 14.78%.
  6. Tax basis: Assumption of depreciable tax basis for asset A TAB factor of 1.20 is added to the final value conclusion. TAB factor is calculated based on the discount rate used to value customer relationship.

  1. Revenues: The total projected revenues for the Company are assumed to be associated with the trade name. Calculating the value of an acquisition

  2. Royalty rate: Royalty rate of 3 % is based on search of comparable trade name royalty agreements from “KtMine” database, which is a third-party database for licensing agreements for comparable trade names. Calculating the value of an acquisition

  3. Useful life: Assumption of an indefinite life. The useful life is assumed to be indefinite based on the management’s intention of continuing using the M&P trade name in the foreseeable future.

  4. Discount rate: The discount rate is assumed to be equivalent to WACC as the risk profile of the cash flows used to value trade name is consistent with the risk profile of the overall entity.

  5. Tax basis: Assumption of depreciable tax basis for asset. A TAB factor of 1.19 is added to the final value conclusion. TAB factor is calculated based on the discount rate used to value trade name.

  1. Workforce: Assumed all employees are required to generate value and are compensated at FMV Calculating the value of an acquisition

  2. Hiring costs: Costs to find and replace workforce based on normal search and hire costs Calculating the value of an acquisition

  3. Training costs: Opportunity cost of salary incurred over period new hires would be unproductive or underutilized Calculating the value of an acquisition

  4. Total replacement costs: The costs to recruit, hire and train a replacement workforce are based on current cost levels and incorporate all of the necessary costs to rebuild assembled workforce to the mature level/stage that exists as at the valuation date.


Step 9 Recognize and measure goodwill or a gain from a bargain purchase

Calculate goodwill or gain from bargain purchase as a residual amount considering the below equation:


Step 10 analyze WACC, IRR and WARA Calculating the value of an acquisition

Develop an appropriate discount rate based on the risk profile of underlying asset, liability or business.

The value of the WARA typically needs to be close to the WACC and IRR values in order for the analysis to be deemed reasonable.

NOTES: Calculating the value of an acquisition

A] Risk-free rate – The risk-free rate is the rate available on instruments considered to have virtually no possibility of default, such as U.S. Treasury obligations. The ultimate risk-free security is considered to be the 30-day U.S. Treasury Bill. However, most analysts prefer to use a 20-year yield to maturity U.S. Treasury coupon bond, since published equity risk premium data considers the same bond horizon. The corresponding rate for the 20-year U.S. Treasury Bond yield is 2.76 %. (Source : http://www.treasury.gov/resource-center)

B] Beta: The two-year beta is calculated as median of the comparable companies and has been adjusted for leverage.

C] Equity risk premium – The equity risk premium is the additional return that investors expect to earn in excess of U.S. Longterm treasury securities to compensate for the additional risk, or the degree of uncertainty, that the expected future equity returns will not be realized. It is a forward-looking concept in that the discount rate should reflect what investors think the risk premium will be going forward. The premium represents large company total returns over long-term government bond income returns. One of the most commonly cited sources of equity risk premium data is published by Duff & Phelps. Duff & Phelps Valuation Handbook contains a history of U.S. capital market returns. According to the 2015 Valuation Handbook, the long-horizon equity risk premium is the arithmetic average total return (i.e., income plus price appreciation) for the S&P 500 less the average income returns of 20-year Treasury Bonds, from 1926 to the present. The period since 1926 is considered to be relevant because of the number of different economic shocks that have occurred during that time. The resulting equity risk premium is 7.00 % (Source: Duff & Phelps Valuation Handbook)

D] Size premium – The average market return determined above represents a rate of return that an average investor would consider adequate for an investment in a portfolio of S&P 500 stocks. Both financial theory and empirical evidence indicate there is a relation between company size and return. The size risk premium represents small company total returns over large company total returns. Because the Company is smaller than the S&P 500 stocks used to derive the equity risk premium, it is appropriate to add a premium for size. The return on small stocks is determined by a study that examines returns by market capitalization of all stocks on the NYSE from 1926 through December 2014. The company being a private company, we cannot derive market capitalization. Hence, we consider the purchase price paid for the acquisition of the subject company. Since the purchase price is in the range of $3.037 to $115.92 million, the corresponding 10z decile equity size premium is 8.94 %. (Source: Duff & Phelps Valuation Handbook) Calculating the value of an acquisition

E] Company specific risk premium – Our assessment of the positive and negative factors affecting M&P and its operating environment led to conclude that investors will expect a greater return than average for the relative market. The factors considered for adding a company specific risk premium include, stability of industry in which the company operates, diversification of product lines, stability of earnings, earnings margins, financial structure, management depth and achievability of projections. Therefore, an additional risk premium of 100 basis points was added.

F] Cost of Debt is taken as the industry cost of debt for SIC Code XXXX @ 6.30 %. Calculating the value of an acquisition

G] The tax rate is assumed to be 40 % based on the U.S. domiciled blended federal and state statutory rates. Calculating the value of an acquisition

H] The debt to total capital ratio has been taken as the median debt to total capital ratio of the comparable companies. Calculating the value of an acquisition

Computation of Internal rate of return (“IRR”)

Weighted average return on assets (“WARA”) analysis

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