A bidder cannot know what a target is worth. It can only estimate, and so can the target’s board and shareholders. Pitch the offer too low and shareholders refuse. Pitch it too high and the bidder pays away the gain. The skill is to build a range from several methods, understand what drives each, and decide where to open and where to stop.
This topic covers why valuations are needed in mergers and takeovers, the particular points for quoted and private targets, factors that affect the price (synergy, risk exposure, real options, financing and valuation assumptions), the valuation methods, and the three types of acquisition with the method suited to each. The previous topic covered strategic and regulatory issues. The next covers financing acquisitions.
The November 2014 Pathfinder paper asked for an appraisal of an agreed price.
In 30 seconds
In a takeover the bidder sets the price it will offer, the target’s directors decide whether to recommend it and the target’s shareholders decide whether to accept. For a quoted target, the market price is the floor and the offer must exceed it. For a private target there is no benchmark. Bidders value the equity (debt and preference shares are not usually bought).
Valuation is an art, not a science: use several methods (net assets, market-based earnings or dividends, cash flow and EVA), compare, and use judgement. Factors: synergy, change in risk exposure, real options, financing and assumptions. Prepare an opening price and a ceiling; the target sets a minimum.
Type I acquisitions change neither business nor financial risk (use the existing cost of capital); Type II change financial risk only (use APV); Type III change both (use iterative methods).
Key terms in plain English
| Term | What it means |
|---|---|
| Offer price | The price per share the bidder offers to target shareholders |
| Ceiling price | The most a bidder is prepared to pay |
| Minimum price | The lowest price the target’s directors would recommend |
| Real option | The value of a future choice an acquisition opens up |
| Risk profile | The mix of business risk and financial risk |
| Iterative valuation | Repeated calculation when value and cost of capital depend on each other |
Syllabus check
This topic is in syllabus area D (mergers and acquisitions, organic growth and reconstruction). It covers:
- valuation of an organisation in the context of a potential takeover.
CAMA 2020 and takeover pricing
The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.
| Section | What it says | Link to this topic |
|---|---|---|
| ss. 715 to 717 | A scheme of arrangement requires full disclosure of its terms, valuation reports and independent expert opinions to the members and creditors affected | Valuations support the price that shareholders are asked to accept |
| s. 711 | A merger scheme binds the companies once the Court sanctions it, after three-quarters in value of the members at each meeting approve | The price must win this vote |
| s. 305 and s. 308 | Directors must act in good faith and with the care, diligence and skill of a reasonably prudent director | Directors must test the valuation behind an offer they make or recommend |
The need for a valuation
In a merger, both companies must agree the value of each other’s shares to set the terms. In a takeover:
- (a) the bidder decides what price to offer
- (b) the target’s directors decide whether it is acceptable and to be recommended
- (c) target shareholders decide whether to sell
For a quoted target, the current share price guides the value, but the offer must be higher or shareholders have no reason to sell. For a private target, there is no market price, so the bidder must estimate. The price should win acceptance without being so high that the bidder pays too much; an over-priced acquisition gives a low return and loses value for the bidder’s shareholders.
A bid is rarely made for the target’s debt or preference shares, so the valuation is of the equity.
Valuation is an art. All methods rest on estimates. Methods can set an offer or justify one, but price is finally negotiated. The only “correct” value is the price the bidder offers and the shareholders accept. Use several methods, compare them and apply judgement.
Factors in pricing a bid
- Synergy: the value of expected savings or extra sales, and how much to pay the target for it.
- Risk exposure: an acquisition may raise or lower the asset beta of the enlarged company.
- Real options: an acquisition may create options, such as to expand into a new region later, that have value.
- Financing: large deals need finance. It may be hard to raise debt for a highly geared target if the bidder is also geared, and using retained earnings has dividend implications.
- Valuation assumptions: the bidder, the target’s directors and shareholders each form a view. Assumptions such as growth in profit or free cash flow are judgements. The bidder should set an initial offer and a ceiling. The target’s directors may reject the first offer but should set a minimum they would recommend.
Valuation methods
Be ready to use several and discuss their assumptions:
- Net asset value: a floor, not a likely price.
- Market-based: earnings (P/E, earnings yield) or dividends (dividend yield and the dividend valuation model).
- Cash flow based: DCF of expected returns from the acquisition, including synergies and extra investment.
- EVA/MVA: another cash-flow-type model.
Compare the values, explain the differences and recommend a value for the offer.
Types of acquisition
An acquisition may alter the bidder’s financial risk (through the gearing created by the financing) and its business risk (if the target is in a different industry). That decides the method:
| Type | Effect on risk | Suitable valuation |
|---|---|---|
| I | No change in business or financial risk | Asset-based, market-based (dividends or earnings), cash flow models including EVA and MVA; the current cost of capital can be used |
| II | Changes financial risk only | Adjusted present value |
| III | Changes both | Iterative valuation procedures |
The rules in more depth
Why a bid must exceed the market price
Shareholders already own shares worth the market price. They sell only for more.
Why a bidder values equity, not the company
It is buying shares. Debt stays in the target and is taken over with it, so its value is deducted from any enterprise value.
Why different parties value differently
The bidder prices synergy and its own plans. The target’s directors know more about the business. Shareholders compare with alternatives.
Why a ceiling matters
Without one, competitive pressure leads to paying away all the gain, or more.
Effect on analysis
List the methods, show each value, state assumptions, give the range and recommend an opening price and a ceiling.
Worked examples
Example 1: a P/E value with synergy. A target earns ₦40m a year. Peers trade at a P/E of 8. The bidder expects extra earnings of ₦10m from synergy.
- Stand-alone value.
8 × 40 = ₦320m. - Value to the bidder.
8 × 50 = ₦400m. - The synergy is worth ₦80m; a ceiling should sit below ₦400m.
Example 2: a premium. A quoted target has a market value of ₦300m. The bidder offers a 25% premium.
- Offer = 300 × 1.25.
- Offer = ₦375m.
- This is a floor of ₦300m and an offer above it.
Example 3: a range. Valuations are ₦280m (net assets), ₦320m (P/E) and ₦330m (cash flow). The value with synergy is ₦400m.
- The net asset value is the floor.
- An opening offer near ₦330m is justified by the cash flow value.
- A ceiling of about ₦370m leaves the bidder some of the synergy.
Example 4: choosing a method. A bank acquires an insurance firm and funds it mainly with new debt.
- Business risk changes, because it is a different industry.
- Financial risk changes, because gearing rises.
- This is Type III, so use iterative methods, not the existing WACC.
How to score full marks
- State whose point of view the valuation takes.
- Compute several values and show them together.
- Add synergy separately and explain who gets it.
- Give an opening price and a ceiling.
- Classify the acquisition type and match the method.
- Comment on assumptions and financing.
Common mistakes in the exam
- Giving one value and no range.
- Valuing the company when the question wants the equity.
- Paying away all the synergy.
- Using the bidder’s WACC for a target of different risk.
- Ignoring financing and real options.
- Treating net asset value as the likely price.
Quick revision
- Bidder, target directors and shareholders each decide.
- Quoted: offer above market price. Private: estimate.
- Value the equity; use several methods; judgement.
- Factors: synergy, risk, real options, financing, assumptions.
- Opening price, ceiling, minimum.
- Type I current rate; Type II APV; Type III iterative.
- CAMA 2020: ss. 305, 308, 711, 715 to 717.
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.
Recall check: multiple choice
Recent ICAN papers are written, although older papers such as May 2014 included multiple-choice questions. These questions are for quick recall. The written questions that follow are closer to the exam.
Question 1. A quoted target’s bid price must be:
- Above the market price
- Below the market price
- Equal to book value
- Zero
Show the answer
A. Or shareholders will not sell.
Question 2. A bidder normally values the target’s:
- Equity shares
- Debt only
- Preference shares only
- Premises
Show the answer
A. It buys the shares.
Question 3. Valuation in a takeover is best described as:
- An art based on estimates
- An exact science
- Irrelevant
- Fixed by law
Show the answer
A. Price is negotiated.
Question 4. A real option created by an acquisition is:
- A valuable future choice
- A tax
- A loan
- A dividend
Show the answer
A. For example, expanding later.
Question 5. A Type II acquisition changes:
- Financial risk only
- Business risk only
- Both
- Neither
Show the answer
A. Use APV.
Question 6. A Type III acquisition calls for:
- Iterative valuation
- The current WACC
- Book value only
- No valuation
Show the answer
A. Both risks change.
Question 7. A bidder’s ceiling price is:
- The most it will pay
- The lowest bid
- The market price
- The target’s debt
Show the answer
A. Beyond it value is destroyed.
Question 8. Net asset value is best seen as:
- A floor
- A ceiling
- The offer price
- The synergy
Show the answer
A. Earning power adds to it.
Question 9. Financing a bid mostly with debt raises:
- Financial risk
- Business risk only
- Nothing
- Dividends
Show the answer
A. Gearing increases.
Question 10. Which section of CAMA 2020 sets the director’s duty of care and skill?
- Section 308
- Section 400
- Section 405
- Section 409
Show the answer
A. Directors should test the assumptions behind a decision.
Written questions
Question 11 (10 marks). (a) Explain why the bid price for a quoted target must exceed its market price. (3 marks) (b) Explain the factors a bidder should consider in pricing a bid. (7 marks)
Question 12 (20 marks). Zed Ltd, a private company, has earnings of ₦60m, net assets of ₦400m and dividends of ₦24m a year, growing 4%. A peer trades at a P/E of 9 and investors in Zed would require 12%. The bidder expects extra earnings of ₦15m from synergy. (a) Value Zed by net assets, P/E and the dividend growth model.
(9 marks) (b) Value Zed to the bidder with synergy at the peer P/E. (3 marks) (c) Recommend an opening offer and a ceiling and explain. (5 marks) (d) Explain the three types of acquisition and the valuation method for each. (3 marks)
Question 13 (10 marks). (a) Why is valuation called an art? (3 marks) (b) A quoted target has a market value of ₦300m. Calculate an offer with a 25% premium. (2 marks) (c) Explain who values the target in a takeover and why they may differ. (5 marks)
Model answers
Show the model answer to Question 11
(a) Market price (3 marks). Existing shareholders already own shares worth the market price. (1.5) Without a higher offer they have no reason to sell. (1.5)
(b) Factors (7 marks). Synergy: its value and how much to pay for it. (1.5) Risk exposure: a change in the enlarged company’s asset beta. (1.5) Real options: the value of future choices created. (1.5) Financing: how to raise the money and its effect on gearing and dividends. (1.5) Valuation assumptions: growth and cash flow estimates are judgements, so set an initial offer and a ceiling. (1)
Show the model answer to Question 12
(a) Values (9 marks).
- Net assets = ₦400m. (2)
- P/E.
9 × 60 = ₦540m. (3) - Dividend growth.
24 × 1.04 ÷ (0.12 − 0.04) = 24.96 ÷ 0.08 = ₦312m. (4)
(b) With synergy (3 marks). 9 × (60 + 15) = ₦675m. (3)
(c) Offer and ceiling (5 marks). The net asset value of ₦400m is a floor. (1) The dividend value of ₦312m is low because it suits minority holdings. (1) An opening offer around ₦450m to ₦500m is above the floor and below the earnings value. (1.5) A ceiling near ₦540m to ₦600m keeps part of the ₦135m synergy for the bidder. (1.5)
(d) Types (3 marks). Type I changes no risk, so use asset, market or cash flow methods at the current cost of capital. (1) Type II changes financial risk only, so use APV. (1) Type III changes both, so use iterative procedures. (1)
Show the model answer to Question 13
(a) An art (3 marks). All methods rest on estimates and assumptions. (1.5) The only correct value is the price the bidder offers and the shareholders accept. (1.5)
(b) Offer (2 marks). 300 × 1.25 = ₦375m. (2)
(c) Who values (5 marks). The bidder sets the price it will pay. (1.5) The target’s directors decide whether to recommend it. (1.5) Shareholders decide whether to accept. (1) They differ because of different information, synergy plans and alternatives. (1)
Pathfinder on Pricing a bid, valuation methods and types of acquisition
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Syntax Plc agreed to buy Synapse Chemical for ₦20m. The question asked for an appraisal of the acquisition and advice on whether the price was reasonable, as a report to the board (20 marks). Compare the value of the cash flows with the price, and comment on the assumptions. Read the sections on factors in pricing a bid and valuation methods.
Revise first: Factors in pricing a bid
Questions ask which valuation suits a deal that changes risk. See the section on types of acquisition.
Revise first: Types of acquisition
Source: ICAN Pathfinder, Strategic Financial Management. Diets covered: November 2014 question 3.
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