“In other words, the challenge for the acquirer is to condense a large bundle of information and expectations into one figure - the offered purchase price”

The central question in the acquisition of any business is whether the price paid is reflective of the value received. In this article Carl Gordon, of IGFSL Singapore, will discuss the issue from an advisor’s perspective and puts these into context for the SE Asia market. The importance of a company valuation for the deal pricing process is discussed and an overview of the common valuation methods is given.

SE Asia has a tremendous amount to offer to investors and entrepreneurs, from the advanced, regional and important global hub of Singapore, to the rapidly growing G20 emerging economy of Indonesia to the recently opened “frontier” market of Myanmar. The region offers rapid economic growth, resulting in tremendously increasing customer spending and the emergence of a large middle class and a young and well-trained workforce.

The opportunity to participate in the strong growth of many of the regions’ economies and even realising first-mover advantages in some domestic emerging sectors naturally entails certain risks. The high volatility of many of the regions’ economies, as well as individual sectors in combination with often limited market transparency, makes the return on investment hard to predict.

When it comes to pricing a deal, all these factors have to be considered. In other words, the challenge for the acquirer is to condense a bundle of hard information and expectations into one figure – the offered purchase price. The selling side will have to make a similar calculation to determine the price they should ask for. The factors entering into the transaction price include operational value drivers such as:

- Expected growth of demand and price for the business products or services

- Expected development of the market share, reflecting existing and emerging competition

- Costs for raw materials, labour and other key costs

- Asset base and capex requirements.

Macroeconomic data such as:

- Long-term perspective of the economy regarding growth and stability

- Interest rates, inflation and expected exchange rate movements

- Overall level of asset prices and price volatility as well as investor specific factors such as satisfaction with the information available and risk appetite.


Make Pricing Transparent

It’s not a question of whether the price is an aggregation of the above factors – this will always be the case - unless the transaction parties act irrationally. The real question is will this aggregation be done explicitly or implicitly? In practice, this is largely dependent on which SE Asia country is the businesses’ primary market. In the emerging markets the implicit variant would be the norm, meaning that the deal is priced at the end according to “gut feelings” and back-and-forth negotiations. The converse more the norm in the more advanced regional economies; and performing the deal pricing explicitly has substantial advantages, especially in a dynamic and complex market environment:

- It requires the transacting parties to specify their expectations regarding the future of the target’s business, which helps to put the pricing on a rational basis and direct attention to crucial issues

- It gives the buy side an idea beforehand of which price range the seller is likely to accept and vice versa

- It smoothes price negotiations, since the price is based on transparent assumptions

- The value impact of due diligence findings can be readily assessed

- A proper valuation documents that the pricing was done diligently, and helps to explain the transaction price to senior management, shareholders, analysts, auditors, regulators and others who may challenge it.

How is a valuation made and how can the specific market environment of the target be factored in?

Generally, the value of a business can be assessed from three angles - the ability of the business to generate cash in the future, the prices paid for similar businesses in the market (including the stock market) and the company’s asset base. From these angles result three different approaches, which are usually referred to as income approach, market approach and net asset approach.

All of these approaches are “correct” and lead in an ideal world to similar results. That raises the question - which approach to select? The answer depends on the specific case. Each valuation can only be as accurate as the parameters entering into it – the phrase “garbage in - garbage out” could have been coined for company valuations.

A closer look at each of the three approaches helps with the understanding, nature and relevance of various input data.

Income approach

The most common method under the income approach is discounted cash flow (DCF). Based on the management’s financial projections of the business, the advisor calculates the cash flow that the business is able to generate in future years for shareholders and debt holders – the so called “free cash flow to firm”.

These cash flows can be explicitly forecast for the period for which the management prepared projections. For the years thereafter, the advisor usually estimates a sustainable yearly cash flow, which is often based on the cash flow projected for the last projected year. This sustainable cash flow is assumed to grow at a constant rate, often determined with reference to the long-term inflation, in the years after the projection period.

To determine the DCF value, these cash flows have to be discounted to the valuation date with an appropriate discount rate. This rate is calculated as a blended average of the company’s cost of equity and cost of debt – the famous “WACC” (weighted average cost of capital).

For cost of equity and cost of debt a build-up approach is usually applied. The starting point is the base rate, which is the sum of the risk-free interest rate and the premium country risk, both derived from government bond yields.

The cost of debt results from the base rate plus the company’s credit spread, the cost of equity is the base rate plus risk premium. This is often calculated from the company-specific “beta factor”, with reference to the capital asset pricing model.

The value calculated by discounting the free cash flows to firm with the WACC is the so called “enterprise value”, which is the value of the company’s debt and equity combined. The equity value results from subtracting the debt from the overall enterprise value.

Market approach

While the income approach can be seen as a “bottom up” analysis – the value is derived from specific expectations about the business - the market approach takes a “top down” perspective. The advisor analyses the price paid for comparable businesses and translates them into prices for the business to be valued.

This translation is often performed by multiples such as price/earnings, price/book or enterprise value/EBITDA. The choice of the adequate multiple(s) depends on the nature of the business and is a matter of professional judgement.

The main challenge of the market approach is to identify companies which are well enough comparable to the business to be valued and for which recent transaction prices are observable. In practice, the valuer usually refers to listed companies and to recent private transactions in unlisted companies for which the price is disclosed. The likelihood of finding a set of closely comparable companies in this space in a specific country for the business to be valued is often low.

Care must also be taken that the transaction prices are orderly, ensuring that the transaction was negotiated at arm’s length without compulsion to act for either party – which is not always easy to establish in less transparent markets. The advisor may extend the search for comparables to broader regions – such as emerging South East Asia, ASPAC or even global - but the relevance of the overseas comparables has to be assessed with care.

Net asset approach

The net asset approach is used if the value of the company is driven mainly by the value of the company’s tangible assets. This is usually the case for real estate companies and investment holding companies. The starting point for the net asset approach is the balance sheet of the company.

The valuer identifies those assets and liabilities for which the fair value differs significantly from the book value. If for those assets the book value is replaced by the fair value, the net asset value results from the difference between the aggregate fair values of the assets and the aggregate fair values of the liabilities.

Care must be taken whether the company holds any material intangible assets (such as a brand name or customer relationships) which have not been factored into the fair value of the assets. The net asset approach relies on fair value calculations for the company’s main assets which may be performed by the company advisor or – often in the case of real estate – by specialized asset valuers.

In conclusion

It should be clear from the above that business valuation is a technical discipline, but is neither rocket-science nor a black box. The inputs to a valuation model centre around the same issues that the transaction parties are concerned about.

Experience shows that in emerging markets the income approach leads to the most accurate results, except for highly asset-driven businesses like real estate or investment holdings. For mature markets, the market approach is more likely to produce the more accurate results; those results not being reliant on the management’s financial projections of future results.

Performing a valuation means to derive an adequate price from these factors in a rational way. The benefits of a quality and well documented valuation can make the difference between a successful and an unsuccessful M&A deal.


Carl Gordon

Mr. Carl Gordon, is Assistant Vice President with IL&FS Global Financial Services Pte Ltd. – ( Singapore ) – IGFSL
IGFSL, is a 100% subsidiary of IL&FS Financial Services Ltd.

Website link : http://www.ilfsifin.com/singapore/index.html


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