Here is a simple model that smart corporate acquirers use in determining the value of a business.

Note that this applies specifically to entities that are publicly listed (PLE).

Here is the case:

  • The PLE wants to acquire a company
  • It asks for projected earnings over 5 years and does all the necessary due diligence that corporate guys do.
  • They conclude that the projections are reasonable and there is sufficient headroom to absorb any sudden market changes.
  • The PLE is trading on a P/E of 20.
  • The company being acquired is a private company traditionally tightly held by the owners of the business.
  • The projected earnings of the acquired entity for the next 12 months is projected at R10m after interest and tax. The due diligence revealed that quality of earnings over the next 5 years was represented by the R10m reflected in the one year forecast.
  • Assume that the PE is stable at 20 and has not been recently swelled by a leak to the market about this acquisition.
  • The acquisition will be funded entirely via bank loan at an interest rate of 10% p.a.

Here is the one year forecasted income statement.

  • Turnover:__________________ R75m
  • Variables expeneses___________(R45m)
  • GP _______________________R30m
  • Fixed expenses_______________(R15m)
  • EBIT ______________________R15m
  • TAX ______________________(R 5m)
  • NP _______________________R10m

The existing owners are asking for R100m for the business.

This a fair price, considering that the quality of earnings have been confirmed during the due diligence process.

Consequently the effect on EBIT would be as follows:

  • EBIT ______________________R15.0m
  • Interest ____________________(R10.0m)
  • EBT_______________________R 5,0m
  • Tax _______________________(R 1.7m)
  • NP ________________________R 3.3m

On the face of it there appears to be no real value-add in acquiring the business.

Being a family business, there are inherent risks and one would want some fat in the multiple to cover the viability of the acquisition.

They have overpaid?

The perceived value is only really the conversion of the net profit at the P/E ratio. This the net profit of R3.3m multiplied by the P/E of 20 which equals R66.0m.

Having raised debt of R100m to acquire the entity, only R66m of additional value has been created.

The deal is R34m in the red!

But what if the PLE had cleverly assessed the systems and processes of the purchased entity and established that there were a number of the fixed expenses that could be saved by lumping the infrastructure of the newly acquired entity on the existing group.

This saving was carefully calculated during the due diligence process and amounted to R8m.

The result?

Revised income statement:

  • GP as above __________________R30.0m
  • Reduction fixed expenses_________(R 7.0m)
  • EBIT _______________________R23.0m
  • Interest _____________________(R10.0m)
  • EBT________________________R13.0m
  • Tax ________________________(R 4.0m)
  • NP _________________________R 9.0m

At a P/E of 20, this profit add-on would generate R180m of value (R9m x PE of 20). The deal is now effectively R80m ahead of the curve (R180m value less R100m loan).

It’s a no-brainer!

True or false?

About the author

Clive Kaplan, leading executive coach, is a CA(SA) with over 25 years’ experience as an executive director in both listed and unlisted companies.

Clive brings some interesting perspectives to the field of management. Having been involved at Director/Board level, he offers a wealth of wisdom on both the people and business front.

Clive is the CEO of THE GREEN MIND CAPITAL GROUP. The company focuses on assisting executives, especially emerging young CA’s, in maximizing their potential and fast-tracking their careers.

Clive has been involved with coaching and self-development since 1994. His mix of years of practical executive experience coupled with his own personal self-development journey brings together a unique method of Transformation Coaching. He has hundreds of hours of one-on-one coaching to his credit.

Clive is also a prolific writer on LinkedIn PULSE. He has written over 80 articles on various topics from financial management and operations to job search and confidence building. He is also the author of the winQs series (pronounced ‘winks’) which appears regularly on the LinkedIn network. 

Clive is also a mentor for ORT Jet and The Hope Factory, (a SAICA initiative). He also works closely with the More To Life Program, all on a voluntary basis.

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