Shares buy back is when the company buys back part of its free float. This is a good strategy when shareholders are interested in EPS (earnings per share) indicator. But, does it really increases the company value? The answer for me is NO! Look at the example:
A company has annual earning of 6,000, a market cap of 50,000 and 1,000 shares, thus, its shares worth 50 per share.
Imagine the following balance sheet in market values:
TOTAL ASSETS 70,000
Extra cash 2,500
Other assets 67,500
TOTAL LIABILITIES 70,000
Liabilities 20,000
Equity 50,000
If the company buys back shares at market value, it can us its 2,500 extra cash to buy 50 shares. So, it spends 2,500 cash and replace it to 2,500 worthen assets (its own shares), and then, using an accountant measure zero its assets with 2,500 on its equity, reducing the outstanding shares to 1,000 - 50 = 950 shares. So its assets worth 50,000 - 2,500 = 67,500 and its equity worth 47,500.
It's price per share keeps with a value of 47,500 / 950 = 50, but its EPS now is 6,000 / 950 = 6.32.
So the EPS increased. But so does the value to the shareholder? Of course not and the price per share reflects that. Each shareholder will now receive a higher share of the earning, but the 2,500 extra cash that could be immediately distributed as dividends are not available anymore.
Imagine the company has to pay a premium for buying back the shares and make it a 52 per share.
With the same 2,500 extra cash, the company can only buy now 48 shares, reporting a loss of (52 - 50) * 48 = 96 on its equity. Automatically the company replaces 2,500 extra cash with assets worthing 50 x 48 = 2,404 and its equity value decreases from 50,000 to 49,904.
After zeroing the treasury shares, its total assets worth now 67,500 and its equity 49,904 - 2,404 = 47,500 . The outstanding shares now are only 1,000 - 48 = 952 shares, worthing 47,500 / 952 = 49.90 per share.
It's earning per share are now 6.30, but, again, it doesn't mean the company created value to the shareholder. Actually, as we can see through the share value, the company destroyed value to the shareholder buying shares over its market price.
To conclude, what we have to understand is that, in the very first moment, before buying back shares, the equity value was the expected earning discounted to present value (6,000/ 12.63%), plus the cash value of 2,500. The discount rate was obtained doing th reverse calculation : 6,000 / (50,000 - 2,500). If we make the calculation for all the examples before, we see that the discounted rate, that is the profitability expected by the shareholder and associated with the business risk, keeps the same in all the cases, 12.63%.
But if your bonuses are based on EPS indicator, don't try to explain this to your boss.
Sunday, November 22, 2009
The effect of paying with shares for acquisitions on the deal's NPV
To understand the effect of different forms of payment in an acquisition, is better to follow an example.
Company Buyer (B):
# Shares = 1,000
Market price p/ share = 50
Market Capitalization = 50,000
Company Seller (S):
# Shares = 600
Market price p/ share = 15
Market Capitalization = 9,000
Value of S to B = 14,000 (synergy = 5,000)
1) If B buy S with cash based in a price of 20 per share the NPV to B would be:
14,000 - 20 x 600 = 2,000
2) If B buy S with stocks based on market prices the NPV to B would be:
Shares needed to be issued to buy S: 600 x 15 / 50 = 180 shares
Total # of shares after the acquisition = 1,000 + 180 = 1,180
Total market cap after the acquisition = 50,000 + 14,000 = 64,000
Price per share = 64,000 / 1,180 = 54.24
NPV = 14,000 - 180 x 54.24 = 4,237
3) If B buy S with stock based in a price per share of S of 20:
Shares needed to be issued to buy S: 600 x 20 / 50 = 240
Total # of shares after the acquisition = 1,000 + 240 = 1,240
Total market cap after the acquisition = 64,000
Price per share = 64,000 / 1,240 = 51.61
NPV = 14,000 - 240 x 51.61 = 1,613
So buying with stock at market price seems to be a good deal in this case, huh?
Company Buyer (B):
# Shares = 1,000
Market price p/ share = 50
Market Capitalization = 50,000
Company Seller (S):
# Shares = 600
Market price p/ share = 15
Market Capitalization = 9,000
Value of S to B = 14,000 (synergy = 5,000)
1) If B buy S with cash based in a price of 20 per share the NPV to B would be:
14,000 - 20 x 600 = 2,000
2) If B buy S with stocks based on market prices the NPV to B would be:
Shares needed to be issued to buy S: 600 x 15 / 50 = 180 shares
Total # of shares after the acquisition = 1,000 + 180 = 1,180
Total market cap after the acquisition = 50,000 + 14,000 = 64,000
Price per share = 64,000 / 1,180 = 54.24
NPV = 14,000 - 180 x 54.24 = 4,237
3) If B buy S with stock based in a price per share of S of 20:
Shares needed to be issued to buy S: 600 x 20 / 50 = 240
Total # of shares after the acquisition = 1,000 + 240 = 1,240
Total market cap after the acquisition = 64,000
Price per share = 64,000 / 1,240 = 51.61
NPV = 14,000 - 240 x 51.61 = 1,613
So buying with stock at market price seems to be a good deal in this case, huh?
Monday, November 16, 2009
Comparable valuation (Multiples) Working Post
What is the rational behind the utilization of each one of the multiples? How to relate them to the company's main value drivers?
Multiples that use EBITDA: Don't consider the continuity of the company, as the depreciation and the amortization is not included.
Multiples that use EBIT: Consider the continuity of the company.
Multiples that use SALES: Important when the volume is the most important thing to the company. Is related to the brand value and the cost of creating and positioning a brand. It is also important when the business depend on the points of sales.
Multiples that use Number of stores: Can be compared to the cost of setting the new stores, and this is the most important asset.
Multiples that use EBITDA: Don't consider the continuity of the company, as the depreciation and the amortization is not included.
Multiples that use EBIT: Consider the continuity of the company.
Multiples that use SALES: Important when the volume is the most important thing to the company. Is related to the brand value and the cost of creating and positioning a brand. It is also important when the business depend on the points of sales.
Multiples that use Number of stores: Can be compared to the cost of setting the new stores, and this is the most important asset.
Step-by-step to find the correct Free Cashflow (Working Post)
This one is easy, but some weird lines on the Income Statement and in the Balance Sheet can create some doubts. I'll write down here the basic steps. When we find out the problems in real life we can discuss in this topic.
The free cash flow to the firm is composed of 3 components: operational cash flow, investments in working capital, capital expenses (CAPEX).
1) Operational Cash Flow
The Operational Cash Flow can be easily assessed from the Income Statement. However no all the lines of this statement are used. We will check later what was missing!
+ Revenues
- Cost of Sales
= Gross Profit
- Overhead
= EBITDA
- Depreciation and Amortization
= EBIT
- Taxes
= Operational Cash Flow
It's missing XXXXX??????????????
2) Investment in Working Capital
The Investment in Working Capital is based mainly on assumptions over the cash conversion periods (inventory, receivables and payables). After this assumptions are made, almost all the work is done.
The debate here is about the operational cash needed and the short term debt. The premises for them can be made based on a percentage of sales, for the former and cost of sales, for the latter, as an example. After knowing the cash and the short term debt needed, the result of the extra cash and debt (non-operational cash and short term debt) should be netted and added / subtracted to the needed working capital on the period 0, consequently, increasing / decreasing, the value of the company exactly in that amount.
3) CAPEX
The investments plan must be carefully analysed as it can have a big impact, principally in companies with a high operational leverage. If there is a forecast of growing revenues, the capex mut, a least, cover the depreciation expenses.
It should be excluded from the valuation the investments in future projects. Future project shouldn't take part on the valuation, either the costs as well as the revenues. The value os these future projects is equal the value of the options manager have of realizing or not these projects. They should be included on the final value of the company, but now mixed together with the DCF valuation. A solution is real options valuation.
This makes us remind that companies with investment cycles in development and marketing of new projects should have their cash flows forecast up to the life of the actual cycle. (Why? More comments here...)
x----------------------------------------------------
General rules:
1) Years to be forecasted: related to one cycle of investments or up to the stabilization of the cash flows.
2) Terminal value: This is a new topic for this blog.
Anything else???
The free cash flow to the firm is composed of 3 components: operational cash flow, investments in working capital, capital expenses (CAPEX).
1) Operational Cash Flow
The Operational Cash Flow can be easily assessed from the Income Statement. However no all the lines of this statement are used. We will check later what was missing!
+ Revenues
- Cost of Sales
= Gross Profit
- Overhead
= EBITDA
- Depreciation and Amortization
= EBIT
- Taxes
= Operational Cash Flow
It's missing XXXXX??????????????
2) Investment in Working Capital
The Investment in Working Capital is based mainly on assumptions over the cash conversion periods (inventory, receivables and payables). After this assumptions are made, almost all the work is done.
The debate here is about the operational cash needed and the short term debt. The premises for them can be made based on a percentage of sales, for the former and cost of sales, for the latter, as an example. After knowing the cash and the short term debt needed, the result of the extra cash and debt (non-operational cash and short term debt) should be netted and added / subtracted to the needed working capital on the period 0, consequently, increasing / decreasing, the value of the company exactly in that amount.
3) CAPEX
The investments plan must be carefully analysed as it can have a big impact, principally in companies with a high operational leverage. If there is a forecast of growing revenues, the capex mut, a least, cover the depreciation expenses.
It should be excluded from the valuation the investments in future projects. Future project shouldn't take part on the valuation, either the costs as well as the revenues. The value os these future projects is equal the value of the options manager have of realizing or not these projects. They should be included on the final value of the company, but now mixed together with the DCF valuation. A solution is real options valuation.
This makes us remind that companies with investment cycles in development and marketing of new projects should have their cash flows forecast up to the life of the actual cycle. (Why? More comments here...)
x----------------------------------------------------
General rules:
1) Years to be forecasted: related to one cycle of investments or up to the stabilization of the cash flows.
2) Terminal value: This is a new topic for this blog.
Anything else???
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