Vernimmen Letter Number 46

8/8/2019 Vernimmen Letter Number 46

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THE VERNIMMEN.COM NEWSLETTER: AND TO THE WEB SITE

COMPLEMENTARY TO THE BOOK WWW.VERNIMMEN.COM

NEWS: New rules for allocating goodwill: key features forvaluation

THIS MONTH'S GRAPH: Liquidity and EBIT margins intimes of crisis

RESEARCH: Are investors better off backing managementor the project, the jockey or the horse?

Q&A: Tobins Q, Jensens , Sharpe and Treynor ratios

* * *NEWS: New rules for allocating goodwill:

key features for valuation

by Jean Pier re Col le and Phi l ippe Leduc( Gran t Tho rn ton Valua t i on serv i ces)

IFRS 3R on business combinations came into force in July 2009. This article setsout its key features that impact on valuations.

Key feature #1: 100% of the value of the target is definitivelyrecognised on the date control is achieved

Under IFRS 3R, goodwill is calculated by working out the difference between theaggregate and the revalued net identifiable assets.

The aggregate is calculated by valuing: at fair value, the price paid for acquiring the controlling interest at fair value or at book value, the minority interests (non-controlling interestsor NCIs), at fair value, the previously held investments. i.e., 100% of the target.

Whatever option is taken for valuing the NCIs (fair value or book value), theresulting aggregate and goodwill cannot be adjusted when the NCIs aresubsequently acquired. Accordingly, their value calculated at the date on whichcontrol is achieved is frozen.

So, under IFRS 3R, 100% of the value of the target is recognised definitively atthe date on which control is achieved, regardless of the percentage acquired.Consequently, greater importance is given to the accounts of the economicentity (which are drawn up for shareholders and holders of NCIs) than to theaccounts of the parent company (which are only drawn up for shareholders).

Key feature #2: the fair value of contingent consideration must beincluded in the price paid

Generally, the payment of contingent consideration is triggered if the targetexceeds certain earnings thresholds.

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N 46

December 2009

ext month :

NEWS: Howompanies assessk in Capex?

TABLE: Capitalructures

RESEARCH: Accesso capital

Q&A: Steps of an&A process
http://www.vernimmen.com/http://www.vernimmen.com/http://www.vernimmen.com/html/letter/subscription.htmlhttp://www.vernimmen.com/html/letter/subscription.htmlhttp://www.vernimmen.com/http://www.vernimmen.com/html/letter/subscription.htmlhttp://www.vernimmen.com/http://www.vernimmen.com/


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Under IFRS 3R, the acquirer is assumed to be capable of defining a valuationmodel that would measure the fair value of the contingent consideration reliably(IFRS 3R.BC 349), even if in most cases this turns out to be difficult.

In practice, the fair value of contingent consideration can be determined bycalculating the weighted average consideration contingent on the likelihood ofthe occurrence of the various scenarios put forward by management.

The valuer should not merely rely on a probability valuation model. Forecastsshould also be challenged. The stakes are not neutral. For example, if thetarget achieves better than forecast results:

the contingent consideration effectively paid is more than the contingentconsideration booked; the acquirer cannot increase goodwill and accordingly has to book thedifference under expenses.

Some acquirers might be tempted to overestimate forecasts of the targets post-acquisition results, and accordingly the initial goodwill. This would give rise tothe risk of having to book income that at the very least would be viewed ascontradictory if results achieved turn out to be lower than forecasts and,conversely, being confronted with the subsequent depreciation of goodwill.

Key feature #3: the fair value of NCIs or previously held interests doesnot necessarily correspond to the extrapolation of the price of thecontrolling interest

The fair value of NCIs or previously held interests should in most cases be

determined by an expert.This will not necessarily involve extrapolating a figure from the price of thecontrolling interest, especially when the company is not listed.

In these circumstances, the fair value corresponds to the price resulting fromnegotiations between holders of NCIs and a potential acquirer, which could bethe majority shareholder or a third party.

IFRS 3R does not give cast iron instructions on how to value an NCI.

It restricts itself to stating that the price paid for taking control could include acontrol premium and that the value of an NCI could be impacted by a minority

discount (IFRS 3R B45).The diagram below provides an illustration of a possible approach for valuing an

NCI:

DCF ValueMarket

Participant

=Fairvalue NCI

Price

paid

Control premium(IFRS 3R. B45)

Minority discount(IFRS 3R. B45)

DCF ValueStandAlone

Value

includingsynergies for

the

acquisition

=

Fairvalueforce

controling

stake

Stock market

comparaisons

DCF ValueMarket

Participant

=Fairvalue NCI

Price

paid

Control premium(IFRS 3R. B45)

Minority discount(IFRS 3R. B45)

DCF ValueStandAlone

Value

includingsynergies for

the

acquisition

=

Fairvalueforce

controling

stake

Stock market

comparaisons


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In this diagram:

the lowest value is the DCF stand alone value, which excludes all synergiesthe intermediate value is the DCF Market Participant value, obtained bysubstituting the sector margin for the targets margin and thus includes marketsynergies; the highest value is the majority interest which includes the acquirerssynergies as well as those of the market. Here, it is even higher than the pricepaid in as far as, during the course of negotiations, the acquirer did not discloseall of the expected synergies; the expert estimated that they NCIs, if they had to be acquired, could benefitfrom market synergies not put in place by the seller. Accordingly, the expertsuggests valuing the NCI on the basis of the DCF Market Participant value, whichinvolves cancelling part of the control premium included in the price.

The advantage of this method is that it fixes the value of an NCI withoutimposing a lumpsum minority discount. It allows for the introduction of a certainamount of objectivity when valuing NCIs.

Key feature #4: by specifically getting rid of the reliability criterion forvaluing intangibles, IFRS 3R rubber stamps the standard practiceemployed by valuers

Under the current IFRS 3, the reliability of the valuation is a condition forbooking intangibles (IFRS 3.37c). However, it is specified in IFRS 3.BC 102 thatit must always be possible to value an intangible asset for the purposes of abusiness combination.

Under this postulate, we see that for Purchase Price Allocations (PPAs), valuersagree to derive values that are not necessarily reliable.

The most common criticism levelled against PPA valuations are as follows:

The PPA encourages the valuation of isolated assets such as brands,technologies or customer relations as opposed to the valuation of their content(i.e., the shares in the company holding these assets). It implicitly accordsgreater importance to the net asset value (NAV) method, which has for manyyears been neglected, except in special cases involving real estate and holdingcompanies. The valuation methods generally used (Relief from royalty, Excess earnings)are specific to the exercise of PPA. The DCF method is not used, and rightly so,as this method is intended to value the whole and not isolated assets. The difference between the extreme values obtained using these methods issometimes very large, especially when using the Relief from royalty method,given the wide disparity often seen in the royalty rates of comparableintangibles, such as those available on the public market. The multi-criteriamethod, which alone can make it possible to reduce this difference thanks to theuse of other methods, is used too infrequently. Management is of the view that intangibles are not intended to be sold offindividually and thus sets greater store by the accounting consequences of thevaluation (future amortisation, impairment risk) than by the values obtained.

To summarise, by not including the reliability criterion mentioned under theexisting IFRS 3, IFRS 3R confirms as correct the common practice of valuers.Notwithstanding the criticism levelled above, this is undeniably a step in theright direction. Trying to establish the motivations of the acquirer,understanding what the acquirer was wanting to buy and the resulting price, andfinally translating them into the accounts, represent a great leap forward interms of financial information.


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THIS MONTHS GRAPH: Liquidity and EBIT margins

The first graph gives an idea of how many billions of US$ have fled in the USA inshort-term risk-free assets that are yielding only 0.25% a year (it is better thana year ago when this yield was briefly negative!):

Source : Datastream.

The second graph illustrates that even if the drop in EBIT margins was indeedsharp, the low point reached is actually above that of the previous economiccrisis. This is one of the rules of break-even (1 ): the further away from it, theless the operational leverage. As for the rebound expected by stock marketanalysts, we will see what 2010 has in store!

Source : Exane BNP Paribas.

(1) For more details, see chapter 10 of the Vernimmen.

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5

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C o n s e n s u s

b o tto m - u p

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RECHEARCH PAPER: Are investors better off backingmanagement or the project, the jockey or the horse?

The key factors behind the success of large firms have been the subject ofnumerous theories and empirical studies, since the seminal 1937 article on thesubject by Ronald Coase (1). On the other hand, not much work covers the firstyears of a firms existence, given the difficulty in collecting data in this area.Kaplan et al recently published a study (2) of 50 companies, that starts with theimplementation of their business plan and runs for three years after their IPO.The 50 companies making up the sample were all backed by a venture capitalist.This study shows that venture capital firms are better off backing companieswith solid, promising business plans, even when their management teams arenot as high-powered and efficient as might be hoped. In other words, its betterto bet on the horse than on the jockey.

The reason for this is that it is easier for a firm to change management than tochange its business plan. Of the 50 firms in the sample, 49 continued tooperate the same business with the same type of customer and competition. Onthe other hand, only 44% of CEOs in place three years after the IPO had beenthere at the time the business plan was drawn up.

The data collected are also used to draw up a description of the initial stages ofthe development of the listed companies:

their growth is impressive: over the six-year period that separates theimplementation of the business plan and the IPO +3, the median companygrows from $0 to $43m, and its head count rises from 22 to 432; 46% of these firms cite management expertise as a key factor for successwhen the business plan is implemented, but management expertise is onlymentioned by 16% of firms three years after their IPO; the founders hold an average stake of 31.7% of the share capital when thebusiness plan is implemented, 12.5% at the time of the IPO and 3.2% threeyears later.

Accordingly, Kaplan et al call into question the claim made by the venturecapitalist Arthur Rock, one of the first investors in Apple, that a top qualitymanagement team can, if necessary, change a firms business plan. Theysupport the theory of Hannan and Freeman (3) which holds that the natural

selection (creation and destruction) of firms plays a greater role in theiradapting to the environment than any adaptation that they may undertake. Thequality of the management team is important, especially when the company isbeing set up and the business plan is being defined. Steve Jobs is often statedto be the key reason behind the success of Apple, but eBay, Cisco and Googlereally took off after the departure of their founders.

The results of this article should be treated with caution. A sample of 50 IPOs issmall and cannot guarantee robust statistical results. Moreover, 38 of theseIPOs involved high tech companies, a sector in which there is a markedtendency for the young founding managers to sell their companies and move on.The article does, however, make an interesting contribution to our

understanding of the initial stages of the development of listed firms.(1) R.COASE (1937), The nature of the firm, Economica, n4 p.386-405.(2) S.N.KAPLAN, B.A.SENSOY and P. STRMBERG (2009), Should investors bet on the jockey or thehorse? Evidence from the evolution of firms from early business plans to public companies, Journalof Finance, vol.64, p.75-115.(3) M.HANNAN et J.FREEMAN (1984), Structural inertia and organizational change, AmericanSociological Review, n49, p.149-164.


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Vernimmen Letter Number 46

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