The words above are the first two paragraphs of a Valuation for Financial Reporting Advisory Paper ('VFR') issued by The Appraisal Foundation in the USA in September 2017. In these eight lines it summarises the contrarian views of Eric Nath, first raised in the early 1990’s. These views are now in the full flow of the mainstream.
It has to be said that the phrase 'market participant acquisition premium' ('MPAP') is neither elegant nor memorable. It is however descriptive: in order to apply what has, up to now, been called a “control premium” it is necessary to focus on the market participants. A price above the market price will only normally be payable if a market participant sees the potential for increased cash flows or reduced risk. There needs to be confidence that this will be achieved under different stewardship or management.
The strong implication is that the days of applying a blanket control premium of 30% or 40% when using valuation metrics from guideline listed companies should be behind us.
Relevance?
The VFR cites three financial reporting situations in which valuers have to consider the concepts behind the MPAP:
- Goodwill/intangibles impairment;
- Valuations of portfolios of investments.
- Step acquisitions of business combinations using acquisition accounting.
The concept of foundation
The Paper refers to the Foundation as being the value of a company under current stewardship and ownership. For a listed company the equity Foundation will equate to the market capitalisation.
The MPAP is then defined as the difference between the value as perceived and the Foundation.
The practical challenges for the valuer
An example is given of a listed company which is well managed. It has developed a unique technology and has enjoyed strong growth in consequence. In this example the opportunities to generate benefits from the prerogatives of control are limited. The Paper gives two possibilities:
- There may be a market participant with complementary technologies which have the potential to boost revenue growth;
- Alternatively, another market participant may have a well-developed distribution network which can be used to market the product, resulting in cost savings.
The challenges for the valuer are clear: I will dissect several of them.
What does good management look like?
Firstly the company is described as being well managed. The implication, albeit unstated, is that a company which is not well managed will offer opportunities for a broader range of market participants to seize control and to increase profits and value. We can all recognise that poor management is only too evident with the benefit of hindsight: we survey the smouldering wreck of a failed plc and shake our heads in disbelief as we gaze at the debris.
Despite these experiences, it is indeed a courageous valuer who considers that she can identify those listed companies which are overdue a management shake-up in order to squirt some life into failed ambitions.
Synergy benefits?
The VFR returns time and again to the concept of synergy. It does seem to be recognised that the bid premiums as evidenced in the markets are better considered as either a synergy (or a hubris) dataset.
The two circumstances proffered by the Paper both relate to types of synergy. There are market participants swimming in the market to whom the company is seemingly worth more than the Foundation. What does the valuer make of such considerations?
If the valuer considers himself to be alone in having this insight, then it is clearly a case of the valuer bestowing himself with the remarkable visionary skills of a soothsayer. He should be as wealthy as Croesus as a stock-picker without equal.
If he is not alone in having this knowledge, there are several expectations from a broadly efficient market:
- The market participants will have made a takeover bid;
- The market price will have increased, by a process known as run-up, in the expectation of a bid which may come;
- The market participants will have decided not to make a bid: the potential benefits are outweighed by the premium that will be demanded by shareholders in order to gain 90%+ acceptances.
Special market sectors
The VFR recognises that a market sector which is ripe for consolidation can be viewed in two ways:
- There is likely to be an enhanced MPAP in that sector;
- There is likely to be a reduced MPAP as the market pricing will have signalled the enhanced takeover prospects.
Are markets efficient?
The unstated assumption in the VFR, wisely made, is that markets are broadly efficient. This need not mean that every share is priced at its economic value. What it means is that there is no particular trading style which will deliver unerring gains: an individual share is as likely to be undervalued if it is trading at a relatively high p/e ratio as a relatively low one. Whichever valuation metric is favoured, it will not deliver investment returns above those of the broad market.
Total invested capital
The paper makes a point which cannot readily be argued against: if the valuer assumes an MPAP this should be measured at the enterprise value level and it is the total invested capital which should comprise the Foundation as referred to above. Therefore any data on guideline transactions should be sure to adjust for differing capital structures.
The curfew tolls the knew of parting day
This is, I think, the end of the concept of the 'control premium' as a factor in business valuation.
Andrew Strickland, Consultant, Scrutton Bland
Valuation Community, October 2018
