1. Schedule of free cash flows

Free cash flows measure the cash-producing capacity of the company. Free cash flows are estimated as follows:

You buy a company for its future, not its past, no matter how successful it has been. Consequently, future cash flows are based on projections. As they will vary depending on growth assumptions, the most cautious approach is to set up several scenarios. But for starters, are you the buyer or the seller? The answer will influence your valuation. The objective of negotiation is to reconcile the buyer’s and seller’s points of view. We have found in our experience that discounted cash flow analysis is a very useful discussion tool: the seller gets accustomed to the idea of selling his company and the buyer gets a better understanding of the company for sale.

It is all right for a business plan to be optimistic – our bet is that you have never seen a pessimistic one – the important thing is how it stands up to scrutiny. It should be assumed that competition will ultimately eat into margins and that increases in profitability will not be sustained indefinitely without additional investment or additional hiring. Quantifying these crucial future developments means entering the inner sanctum of the company’s strategy.

(a) Business plan horizon

The length of the explicit forecast period will depend on the company’s “visibility” – i.e. the period of time over which is it reasonable to establish projections. This period is necessarily limited. In 10 years’ time, for example, probably only a small portion of the company’s profits will be derived from the production facilities it currently owns or from its current product portfolio. The company will have become a heterogeneous mix of the assets it has today and those it will have acquired over the next 10 years.

The forecast period should therefore correspond to the time during which the company will live off its current configuration. If it is too short, the terminal value will be too large and the valuation problem will only be shifted in time. Unfortunately, this happens all too often. If it is too long (more than 10 years), the explicit forecast is reduced to an uninteresting theoretical extrapolation.

Let’s look at ArcelorMittal’s financial projections and its stock trend chart. Below are a few projections that we made for teaching purposes, building on analysts’ consensus.

($m)	2015	2016e	2017e	2018e	2019e	2020e
Profit and loss statement
Turnover	63 578	59 311	62 019	64 173	63 666	64 803
EBITDA1	3 795	4 928	5 782	6 583	7 999	8 546
− Depreciation and amortisation	3 192	3 087	3 146	3 236	3 007	3 020
= EBIT	603	1 841	2 636	3 347	4 992	5 526
Balance sheet
Fixed assets	48 157	47 514	46 989	46 537	46 401	46 361
+ Working capital	4 764	4 444	4 647	4 809	4 771	4 856
= Capital employed	52 921	51 958	51 636	51 346	51 172	51 217
Operating margin after 20% tax	0.8%	2.5%	3.4%	4.2%	6.3%	6.8%
ROCE after 20% tax	0.9%	2.8%	4.1%	5.2%	7.8%	8.6%

It should be noted that these projections seem to predict a slow upturn; however, it is not good enough for ROCE (8.6%) to equal the cost of capital (10%) at the end of the period.

Projected after-tax free cash flows are as follows:

($m)	2015	2016e	2017e	2018e	2019e	2020e
EBIT	603	1841	2636	3347	4992	5526
− Corporate income tax at 20%	121	368	527	669	998	1105
+ Depreciation and amortisation	3192	3087	3146	3236	3007	3020
− Capital expenditure	3678	2444	2621	2784	2871	2980
− Changes in working capital	3825	−320	203	161	−38	85
= Free cash flow	−3829	2436	2431	2968	4168	4376

Using a weighted average cost of capital of 10%, the end-2015 present value of the free cash flows generated during the explicit forecast period is $12 017m.

Some practitioners discount cash flows over half years, the formula then becomes:

This assumes that cash flows are cashed in “on average” at half-year and that the valuation is performed at the beginning or end of the year.

(b) Terminal value

It is very difficult to estimate a terminal value because it represents the value at the date when existing business development projections will no longer have any meaning. Often analysts assume that the company enters a phase of maturity after the end of the explicit forecast period. In this case, the terminal value can be based either on the capital employed or on the free cash flow in the last year of the explicit forecast period.

The most commonly used terminal value formula is the Gordon–Shapiro formula. It consists of a normalised cash flow, or annuity, that grows at a rate (g) out to perpetuity:

Value of the company at the end of the explicit forecast period

However, the key challenge is in choosing the normalised free cash flow value and the perpetual growth rate. The normalised free cash flow must be consistent with the assumptions of the business plan. It depends on long-term growth, the company’s investment strategy and the growth in the company’s working capital. Lastly, normalised free cash flows may be different from the free cash flow in the last year of the explicit forecast period, because normalised cash flow is what the company will generate after the end of the explicit forecast period and will continue to generate to perpetuity.

Concerning the growth rate to perpetuity, do not get carried away:

• Apart from the normalised cash flow’s growth rate to perpetuity, you must take a cold, hard look at your projected long-term growth in return on capital employed. How long can the economic profit it represents be sustained? How long will market growth last?
• Most importantly, the company’s rate of growth to perpetuity cannot be significantly greater than the long-term growth rate of the economy as a whole. For example, if the anticipated long-term inflation rate is 2% and real GDP growth is expected to be 2%, then if you choose a growth rate g that is greater than 4%, you are implying that the company will not only outperform all of its rivals but also eventually take control of the economy of the entire country or indeed of the entire world (trees do not grow to the sky)!²

In the case of ArcelorMittal, the normalised cash flow must be calculated for the year 2021, because we are looking for the present value at the end of 2020 of the cash flows expected in 2021 and every subsequent year to perpetuity. Given the necessity to invest if growth is to be maintained, you could use the following assumptions to determine the normalised cash flow:

Normalised cash flow
Normalised 2021 EBIT	5609
− Corporate income tax at 20%	−1122
+ Depreciation and amortisation	3065
− Capital expenditure	−3025
− Change in working capital	−86
= Normalised 2021 free cash flow	4441

Using a rate of growth to perpetuity of 1.5%, we calculate a terminal value of 
$52 250m. Discounted over five years, this gives us $32 443m at the end of 2015. The enterprise value of ArcelorMittal is therefore $12 017m + $32 443m, or $44 460m. Note that the terminal value of $60 524m at end-2020 corresponds to a multiple of 9.5 times 2020 EBIT. This means that choosing a multiple of 9.5 is theoretically equivalent to applying a growth rate to perpetuity of 1.5% to the normalised cash flow and discounting it at the required rate of return of 9.5%.

Given a net debt of $26 480m, the equity value of ArcelorMittal works out, with this method, at $17 980m.

Sometimes the terminal value is estimated based on a multiple of a measure of operating performance. This measure can be, among other things, turnover, EBITDA or EBIT. Generally, this “horizon multiple” is lower than an equivalent, currently observable, multiple. This is because it assumes that, all other things being equal, prospects for growth decrease with time, commanding a lower multiple. Nevertheless, since using this method to assess the terminal value implies mixing intrinsic values with comparative values, we strongly advise against it.

Computing the terminal value with a multiple prevents you from pondering over the level of ROCE that the company can maintain in the future.

Remember that if you compute a terminal value greater than book value, you are implying that the company will be able to maintain forever a return on capital employed in excess of its weighted average cost of capital. If you choose a lower value, you are implying that the company will enter a phase of decline after the explicit forecast period and that you think it will not be able to earn its cost of capital in the future. Lastly, if you assume that terminal value is equal to book value, you are implying that the company’s economic profit³ falls immediately to zero. This is the method of choice in the mining industry, for example, where we estimate a liquidation value by summing the scrap value of the various assets – land, buildings, equipment – less the costs of restoring the site.

In the case of ArcelorMittal, the capital employed end-2020 is $51 217m, and discounted over five years at 10% results in $31 802m. With this method, the enterprise value as at end-2015 becomes 12 017 + 31 802 = $43 818m.

Generally speaking, no economic profit can be sustained forever. The company’s expected return on capital employed must gradually converge towards its cost of capital. This is the case with Coca-Cola, Michelin or British Airways. Regardless of the 
calculation method, the terminal value must reflect this. To model this phenomenon, we recommend using a “cash flow fade” methodology. In this approach, you define a time period during which the company’s return on capital employed diminishes, either because its margins shrink or because asset turnover declines. Ultimately, the ROCE falls down to the weighted average cost of capital. At the end of this time period, the enterprise value is equal to the book value of capital employed.

Readers will have to make choices: length of the cash flow fade period or speed of the convergence towards the cost of capital (form of the ROCE curve: convex, concave or a straight line as in our graph). They might also think that the company will be in a position to earn 1% or 2% more than its cost of capital due to the strength of its strategic position in its markets. Economic theory would not approve that!

This model can also be used for value-destroying companies. Sooner or later, there will be restructurings and bankruptcies triggering improvements in ROCE, but before applying the cash flow fade method the other way around, our readers would be well advised to ask themselves whether or not their company will be among the survivors!

2. Choosing a discount rate

As we value cash flow to the firm, the discount rate is the weighted average cost of capital (WACC) or simply the cost of capital, which corresponds to the minimum rate of return required by the company’s fund providers, i.e. shareholders and lenders to finance the company’s capital employed. You may want to turn back to Chapter 29 for a more detailed look at this topic.

3. The value of net debt

Once you obtain the enterprise value using the above methodology, you must remove the value of net debt to derive equity value. Net debt is composed of financial debt net of cash, i.e. of all bank borrowings, bonds, debentures and other financial instruments⁴ (short, medium or long-term), net of cash, cash equivalents and marketable securities.

Theoretically, the value of net debt is equal to the value of the future cash outflows (interest and principal payments) it represents, discounted at the market cost of similar borrowings. When all or part of the debt is listed or traded over the counter (listed bonds, syndicated loans), you can use the market value of the debt. You then subtract the market value of cash, cash equivalents and marketable securities.

The book value of net debt is often used as a first approximation of its present value. Nevertheless, in some cases, the value of debt can differ materially from its book value:

• when the firm has borrowed at fixed rates (directly after having swapped floating-rate debt) and rates have evolved since then;
• when the company’s solvency situation has significantly changed (for better or worse) since it has contracted the debt and there has been no spread adjustment to recognise this change;
• when the interest rate has been artificially reduced thanks to the issue of debt with warrants or other products (note that this would nevertheless be restated in IFRS or US GAAP accounts).

Hence, we strongly advise retaining the market value of debt rather than its book value when the net debt is high and the difference between book and market value is material.

For example, as at 31 December 2015, the book value of the Solocal Group’s financial debt was €1137m, its fair value was only €754m, a difference of €383m!

When the company’s business is seasonal, year-end working capital may not reflect average requirements, and debt on the balance sheet at the end of the year may not represent real funding needs over the course of the year (see Chapter 11). Some companies also perform year-end “window-dressing” in order to show a very low level of net debt. In these cases, if you notice that interest expense does not correspond to debt balances,⁵ you should restate the amount of debt by using a monthly average of outstanding net debt, for example.

Some other items may add complexity in the assessment of the real level of debt. For example, if assets have been removed from the balance sheet thanks to factoring or securitisation, they need to be added back in. In other cases, sellers may try to “dress” the balance sheet to show a very low level of debt.

4. Other valuation elements

5. Pros and cons of the cash flow approach

The advantage of the discounted cash flow approach is that it quantifies the often implicit assumptions and projections of buyers and sellers. It also makes it easier to keep your feet closer to the ground during periods of market euphoria, excessively high valuations and astronomical multiples. It forces the valuation to be based on the company’s real economic performance.

You might be tempted to think this method works only to estimate the value of the majority shareholder’s stake and not for estimating the discounted value of a flow of dividends. You might even be tempted to go a step further and apply a minority discount to the present value of future cash flows for valuing a minority holding.

This is wrong. Applying a minority discount to the discounted cash flow method implies that you think the majority shareholder is not managing the company fairly. A discount is justified only if there are “losses in transmission” between free cash flow and dividends. This can be the case if the company’s strategy regarding dividends, borrowing and new investment is unsatisfactory or oriented towards increasing the value of some other assets owned by the majority shareholder.

Minority discounts are inconsistent with the discounted cash flow method. Similarly, increasing the cash flow-based value can be justified only if the investor believes he can unlock synergies that will increase free cash flows.

Nevertheless, as satisfying as this method is in theory, it presents three major drawbacks:

1. It is very sensitive to assumptions and, consequently, the results it generates are very volatile. It is a rational method, but the difficulty in predicting the future brings significant uncertainty.
2. It sometimes depends too much on the terminal value, in which case the problem is only shifted to a later period. Often the terminal value accounts for more than 50% of the value of the company, compromising the method’s validity. However, it is sometimes the only applicable method, such as in the case of a loss-making company for which multiples are inapplicable.
3. Lastly, it is not always easy to produce a business plan over a sufficiently long period of time. External analysts often find they lack critical information.

6. Discounting cash flow and discounting dividends

Before people grew accustomed to using the discounted free cash flow to firm method,⁷ the dividend discount model was very popular: the value of a share is equal to the present value of all the cash flows that its owner is entitled to receive, namely the dividends, discounted at the cost of equity (k _E).

This method is rarely used today, because it is extremely complicated. The critical variable is the rate of growth in dividends. It is quite an arbitrary figure as, in the computation, this rate is not a function of any of the factors that give rise to it: marginal rate of return, payout ratio, gearing, etc.

This method is still used in very specific cases – for example, for companies in mature sectors with very good visibility and high payout ratios, such as utilities, concessions and real-estate companies.

Using the same logic, one can compute the value of equity by discounting free cash flow to equity (and no longer to firm) at the cost of equity. Free cash flow to equity is money available for shareholders, i.e. free cash flow to the firm minus after-tax interest payments and plus changes in net debt.

This method is not an easy one to carry out if there is a regular change in the financial structure, which prompts a regular change in the cost of equity. But it is widely used to value banks, whose financial structures do not change much over time due to regulatory constraints.⁸

1. Presentation

The peer comparison or multiples approach (or comparables, “comps” method) is based on three fundamental principles:

• the company is to be valued in its entirety;
• the company is valued at a multiple of its profit-generating capacity. The most commonly used are the P/E ratio, EBITDA and EBIT multiples;
• markets are efficient and comparisons are therefore justified.

The approach is global, because it is based not on the value of operating assets and liabilities per se, but on the overall returns they are expected to generate. The value of the company is derived by applying a certain multiplier to the company’s profitability parameters. As we saw in Chapter 22, multiples depend on expected growth, risk and interest rates.

The approach is comparative. At a given point in time and in a given country, companies are bought and sold at a specific price level, represented, for example, by an EBIT multiple. These prices are based on internal parameters and by the overall stock market context. Prices paid for companies acquired in Europe in 2016, for example, when EBIT multiples were moderate (10 times on average) were not the same as for those acquired in 1980 when multiples hovered around four times EBIT, nor for those bought in 2000, when multiples were very high (c. 12 to 15 times).

Multiples can derive from a sample of comparable, listed companies or a sample of companies that have recently been sold. The latter sample has the virtue of representing actual transaction prices for the equity value of a company. These multiples are respectively called market multiples or trading multiples and transaction multiples. The first ones will be used to value shares of a firm that will not change control (for portfolio management or in the context of an IPO). The second ones are useful for assessing the value of equity in the context of change of control.

2. Building a sample of comparable companies

For market multiples, a peer group comparison consists of setting up a sample of comparable listed companies that have not only similar sector characteristics, but also similar operating characteristics, such as ROCE and expected growth rates. Given that the multiple is usually calculated on short-term projections, you should choose companies whose shares are liquid and are covered by a sufficient number of financial analysts.

3. The menu of multiples

There are two major groups of multiples: those based on the enterprise value (i.e. the value of capital employed), which is then used to obtain the value of equity, and those which are based directly on the value of equity.

Multiples based on the value of capital employed are multiples of operating balances before subtracting interest expense. We believe NOPAT is the best denominator, i.e. EBIT less corporate income taxes on EBIT. But many practitioners use EBIT, which is not a major problem provided corporate income tax rates are roughly the same for all the companies in the sample. The EBITDA multiple is also widely used.

Multiples based on the value of equity are multiples of operating balances after interest expense, principally net income (P/E multiple), as well as multiples of cash flow and multiples of underlying income – i.e. before non-recurring items.

4. Transaction multiples

The approach is slightly different, but the method of calculation is the same. The sample is composed of information available on recent transactions in the same sector, such as the sale of a controlling block of shares, a merger, etc.

If we use the price paid by the acquirer, our multiple will contain the control premium the acquirer paid to obtain control of the target company. As such, the price includes the value of anticipated synergies. Using the listed share prices leads to a so-called minority value, which we now know is nothing other than the standalone value. In contrast, transaction multiples reflect majority value – i.e. the value including any control premium for synergies. For listed companies it has been empirically observed that control premiums are around 25% of pre-bid market prices (i.e. prices prior to the announcement of the tender offer).

You will find that it is often difficult to apply this method, because good information on truly comparable transactions is often lacking or incomplete (price paid not made public, unknown aggregates when the company is private, etc.).

As an example, the EBITDA multiples used in Europe for medium-sized company transfers are given in Section 31.6.

5. Medians, means and regressions

People often ask if they should value a company by multiplying its profit-generating capacity by the mean or the median of the multiples of the sample of comparable companies. Our advice is to be wary of both means and medians, as they can mask wide disparities within the sample, and sometimes may contain extreme situations that should be excluded altogether. Try to understand why the differences exist in the first place rather than burying them in a mean or median value that has little real significance. For example, look at the multiples of the companies in the sample as a function of their expected growth. Sometimes this can be a very useful tool in positioning the company to be valued in the context of the sample.

Some analysts perform linear regressions to find a relationship between, for example, the EBIT multiple and expected growth in EBIT, the multiple of turnover and the operating margin, and the price-to-book ratio and the return on equity (to value banks).

This method allows us to position the company to be valued within the sample. The issue remaining, then, is to find the most relevant criterion. R ² indicates the significance of the regression line, and will be our guide in determining which criteria are the most relevant in the industry in question. Sometimes it allows you to choose a multiple outside the range of comparables’ multiples, simply because the company you are valuing has higher or lower expected growth than others you are comparing it with.

1. Tangible assets

Tangible assets can be evaluated on the basis of replacement value, liquidation value, going-concern value or yet other values.

We do not intend to go into great detail here. Our main point is that in the sum-of-the-parts method it is important to determine an overall value for productive and commercial assets. Rather than trying to decompose assets into small units, you should reason on a general basis and consider sufficiently large groups of assets that have a standalone value (i.e. for which a market exists or that can operate on a standalone basis).

For example, it makes no sense to value the land on which a warehouse has been built. It makes more sense to value the combination of the land and the buildings on it. An appraiser will value the combination based on its potential productive capacity, not on the basis of its individual components. Of course, this is not the case if the objective is to reuse the land for something else, in which case you will want to deduct the cost of knocking down the warehouse.

2. Inventories

For industrial companies, valuing inventories usually does not pose a major problem, unless they contain products that are obsolete or in poor condition. In this case, we have to apply a discount to their book value, based on a routine inventory of the products.

In some situations, you will have to revalue the inventories of companies with long production cycles; the revaluation can lead to gains on inventories. This is often the case with champagne, cognac, whisky and spirits in general. Here again, revaluation will have an impact on income taxes. Remember that when you revalue inventories, you are decreasing future profits.

3. Intangible assets

It might seem paradoxical to value intangible assets, since their liquidation value has, for a long time, been considered to be low. It is now widely acknowledged, however, that the value of a company is partly determined by the real value of its intangible assets, be they brand names, a geographical location or other advantages.

Some noteworthy examples:

• Brands: particularly hard to value but the importance of brands in valuation is growing.

  In general, there are three methods for valuing brands:

• Method 1 The first method asks how much would have to be spent in advertising expense, after tax, to rebuild the brand. This method leads to undervaluation of new and successful brands and overvaluation of older and failing brands.
• Method 2 The second method calculates the present value of all royalty payments that will or could be received from the use of the brand by a third party. It is very sensitive to the chosen royalty rate.
• Method 3 The third method consists in analysing the brand’s fundamental utility. After all, the brand’s raison d’être is to enable the company to sell more and at higher prices than would otherwise be possible without the brand name (costs of enhanced quality and services, of communication). Discounting this “excess profit” over a certain period of time should, after subtracting the related higher costs, yield an estimate of the value of the brand. Users of this method discount the incremental future operating income expected from the use of the brand and subtract the additional operating expense, working capital and investments, thereby isolating the value of the brand. We will not hide the fact that this approach, while intellectually appealing, is very difficult to apply in practice, because often there is no generic “control” product to use as a benchmark.

• Patents and technical know-how: they are valued as brands, but with the same difficulties.
• Lease rights: the present value of the difference between market rental rates and the rent paid by the company.

4. Tax implications

The acquirer’s objectives will influence the way taxes are included (or not) in the sum-of-the-parts approach.

• If the objective is to liquidate or break up the target company into component parts, then the acquirer will buy the assets directly, giving rise to capital gains or losses. The taxes (or tax credits) theoretically generated will then decrease (increase) the ultimate value of the asset.
• If the objective is to acquire some assets (and liabilities), and to run them as a going concern, then the assets will be revalued through the transaction. Increased depreciation will then lower income tax compared to liquidation or the breakup case above.¹²
• If the objective is to acquire a company and maintain it as a going concern (i.e. not discontinue its activities) and as a separate entity, then the acquiring company buys the shares of the target company rather than the underlying assets. It cannot revalue the assets on its books and will depreciate them from a lower base than if it had acquired the assets directly. As a result, depreciation expense will be lower and taxes higher.

5. Usefulness of sum-of-the-parts values

Sum-of-the-parts values can be deceptive, as many people think they imply safe or reliable values. In fact, when we say that a company has a high net asset value, it means that from a free cash flow point of view, the company’s terminal value is high compared with the value of intermediate cash flows. Consequently, the more “net asset value” a company has and the fewer cash flows it has, the more speculative and volatile its value is. Granted, its industrial risk may be lower, but most of the value derives from speculation about resale prices.

For this reason, the sum-of-the-parts method is useful for valuing small companies with no particular strategic value, or companies whose assets can be sold readily on a secondary market (aeroplanes, cinemas, etc.).

1. Reconciling the different methods of valuation

If markets are efficient, then all of the valuation methods discussed so far should lead to the same valuation. In reality, however, there are often differences among the sum-of-the-parts value, the DCF-based value and the peer-comparison value. You must analyse the source of these differences and resist the temptation to average them!

2. The lifecycle theory of company value

Companies that have achieved a certain level of success will see their sum-of-the-parts and cash flow values differ throughout their lifecycle. Lifecycle is an important factor in determining the value of companies, as it was in determining the optimal capital structure and financing policies.

When the company is founded, its net asset value and cash flow value are identical; the company has not yet made any investments. After the first year or two of operations, net asset value may dip because of start-up losses. Meanwhile, cash flow value is greater because it anticipates hopefully positive future profitability.

During the growth phase, net asset value will rise as all or part of the company’s profits are reinvested and the company builds a customer base (the value of which does not appear in the accounts, however). Cash flow value also continues to rise and remains above the net asset value. The company’s expertise has not yet become a tangible asset. It is still associated with the people who developed it.

At maturity, cash flow value will start growing more slowly or stop growing altogether, reflecting a normal profit trend. Nonetheless, the net asset value continues to grow, but more slowly because the company increases its payout ratio. Broadly speaking, net asset value and cash flow value are very close.

If the company then enters a phase of decline, its profits decline and the cash flow value slips below net asset value. The latter continues to grow but only very slowly, until the company starts posting losses. The net asset value falls. As for cash flow value, it is already very low. The net asset value then becomes particularly speculative.

At any given point in time, it is very important to understand the reasons for the difference between the net asset value and the cash flow value, because this understanding gives important clues as to the situation and future prospects of the company.

You might now be thinking that our kaleidoscope of methods leads to as many values as there are images of the company:

• sum-of-the-parts, or net asset value;
• peer-comparison value;
• intrinsic value (i.e. DCF), etc.

We advise against calculating a wide variety of valuations, unless it is to show that you can prove anything when it comes to valuation. But you must not throw up your hands in despair either. Instead, try to understand each type of value, which corporate circumstances it applies to and what its implicit assumptions are. It is more important to determine ranges than to come up with precise values. Precision is the domain of negotiation, the goal of which is to arrive at an agreed price.

Lastly, remember that valuing a company means:

• taking a speculative stance not only on the future of the company, but also on its market conditions. The cash flow and comparison methods demonstrate this;
• implicitly extrapolating past results or expected near-term results far into the future, opening the door to exaggeration;
• sometimes forgetting that net asset value is not a good reference if the profitability of the company differs significantly from its investors’ required return.

Shareholders’ decisions to sell all or part of a company are based on the price they believe they can obtain compared to their set of calculated valuations.

1. Strategic value and control premium

There is no real control value other than strategic value. We will develop this concept later. For a long time, the control premium was a widely accepted notion that was virtually a pardon for dispossessing minority shareholders. When a company was valued at 100 and another company was willing to pay a premium of 20 to the controlling shareholder (holding 50.01%, for example), minority shareholders were excluded from this advantageous offer.

The development of financial markets and financial market regulations has changed this: equality among shareholders is a sacrosanct principle in most countries. Shareholder agreements are a common method for expressing this principle in unlisted companies.

Nevertheless, entrepreneurs often have a diametrically opposed view. For them, minority shareholders are passive beneficiaries of the fruits of all the personal energy the managers/majority shareholders have invested in the company. It is difficult to convince entrepreneurs that the roles of management and shareholders can be separated and that they must be compensated differently – and especially that the risk assumed by all types of shareholders must be rewarded.

What then is the basis for this premium which, in the case of listed companies, can often lift a purchase price to 20% or 30% more than current market price? The premium is still called a “control premium”, even though it is now paid to minority shareholders as well as to the majority shareholder.

If we assume that markets are efficient, then the existence of such a premium can be justified only if the new owners of the company obtain more value from it than its previous owners did. A control premium derives from the industrial, commercial, administrative or tax synergies the new majority shareholders hope to unlock. They hope to improve the acquired company’s results by managing it better, pooling resources, combining businesses or taking advantage of economies of scale. These value-creating actions are reflected in the buyer’s valuation. The trade buyer (i.e. an acquirer who already has industrial operations) wants to acquire the company so as to change the way it is run and, in doing so, create value.

The company is therefore worth more to a trade buyer than it is to a financial buyer (i.e. usually a venture capitalist fund which has no operations in the industry), who values the company on a standalone basis, as one investment opportunity among others, independently of these synergies.

In this light, we now understand that the trade buyer’s expectations are not the same as those of the financial investor. This difference can lead to a different valuation of the company. We call this strategic value.

Strategic value is the maximum value a trade buyer is prepared to pay for a company. It includes the value of projected free cash flows of the target on a standalone basis, plus the value of synergies from combining the company’s businesses with those of the trade buyer. It also includes the value of expected improvement in the company’s profitability compared to the business plan provided, if any.

We previously demonstrated that the value of a financial security is independent of the portfolio to which it belongs, but now we are confronted with an exception. Depending on whether a company belongs to one group of companies or another, it does not have the same value. Make sure you understand why this is the case. The difference in value derives from different cash flow projections, not from a difference in the discount rate applied to them, which is a characteristic of the company and identical for all investors. The principles of value are the same for everyone, but strategic value is different for each trade buyer, because each of them places a different value on the synergies it believes it can unlock and on its ability to manage the business better than current management.

As the seller will also hope to benefit from the synergies, negotiation will focus on how the additional profitability the synergies are expected to generate will be shared between the buyer and the seller.

But some industrial groups go overboard, buying companies at twice their standalone value on the pretext that their strategic value is high or that establishing a presence in such-and-such geographic location is crucial. They are in for a rude awakening. Sometimes the market has already put a high price tag on the target company. Specifically, when the market anticipates merger synergies, speculation can drive the share price far above the company’s strategic value, even if all synergies are realised. In other cases, a well-managed company may benefit little or even be hurt by teaming up with another company in the same industry, meaning either that there are no synergies to begin with or, worse, that they are negative.

2. Minority discounts and premiums

We have often seen minority holdings valued with a discount, and you will quickly understand why we believe this is unjustified. A “minority discount” would imply that minority shareholders have proportionally less of a claim on the cash flows generated by the company than the majority shareholder. This is not true.

In fact, a shareholder who already has the majority of a company’s shares may be forced to 
pay a premium to buy the shares held by minority shareholders. On average, in Europe, the premium paid to buy out minorities is in the region of 20%, only marginally less than that paid to obtain control. Indeed, majority shareholders may be willing to pay such a premium if they need full control over the acquired company to implement certain synergies.

Having said that, the lack of liquidity associated with certain minority holdings, either because the company is not listed or because trading volumes are low compared with the size of the minority stake, can justify a discount. In this case, the discount does not really derive from the minority stake per se, but from its lack of liquidity.

Lack of liquidity may increase the volatility of the share price. Therefore, investors will discount an illiquid investment at a higher rate than a liquid one. The difference in values results in a liquidity discount.

We have encountered some cases where it exceeded 50% for a minority shareholder that wanted to sell its shares, which the majority shareholder only offered to buy after three years. But we have also seen the lack of discount when the disposal of a small stake could change the balance of power in a company.

The minority shareholder may have to wait for the majority shareholder to sell his stake to realise the full value of his investment. This is similar to the situation of a listed company with a reduced free float, where the minority shareholder is then in the hands of the majority shareholder who controls the market communication of the firm. Some listed firms can suffer from an undervaluation due to reduced liquidity of the share, so analysts do not publish research and it then becomes a vicious circle.

In a listed company of sufficient size with widely spread capital, the situation is different as the minority shareholder will be protected by the relevant share price and the protection afforded by market authorities.

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