Before a merger takes place, the acquirer should value the target company correctly. Generally, there are four primary approaches to Valuation of target companies for mergers. These valuation approaches are as under :
(1) Asset Based Valuation Approach :—
Asset based valuation approach assumes that the value of a target company is the sum total of the value of its individual assets. Based on this valuation approach, either of the three methods, i. e a) Book value method, (b) Reinstatement value method, (c) Liquidation value method – is used for valuing a company.
As the underlying concepts of value are not so relevant in determining the intrinsic value of a target company, these methods are also irrelevant.
(2) Relative Valuation Method :
Relative Valuation Method involves valuing a target company by comparing it with the valuation of other companies in the same industry. This comparison is done by means of two approaches:
(a) Comparison with industry averages
(b) Comparison with similar companies
This valuation approach is not a right solution for making an investment decision, let alone for valuing a company from the acquisition point of view. But, relative valuation approach is very popular, right from investors to fund managers and corporate leaders because the approach is easy to understand and apply.
(3) Capitalization of Earnings Approach :
In Capitalization of Earnings Approach, a target company is valued, based on the multiple of its accounting earnings. Here, investors or fund managers project the earnings of a company for the next two-three years, other than for the current year. These earnings are then multiplied by the expected P / E Ratio.
This valuation approach is not the best approach for all time, to find out the intrinsic value of a target company. But, it is comparatively more popular approach in the investment arena and applied as a supplementary approach to valuation of Target Company based on cash flow discounting.
(4) Cash Flow Based Valuation Approach :
There are two basic valuation models under Cash Flow Based Valuation Approach:
(A) Dividend Discount Model
(b) Enterprise Discounted Cash Flow Model or DCF Model
Both these methods are based on the income approach, where the value is determined by calculating the NPV (net present value) of the stream of benefits generated by the business or the asset. Thus the Discounted Cash Flow Model or DCF approach equals the enterprise value to all future cash flows discounted to the present using the appropriate cost of capital.