Background to this Series of Posts

This is the 13th in a Series of 17 Posts that will be published on this Blog each Tuesday and Thursday from September 16 to November 11. All 17 Posts will be filed under the Blog Category ‘Valuation of Mining Companies’. For previously issued Posts in this Series click here. We hope you find this Post Series useful.

Posts #11 – #16 of this Post Series discuss Valuation Methodologies adopted by stock market investors, stock market analysts, corporate acquirers, merger and acquisition intermediaries, and business valuation experts when they value shares in mining companies. In these Posts the following terms have the following meanings, where each is ‘point in time specific’:

1. Enterprise Value: The total value of a business including both its interest bearing debt and equity components.

2. Equity Value: The total value of the shareholders’ equity of a business, where shareholders’ equity is stated at its fair market value, not at its ‘book’ or ‘carrying’ value.

3. En Bloc Value: The value of all outstanding share (or other ownership interests) of a business viewed as a whole.

4. Per Share Value: That portion of the ‘en bloc’ value appropriately attributed to each class of outstanding share capital divided by the number of shares of that share class that are outstanding at a particular point in time.

The following discussion is subject to important caveats:

1. Any conclusion as to whether a particular valuation methodology is reliable or who does or does not adopt it is fact and circumstance specific. Accordingly, the categorizations set out in the following table and commentary may be inaccurate in any given fact situation.

2. ‘Corporate Acquirer’ means a corporation that acquires all of the outstanding shares or control of another company where it is able to access all relevant information of the target company pursuant to a detailed due diligence process after executing Confidentiality and Non-Circumvention Agreements.

3. ‘Corporate Acquirer’ in the context of the following discussion does not mean a corporation who makes a takeover bid for a public company or portion of the shares thereof where the ‘bidder’ has access only to publicly available information with respect to the target company. In the latter circumstance the ‘bidder’, typically being a company who expects post-transaction synergies, will have specific knowledge of its synergy ‘expectations’ and be in a better position to assess the value of the ‘target’ to it than any analyst not directly advising on the transaction.

Earnings and Cash Flow Based Valuation Methodologies – Part 1

The Multiple of Earnings Methodology

This methodology develops an en bloc equity value, and also is adopted by Public Market Participants to develop stock market price and value comparators. Pursuant to this methodology after-tax earnings are derived either from actual historic operating results, from forecasted operating results, or from some combination of those two things. In simple terms, after-tax earnings so determined then are multiplied by a ‘risk assessment based’ multiple (or multiples), and redundant assets are added to the result. The earnings multiple is typically derived through a combination of intuitive deduction and:

1. Transaction (i.e. merger and acquisition activity) market published and ‘experienced based’ ‘perceived relevant’ data in the case of development of en bloc equity value.

2. Stock market multiples in the case of development of stock market prices based in part on what are taken to be ‘stock market peer group’ comparators.

This methodology is commonly adopted by Securities Analysts where a company has and is expected to generate earnings. This is because at any point in time:

1. In a transaction (merger and acquisition) context there frequently is information available through data providers and others as to what are analyzed to be the price/earnings ratios that were paid in open market transactions involving companies that appear to be similar to the subject company.

However, it is important to understand that to adopt such ‘transaction multiples’ from available ‘transaction data’ as proxies for ‘earnings based value’ is highly simplistic where those reported ‘earnings multiples’ are developed from recent reported earnings of the purchased businesses. This is because purchasers typically expect to realize post-acquisition synergies which are not reflected in those reported ‘earnings multiples’.

2. In a stock market context there is ready data available with respect to the price earnings ratios of what are taken to be ‘peer group companies’, although it is necessary to adjust these ‘peer group’ multiples for ‘comparability issues’ when developing their value conclusions.

3. Much of the detailed data and information required to complete meaningful DCF analysis frequently is not publicly available.

Whether adopted in an en bloc or stock market valuation context, value conclusions developed pursuant to the ‘multiple of earnings’ methodology are inherently subjective and should be reviewed carefully and with scepticism. This is because:

1. As a general rule businesses are sufficiently different in their respective management capability, capital base, sustaining capital requirements, operations, and future prospects (and hence related required ‘growth capital’ expenditures and enhanced ‘growth related’ working capital requirements) to make direct comparisons at best uncertain.

2. Where en bloc values are developed pursuant to the use of merger and acquisition transaction information, post-acquisition synergies anticipated by the purchaser typically are not reflected in the price/earnings ratio attributed to the transactions. That is to say a reported transaction price-earnings ratio, based on publicly available information, may appear to be 14X. However, the purchaser may have built post-acquisition synergies into its price and concluded that it was only paying 11X the post-transaction ‘synergistic earnings’ that would accrue to it post-acquisition.

3. Where stock market prices or ‘target prices’ are developed, much information relevant to either the ‘peer group companies’ or the business being analyzed is not public.

4. Reported earnings of each peer group company and the subject company are dictated by fact specific applications of Generally Accepted Accounting Principles.

5. Reported earnings are unlikely to be directly proportional to free cash flow among the peer group companies and the subject company. This is because their respective capital bases, capital investment requirements, financial structures, and so on, all are likely to be different. As a result of these and other things, Corporate Acquirers who have full access to all relevant information related to a target company in my experience typically:

• Place primary reliance on the DCF methodology when determining company value.

• Do not rely on the Multiple of Earnings methodology as a primary methodology.

• Adopt the Multiple of Earnings methodology when determining whether the public markets are likely to assess the acquisition as ‘accretive’.

For previously issued Posts in this Series click here.

Ian R. Campbell has for over 35 years been one of Canada’s best-recognized Business Valuation Experts – see biography on this Blog.

This Series of Posts is reproduced and supplemented in E-Books titled ‘The Valuation of Mining Companies’ and ‘Valuation Methodologies’. Those E-Books can be found under the E-Learning tab in the Main Navigation Bar of www.StockResearchPortal.com. They are reviewed and amended as market conditions change and our experience dictates. Accordingly, we recommend readers of this Blog Series periodically visit www.StockResearchPortal.com and review those E-Books.

For a comprehensive discussion of Share and Business Valuation see ‘The Valuation of Business Interests’, Ian R. Campbell and Howard E. Johnson, The Canadian Institute of Chartered Accountants, 2001, available through the websites of either Campbell Valuation Partners Limited www.cvpl.com, or The Canadian Institute of Chartered Accountants www.cica.ca.

The views expressed in this Post are those of the author. The value of shares of a given company is time and fact specific. The valuation theories, principles, methodologies, observations, comments and data inputs discussed in this Post are of a general nature, and are provided for information and general guidance only. They should not be taken to include all ‘value or price relevant factors’. Nothing in this Post is intended to, nor should be taken to, constitute economic or investment advice. See Legal Disclaimer.

© 2008, Stock Research DD Inc., all rights reserved.

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