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19

option can be exercised.

370 The three pillars of financial analysis

Table (cont.)

Balance sheet

Fixed assets 3,092 3,167

Accounts receivable 1,382 1,536

Inventories 1,732 1,954

Accounts payable (2,000) (2,040)

Net working capital 1,114 1,450

Capital employed 4,206 4,617

ROACE 12.0%

Funds flow statement

Profit 530

Amortisation 329

Working capital (336)

Capital investment (404)

Funds flow 119

We also need to recall that I have calculated the liabilities of Corus PLC to

be Â£1,259m. So can we use these numbers to understand why Tata Steel paid

Â£6.2bn to purchase the company in April 2007 and why the share price in

September 2006 had been one third lower than this?

I will start with trying to understand the September 2006 valuation of

about Â£4bn. This is not difficult. Capital employed at the start of 2006 was

Â£4.6bn and the return on capital in the previous year was 12%. If I assume a

10% CoC20 and 2% growth, the sustainable return on capital method would

work as follows:

Market Value ( Return on Capital âˆ’ Growth )

=

(Cost of Capital âˆ’ Growth )

Book Value

Hence market value = 4.6 Ã— (0.12 âˆ’ 0.02) Ã· (0.10 âˆ’ 0.02)

= Â£5.8bn

We must deduct the liabilities figure of Â£1.3bn to arrive at the equity valuation

of Â£4.5bn. This is quite close to the actual share price valuation of a little over

Â£4bn. (I have to ask readers to believe me when I write that these were my ori-

ginal assumptions and that I did not spend time adjusting the assumptions to

arrive at the answer I wanted!)

The reason that I got close to the market value was that I chose the right short

cut approach. Consider what might have happened if I had used the funds flow

I have used 10% because I judge that steel manufacturing is highly linked to the general economy and

20

so has a ÃŸ of greater than 1.

371 The third pillar: What sets the share price?

to perpetuity method. With a funds flow of just Â£119m I would have arrived at

an asset value of just Â£1,517m.21 Deduct the liabilities from this and the residual

equity value is minute. The reason for this is Corusâ€™s growth during 2005.

Capital employed grew during the year by Â£411m which is almost 10%, yet my

long-run growth assumption is just 2%. Clearly if growth is reduced the funds

flow can increase. This sort of situation is where the growth adjusted profit TV

method should be used. The value would have been as follows:

Value = ( profit âˆ’ growth Ã— capital employed ) Ã— (1 + growth ) Ã· (CoC âˆ’ growth )

= (530 âˆ’ 92) Ã— (1.02) Ã· (0.08)

= Â£5.6bn

I will need to make some further adjustments to explain why Tata had to

pay so much more. I also need to introduce some more background context.

Tata originally made an unsolicited bid to buy Corus based on a significantly

lower valuation. This offer encouraged other companies to think about buy-

ing it and eventually a bidding auction ensued. Tata won the auction by bid-

ding the highest price. One has to assume, therefore, that Tata paid a fair

percentage of its anticipated synergies in order to win the auction. It may

even have suffered from the winnerâ€™s curse.

So what sort of synergies might Tata have anticipated? One thing that is

always possible with a takeover of a company in a related line of business is

that overheads can be reduced. In simple terms the combined company can

operate with just one head office and not two. I do not have any detail to go

on and so will assume that the overhead saving could be Â£50m pa after tax.

Now this will not contribute enough value to reach the takeover price. If we

divide it by 0.0822 we get â€˜justâ€™ Â£0.6bn of value. We need to find a total of at

least Â£2bn to understand the deal.

I think that what Tata Steel might have been hoping to achieve is what is

called transfer of best practice. Suppose that Tata Steel had superior ways

of producing steel that could be implemented at the Corus manufacturing

facilities. Suppose also that there were instances of where Corus was better

than Tata. If the two could share what they did and always implement the

best approach then there would be considerable value potential. Corusâ€™s total

costs were about Â£9bn pa. A 2% improvement through sharing best practice

would lower costs by Â£180m pa. If a further 1% could be transferred back

The calculation is 119 Ã—1.02 Ã· (0.1â€“0.02) = 1,517.

21

Dividing by 0.08 is equivalent to assuming that the saving is sustained to perpetuity and that it would

22

grow at 2% pa.

372 The three pillars of financial analysis

to Tata this would make a total pre-tax synergy of Â£270m. Tax needs to be

allowed for. Readers should recall that the typical rate in Corus was just 22%.

I will apply a 30% rate to arrive at a post-tax benefit of about Â£190m pa. The

value of this to perpetuity with 2% growth would be Â£2.4bn. Now assuming a

perpetuity value for a synergy can be too optimistic. If we take just ten years

with no growth the present value would be 6.145 times the annual saving.23

This is Â£1.1bn.

We are now quite close to explaining the Tata bid. Since I do not have any

inside information I will stop at this point. What I trust readers have appreci-

ated is how to use simple TV and annuity factors to derive rough company

valuations.

ABCDE valuation

This is a technique which I have devised in order to value companies and also

to highlight the importance of full-cycle costs. The name can serve as a mne-

monic for remembering what the steps in the technique are. The technique

works like this:

A is for Asset value. This is the value of the assets which a company already

has.

B is for Business development value. This is the value of the future stream

of NPVs which the company will generate through its business develop-

ment activities.

C is for Costs. Business development does not come for free! It requires

costs and the present value of these must be deducted from the overall

valuation.

D is for Debt and other liabilities. The value of these must be deducted from

the total in order to arrive at our answer.

E is for Equity value. The residual value should be what sets the calculated

share price.

The approach is to start with a plan for a company and its existing assets. The

only future capital investment that is included is major projects which have

already been sanctioned plus an allowance for sustaining investment for the

existing assets. Costs are assumed to be held at the level necessary simply to

sustain the company at its current state. Expenditure aimed at generating

growth beyond that which is necessary in order to utilise existing assets is

6.145 is the ten year 10% annuity factor for end year flows.

23

373 The third pillar: What sets the share price?

excluded. The resultant plan should offer good cash generation by the end of

a five-year plan period. An assumption will need to be made as to how long

this cash generation will last. It might, for example, be appropriate to calcu-

late the required TV based on a specified life of assets beyond the plan period.

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