Control premium

Last updated

A control premium is an amount that a buyer is sometimes willing to pay over the current market price of a publicly traded company in order to acquire a controlling share in that company. [1]

Contents

If the market perceives that a public company's profit and cash flow is not being maximized, capital structure is not optimal, or other factors that can be changed are impacting the company's share price, an acquirer may be willing to offer a premium over the price currently established by other market participants. A discount for lack of control, sometimes referred to as a minority discount, reflects the reduction in value from a firm's perceived optimal or intrinsic value when cash flow or other factors prevent optimal value from being reached.

Minority discount is an economic concept reflecting the notion that a partial ownership interest may be worth less than its proportional share of the total business. The concept applies to equities with voting power because the size of voting position provides additional benefits or drawbacks. For example, ownership of a 51% share in the business is usually worth more than 51% of its equity value—this phenomenon is called the premium for control. Conversely, ownership of a 30% share in the business may be worth less than 30% of its equity value. This is so because this minority ownership limits the scope of control over critical aspects of the business. Share prices of public companies usually reflect the minority discount. This is why take-private transactions involve a substantial premium over recently quoted prices.

Overview of concept

Transactions involving small blocks of shares in public companies occur regularly and serve to establish the market price per share of company stock. Acquiring a controlling number of shares sometimes requires offering a premium over the current market price per share in order to induce existing shareholders to sell. It is made through a tender offer with specific terms, including the price. [2]

The amount of control is the acquirer's decision and is based on its belief that the target company's share price is not optimized. An acquirer would not be making a prudent investment decision if a tender offer made is higher than the future benefit of the acquisition.

Size of premium

In general, the maximum value that an acquirer firm would be willing to pay should equal the sum of the target firm's intrinsic value, synergies that the acquiring firm can expect to achieve between the two firms, and the opportunity cost of not acquiring the target firm (i.e. loss to the acquirer if a rival firm acquires the target firm instead). A premium paid, if any, will be specific to the acquirer and the target; actual premiums paid have varied widely. In business practice, control premiums may vary from 20% to 40%. [3] Larger control premiums indicate a low minority shareholders' protection.

Example

Company XYZ has an EBITDA of $1,500,000 and its shares are currently trading at an EV/EBITDA multiple of 5x. This results in a valuation of XYZ of $7,500,000 (=$1,500,000 * 5) on a EV basis. A potential buyer may believe that EBITDA can be improved to $2,000,000 by eliminating the CEO, who would become redundant after the transaction. Thus, the buyer could potentially value the target at $10,000,000 since the value expected to be achieved by replacing the CEO is the accretive $500,000 (=$2,000,000–$1,500,000) in EBITDA, which in turn translates to $2,500,000 (=$500,000 * 5 or =$10,000,000–$7,500,000) premium over the pre-transaction value of the target.

Enterprise value/EBITDA is a popular valuation multiple used in the finance industry to measure the value of a company. It is the most widely used valuation multiple based on enterprise value and is often used in conjunction with, or as an alternative to, the P/E ratio to determine the fair market value of a company.

Enterprise value (EV), total enterprise value (TEV), or firm value (FV) is an economic measure reflecting the market value of a business. It is a sum of claims by all claimants: creditors and shareholders. Enterprise value is one of the fundamental metrics used in business valuation, financial modeling, accounting, portfolio analysis, and risk analysis.

See also

Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to effect a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest. In some cases, the court would appoint a forensic accountant as the joint expert doing the business valuation.

Divestment reduction of some kind of asset for financial, ethical, or political objectives or sale of an existing business by a firm

In finance and economics, divestment or divestiture is the reduction of some kind of asset for financial, ethical, or political objectives or sale of an existing business by a firm. A divestment is the opposite of an investment.

Equity value is the value of a company available to owners or shareholders. It is the enterprise value plus all cash and cash equivalents, short and long-term investments, and less all short-term debt, long-term debt and minority interests.

Related Research Articles

Mergers and acquisitions transactions in which the ownership of companies, other business organizations or their operating units are transferred or combined

Mergers and acquisitions (M&A) are transactions in which the ownership of companies, other business organizations, or their operating units are transferred or consolidated with other entities. As an aspect of strategic management, M&A can allow enterprises to grow or downsize, and change the nature of their business or competitive position.

Price–earnings ratio

The price/earnings ratio is the ratio of a company's share (stock) price to the company's earnings per share. The ratio is used for valuing companies and to find out whether they are overvalued or undervalued.

In finance, a put or put option is a stock market device which gives the owner the right, but not the obligation, to sell an asset, at a specified price, by a predetermined date to a given party. The purchase of a put option is interpreted as a negative sentiment about the future value of the underlying stock. The term "put" comes from the fact that the owner has the right to "put up for sale" the stock or index.

Real options valuation, also often termed real options analysis, applies option valuation techniques to capital budgeting decisions. A real option itself, is the right—but not the obligation—to undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. For example, the opportunity to invest in the expansion of a firm's factory, or alternatively to sell the factory, is a real call or put option, respectively.

Public company Company that offers its securities for sale to the general public

A public company, publicly traded company, publicly held company, publicly listed company, or public limited company is a corporation whose ownership is dispersed among the general public in many shares of stock which are freely traded on a stock exchange or in over the counter markets. In some jurisdictions, public companies over a certain size must be listed on an exchange. A public company can be listed or unlisted.

Valuation (finance) process of estimating what something is worth, used in the finance industry

In finance, valuation is the process of determining the present value (PV) of an asset. Valuations can be done on assets or on liabilities. Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.

In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value.

In finance, the terminal value of a security is the present value at a future point in time of all future cash flows when we expect stable growth rate forever. It is most often used in multi-stage discounted cash flow analysis, and allows for the limitation of cash flow projections to a several-year period. Forecasting results beyond such a period is impractical and exposes such projections to a variety of risks limiting their validity, primarily the great uncertainty involved in predicting industry and macroeconomic conditions beyond a few years.

Restricted stock, also known as letter stock or restricted securities, is stock of a company that is not fully transferable until certain conditions (restrictions) have been met. Upon satisfaction of those conditions, the stock is no longer restricted, and becomes transferable to the person holding the award. Restricted stock is often used as a form of employee compensation, in which case it typically becomes transferrable ("vests") upon the satisfaction of certain conditions, such as continued employment for a period of time or the achievement of particular product-development milestones, earnings per share goals or other financial targets. Restricted stock is a popular alternative to stock options, particularly for executives, due to favorable accounting rules and income tax treatment.

In economics, valuation using multiples is a process that consists of:

Option (finance) right to to buy or sell a certain thing at a later date at an agreed price

In finance, an option is a contract which gives the buyer the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price prior to or on a specified date, depending on the form of the option. The strike price may be set by reference to the spot price of the underlying security or commodity on the day an option is taken out, or it may be fixed at a discount or at a premium. The seller has the corresponding obligation to fulfill the transaction – to sell or buy – if the buyer (owner) "exercises" the option. An option that conveys to the owner the right to buy at a specific price is referred to as a call; an option that conveys the right of the owner to sell at a specific price is referred to as a put. Both are commonly traded, but the call option is more frequently discussed.

Premium pricing is the practice of keeping the price of a product or service artificially high in order to encourage favorable perceptions among buyers, based solely on the price. Premium refers to a segment of a company's brands, products, or services that carry tangible or imaginary surplus value in the upper mid- to high price range. The practice is intended to exploit the tendency for buyers to assume that expensive items enjoy an exceptional reputation or represent exceptional quality and distinction. A premium pricing strategy involves setting the price of a product higher than similar products. This strategy is sometimes also called skim pricing because it is an attempt to “skim the cream” off the top of the market. It is used to maximize profit in areas where customers are happy to pay more, where there are no substitutes for the product, where there are barriers to entering the market or when the seller cannot save on costs by producing at a high volume.

Stock financial instrument

The stock of a corporation is all of the shares into which ownership of the corporation is divided. In American English, the shares are commonly known as "stocks." A single share of the stock represents fractional ownership of the corporation in proportion to the total number of shares. This typically entitles the stockholder to that fraction of the company's earnings, proceeds from liquidation of assets, or voting power, often dividing these up in proportion to the amount of money each stockholder has invested. Not all stock is necessarily equal, as certain classes of stock may be issued for example without voting rights, with enhanced voting rights, or with a certain priority to receive profits or liquidation proceeds before or after other classes of shareholders.

A share price is the price of a single share of a number of saleable stocks of a company, derivative or other financial asset. In layman's terms, the stock price is the highest amount someone is willing to pay for the stock, or the lowest amount that it can be bought for.

Corporate finance area of finance dealing with the sources of funding and the capital structure of corporations

Corporate finance is an area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

In corporate finance, free cash flow to equity (FCFE) is a metric of how much cash can be distributed to the equity shareholders of the company as dividends or stock buybacks—after all expenses, reinvestments, and debt repayments are taken care of. Whereas dividends are the cash flows actually paid to shareholders, the FCFE is the cash flow simply available to shareholders. The FCFE is usually calculated as a part of DCF or LBO modelling and valuation. The FCFE is also called the levered free cash flow.

<i>Investment Valuation</i> book by Aswath Damodaran

Investment Valuation: Tools and Techniques for Determining the Value of Any Asset is a textbook on valuation, corporate finance, and investment management by Aswath Damodaran. The text was initially published by John Wiley & Sons on October 11, 1995, and is now available in its third edition as a part of Wiley Finance series.

References

  1. Damodaran, Aswath. "The Value of Control: Some General Propositions" (PDF). NYU Stern. Retrieved 4 March 2019.
  2. Damodaran, Aswath. "THE VALUE OF CONTROL: IMPLICATIONS FOR CONTROL PREMIUMS, MINORITY DISCOUNTS AND VOTING SHARE DIFFERENTIAL" (PDF). NYU Journal of Law & Business . Retrieved 4 March 2019.
  3. "CONTROL PREMIUM STUDY 2017: Insights into market dynamics, financial dynamics and other factors" (PDF). RSM International Association. Retrieved 4 March 2019.