Preparing For The Next Merger Meeting (2)

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

Before we start this blog, I must point out that, in this story of the merger of Best Blogs Ever, Inc (BBE) and Blog Topics, Inc. (BTI), the numbers used are simply made up in order to arrive at a certain result, the merger of the companies.  This blog points out several ways to value a privately held business; not in order to teach how to do so, but to introduce several financial concepts.  The financial analysis of a publicly traded share of stock is different than the analysis of a share of a privately held company.  As has been pointed out by one commentator, there is "more art than science" in the valuation of a closely held business.  Now we return to the story.

In the last blog, we learned how our financial consultant, Mary Jo, valued the stock of BBE.  She next presented her analysis of the value of the stock held by Bob and Mary Pat in BTI.  She had looked at their company in the same ways she had analyzed BBE in the last blog.

Her valuation of BTI based on an asset analysis showed an equity of $30,000, represented by the 200 shares of common stock, owned equally by Bob and Mary Pat (100 shares each).  Not surprisingly since we are in the same business, the assets of BTI are the same as BBE's assets: servers, computers, office furniture and furnishings.  With the small number of authorized and issued shares, the book value of each share of BTI common stock is $150 per share, which is an interesting number but of little help in determining what BBE should pay for those shares.

Using the income approach, Mary Jo reviewed BTI's income statement and determined that, in the last year of operations, BTI had net income of $40,000 for earnings per share of $200.  She pointed out that these net earnings were after Bob and Mary Pat had each drawn a salary from the corporation of $30,000 for a total of $60,000 in wages paid to the couple.  They could have increased their salaries or declared a year end bonus for themselves if they had wanted to draw a total of $100,000 out of BTI, both of which would be treated as deductible compensation by BTI on its tax return.  However, they always operated the company conservatively and had left the money in the company as retained earnings, opting to pay taxes on that income.  Unlike BBE which declares nondeductible dividends on its common stock in order to provide the non-employee shareholders with a return on their investment, Bob and Mary Pat did not have BTI declare a nondeductible dividend to them.  Mary Jo did not bother calculating a "present value" for the earnings per share of BTI stock and then discounting them since anyone could use the same math and arrive at a different value, depending on the assumptions made.  

Having discussed BTI's income statement prepared according to generally accepted accounting principles (GAAP), she then spoke about a non GAAP way to analyze a company.  This way of looking at BTI's earnings before the usual deductions for interest, depreciation, taxes and amortization results in a number referred to as EBITDA.  If such deductions (some being non cash reductions in earnings such as depreciation of equipment and amortization of non tangible assets) are added back into a company's net income, you arrive at the amount of cash a company has actually produced.  In our case, the EBITDA plus the salaries paid to Bob and Mary Pat reveals how much free cash flow (funds not needed for any other corporate purpose) BTI generates.  That number represents additional money which BBE could anticipate having in order to pay Bob and Mary Pat a fixed dividend on the preferred shares we propose to exchange with them for their common stock in BTI.  Our goal is an increase in cash flow as a result of the merger sufficient to pay the price for BTI's common shares.

Mary Jo then discussed the market comparison method to determine the value of the BTI shares.  Due to the difference in the number of issued shares of the two corporations, she first had to equalize the number of shares to get comparable earnings per share.  If BTI's $40,000 of earnings were spread over the same number of shares as BBE's 13,500 outstanding shares, the earnings per share would be $2.96.  BBE's earnings per share for last year were $4.82.  If she applied the same price/earnings ratio she had used for BBE, 15, to the per share earnings of BTI, she would come up with a value per share of $44.40 as opposed to BBE's per share value of $72.30 with the same P/E ratio.  This indicates that each share of BBE common stock is worth 1.63 shares of BTI stock.  

If we do a rough calculation of the value of BTI as a business by simply multiplying the $200 per share of GAAP earnings by a P/E of 15, the value of each share is $3,000.  That price applied to the 200 shares owned by Bob and Mary Pat gives us a value of $600,000 ($3,000 x 200).  This seems like a high number until Mary Jo points out that, if we look at the EBITDA plus the salaries of Bob and Mary Pat, we would be paying $600,000 for adjusted annual earnings for BTI of $100,000.  In other words, we are paying $6 for every $1 of additional cash flow we hope to achieve with a merger with BTI.  This could be considered a bargain, especially if you factor in anticipated increases in revenue, income and cash flow in future years.

Mary Jo and Kate from VFI shared their thoughts on offering Bob, Mary Pat and their blog writers a second class of common shares with different voting rights in order to maintain the current voting control balance in BBE common shares.  We intend to bring this up at our next meeting.  We know that they have been going through the same financial exercises with BBE's financial information.  We look forward to, hopefully, reaching an agreement with them next Monday.

Comments are always welcome.