Takeovers could reach an all-time high in 2019

More specifically, he targeted City analysts for being misinformed and the market for reacting disproportionately to factors outside its control such as terrorism. Do these criticisms have any merit?

Following a lull in recent years, takeovers are back in fashion. Bain & Company forecast last week there could be an all-time high of 212 public to private transactions this year, above the 2007 peak. The UK market has witnessed a number of big ticket deals in 2019 already including used car group BCA Marketplace, Ei Group (formerly Enterprise Inns, owner of the Slug & Lettuce bar chain) and, closer to home, Hull telecoms business KCom and Premier Technical Services in Castleford.

In each case, the takeovers have been at a hefty premium to the prevailing share price, in Premier’s case a whopping 72 per cent. Someone has clearly seen value that the stock market hasn’t. In order to look at this disparity, it is worth examining how analysts themselves work. Analysts typically value businesses in one of two ways (or sometimes a hybrid of the two).

Firstly, they will look at the valuation ratios of similar quoted companies, a so-called ‘peer group analysis’, and then apply those ratios to the company they are analysing. The key ratios are P/E Ratio, a measure of the company’s share price to its earnings per share; EV/Sales, its total enterprise value (market value plus any debt) divided by its revenue; and EV/EBITDA, enterprise value divided by its earnings before interest payments, tax, depreciation and amortisation.

This has been the bedrock of fundamental analysis for decades and as long as the sample size is large enough it is as good a place as any to start.

Subjective judgements will then be made as to whether the company in question deserves a premium or discount to the rating of its peers. Intuitively, a company growing at a faster rate than its peer group should command a higher rating whilst a business with greater risks or challenges should expect a discount.

Although different analysts will have different perceptions of what the appropriate rating should be, this assessment is in a constant state of flux reacting to events as they unfold. So it was entirely rational for the Merlin share price to be hit when analysts concluded that terrorist atrocities on UK soil could have an adverse impact on visitor numbers to its UK attractions such as Legoland and The Dungeons.

The second approach is a so-called “absolute valuation” which pays no attention to similar companies but simply values a business with reference to the future cashflows it can be expected to generate. This is also referred to as a discounted cashflow, or DCF, analysis.

This requires much more skill and subjectivity, not least one has to forecast what the business might make not just in the current year but typically for the next ten years. In order to account for the time value of money, a further factor is introduced into the equation – the ‘discount rate’, expressed as an annual percentage.

It is this latter approach – which is the preferred method for private equity and other buyout investors – which may be out of kilter with current thinking in public markets. As a rookie analyst I was always guided to use 10 per cent as a suitable discount rate for an established business. This value has stood up to the test of time and for many in the City it remains the gold standard.

However, a phenomenon of more recent times has been ultra-low interest rates which, all things being equal, should lead to a lower cost of capital. 10 per cent might have been a valid discount rate when interest rates were 4 per cent but with the base rate under 1 per cent then 10 per cent begins to look punitive.

In a world where a wall of cheap money is chasing a finite number of assets, this can also lead to a supply and demand disparity which magnifies the issue.

As a result, quality assets can be bid up in price far higher than a traditional long only fund manager might be willing to pay in a public market based on his or her fundamental analysis.

Only time will tell whether it is the traditional sell-side analysts who are undervaluing companies or it is the private equity world, awash with cash, overpaying for assets on assumptions that turn out to be unrealistic over the course of the cycle.

Whilst the number of takeovers on the stock market is unlikely to subside any time soon, the 2007/8 period warns us that cheap and plentiful money cannot be relied on to last forever.