This paper analyses the feasibility of a takeover bid of the commercial aviation company Ryanair Holdings PLC by a North American airlines firm through determination of the appropriate method of valuation which the latter can adopt to verify the practicability of bidding for the takeover of Ryanair Holdings. Financial factors need to be taken into consideration when deciding for any decision to bid for takeover. Generally, the target company’s financial statements, such as the balance sheet and profit and loss statement are the basis for such financial analysis. There are non-financial issues that must be carefully weighed as well. These issues are those that need to be sorted out in order to come up with a decision which will lead to either taking the takeover bid forward or not. The valuation methods available for utilisation may produce different results as they are based on a variety of variables. The approach deemed most fit for the situation of Ryanair is the earnings-based model which assumes that the value of an entity is equal to the present value of future earnings that will be generated by the business. This approach is applicable to the Ryanair case, as the company’s financial documents offer the year when they have observed a decline in net profit, it will be most useful to use this type of approach to company valuation.
INTRODUCTION
With a North American airline’s plan to takeover Ryan air PLC, it is imperative that the latter be valued either formally or informally. Owing to asymmetry in terms of the underlying financial incentives, it is fundamentally important for the purchaser to understand the principles of business valuation so as to anticipate and, more importantly, to interpret the other's offer. Valuation, as a science, deals with, among other things, the following: (1) adherence of general accounting principles for the organization and presentation of the financial data of the business; (2) chronicalization of the facts associated with the historical growth of the business; (3) extrapolation of financial data into future time periods; and (4) calculation of various valuation ratios and statistical formulae (Boger & Link 1999). These are, without question, critical dimensions to a business valuation, but they are not the only dimensions of a business valuation that are important. All too often, for a variety of reasons, individuals may fall into the trap of believing that business valuation is little more than a formulistic exercise.
There are, in line with the above, non-financial factors affecting business valuation. It deals with, among other things, the following concepts: (1) understanding the economically efficient life of productive assets, compared to the general accounting practice defined depreciable life of productive assets; (2) understanding the economically relevant industry in which the business being valued operates; (3) understanding the appropriateness of one valuation method or one statistical method over another; (4) understanding the limitations of financial information from comparable businesses; and (5) understanding the economic environment into which financial data are being extrapolated, and the appropriateness of such an extrapolation. As such, there is the need for the detailed analysis of Ryanair Holdings PLC in terms of the financial and non-financial factors affecting the planned takeover of the North American Airline in order to arrive at a recommendation either a bid should be made for the takeover or not.
FINANCIAL FACTORS AFFECTING THE TAKEOVER BID
In general, the data needed to provide a valuation of Ryanair are: projected and historical financial data, ownership records, information on products and services, sales and marketing data, and supplementary information on banking, legal and contractual relationships (Mastracchio Jr. & Zunitch 2002). Before work could be started, company data that is needed include financial statements and tax returns for three to five years; an accounting of all outstanding payables, and receivables, if there are any; the actual value of inventories; identification of key customers and the percentage of business tied to the relationship; equipment, including its age; industry, geographic and market comparisons; sales and other projections; resumes of key personnel; the most recent business plan; published corporate literature and press articles; and the percentage of revenues dependent on each product line or service. There is also the need to gather information from other sources, including industry and geographic comparisons, as well as a survey of sales of comparable businesses.
The preparation of financial statements should be foremost in mind in the preparation of a corporate valuation in order to come up with a recommendation if the takeover bid is going to push through or not. It is through peruse of these documents that the valuator will most accurately provide a recommendation for the North American airline client. Another issue relevant to any valuation is whether the valuation should be conducted on a pre-tax or an after-tax basis. The valuation profession differs with regard to this issue, and there is no definite right or wrong answer. What is important is for all parties to understand the underlying assumptions being brought to the valuation and for all parties to verify that the data used in the valuation process are consistent.
Valuations are generally conducted on a pre-tax basis. Some who frequently argue that valuations should be done on a pre-tax basis often point to the fact that courts have argued that future tax liabilities are too uncertain to be included in a valuation. In other words, while all valuators rely on assumptions regarding the future and attempt to predict future financial situations (e.g., profitability), predicting the tax rates that might be applicable to those future financial situations adds another level of judgment and an entirely new set of assumptions. Although this is true, future tax liabilities are no more uncertain than other elements in a valuation, such as the economic conditions that will surround the business in the future. Some who frequently argue that future tax liabilities should be included do so by making the rather obvious observation that taxes are a reality of doing business. These points aside, the justification for conducting business valuations on a pre-tax basis comes from a more pragmatic perspective. It is generally the case that the valuation is done as if there were a reasonable and fully informed buyer, when in most cases there is no buyer at all. As such, there is no a priori way to know the tax liabilities that will pertain to such a hypothetical, and it would be speculative to assume that the potential buyer's tax structure will be the same as that of the seller.
As a general rule, the smaller in size and the more limited the scope of activities of the business being valued, the less likely there will be a set of publicly traded companies that are comparable, or even a single comparable publicly traded company. Publicly traded companies are for the most part large, measured in terms of revenues or assets, and they are diversified across product lines. This diversification implies that reported revenues are from various lines of business, not all of which are relevant for comparison purposes. Also, diversification reduces the operating risk of the company, and to the extent that this reduced risk is reflected in the company's realized earnings and in the publicly reported price, the comparison may be less than accurate. Most small closely held companies are not diversified, and this characteristic alone makes financial comparisons difficult. There are many sources for information on publicly traded companies including information provided by Value Line and Standard and Poor. Internet access to traded securities research services is the more common means to acquire the needed information.
In particular to Ryanair Holdings PLC, their sales, operating profit, and net income have recorded an increase since the company went public prior to the financial setback in 2004. Regardless of the poor financial performance of the company during the said year, they still continued to acquire assets while managing to keep down their flight fares through internal efforts on the part of the Ryanair management and employees to lower costs of providing their commercial aviation services to the public. And although they posted a decrease in net profits in 2004, they still managed to have the highest return on equity percentage among fifteen flight passenger carriers that the company was compared with.
To discuss further, published research on the application of marketability discounts when valuing a business on the basis of information from publicly traded companies follows two lines. One line of research is based on reviews of court cases and the marketability discount that the court has allowed. The conclusions from this line of research are interesting, but not generally applicable to a particular business valuation. First, there is selectivity bias in the sense that only those valuations that are litigated and appealed are available for such study. Second, the court's decision reflects the opinion of a judge or small group of judges, as swayed by the rhetoric of attorneys, many of whom may have less expertise in valuation than the valuator. The other line of research is based on comparisons in the price of initial public offerings of stocks to actual transaction sales, where the initial public offering is viewed as a reliable observation of fair market value in the absence of market demand. Again, there is no reason to assume that the companies involved in the initial public offerings are comparable to the particular businesses being valued.
NON-FINANCIAL FACTORS AFFECTING THE TAKEOVER BID
Apart from the financial considerations, there are non-financial factors that would affect the decision to bid for the takeover of Ryanair Holdings PLC as well. For instance, the business model of the particular company that is under analysis would have to matter. The fundamental business structure of Ryanair is the proven Southwest model, where low fares are combined with high frequencies and excellent punctuality, while giving emphasis to on-time performance, baggage handling and customer satisfaction. Their smaller market share leaves ample room for growth, which is why room for expansion is likewise considered in takeover bids. Britain is saturated, but there is plenty of room in Spain, Low Countries, Germany, Italy, Scandinavia for Ryanair to explore and penetrate. For long-term markets, there is the need to look into regions yet untapped, in particular Eastern Europe. Also, keeping an eye on Singapore/Asia ventures, as it is still enormously untapped markets, will prove helpful in making the decision whether to bid for the takeover of Ryanair or not. As it appears that Ryanair is well-poised to take advantage of new opportunities in the emerging markets of the next decade, it is one point towards a positive reaction to taking the takeover bid.
However, there are also certain considerations to look out for, for example, the Charleroi case, because if Ryanair loses, as they are appealing to EU Supreme Court in Luxembourg, the company will lose all revenue from that airport, numbering to an estimated 2 million passengers. This is a huge hit, if ever the case fails, though it may be made up in growth in other airports, so it is another dimension to look into. Long term, analysts say it may lead to more transparency, shorter leases with publicly-owned airports. This can elevate costs and hurt the bottom line, thus affect everyone in the company equally. It might be wise to wait for the Charleroi decision to settle before entering a position. If it decides against Ryanair, it is expected that headline influence will drag prices down further than fundamentals, which leads to a better entry. If it decides for Ryanair, then it is a very good decision to enter based on its long-term potential. There is the wide belief that EU will not side with Ryanair due to lobbying/protectionist pressure. After all, they saw what happened to UAL/AMR in the time span of a single year.
Additionally, politics must also be considered. Ryanair claims that the EU decisions are heavily lobbied by its traditional competitors like the British Airways and Air France. A similar battle played out in U.S. courtrooms with Southwest and American Airlines over Dallas is observed. It could just be a matter of time in Europe, as well, because in the end, the customers – the public – are on Ryanair’s side due to the low flight fares that they are offering. On a deeper inspection, even British Airways and Air France could not be considered a competitor of Ryanair, as the said companies have a notably higher rate of air fare if compared with the commercial aviation firm under analysis. Thus it can be said that they operate with a different market profile than where Ryanair is currently operating. Deregulation and strong growth is also seen in Europe, as an accompanying depreciation in the dollar makes the European company more attractive. The consensus is that the dollar will depreciate further in 2004 as the deficit soars, so the company is a very lucrative venture to become involve with.
VALUATION METHODS
There are six general types of valuation: (1) earnings valuation; (2) revenues valuation; (3) cash flow valuation; (4) equity valuation; (5) yield valuations; and (6) member valuations. The type of valuation that the North American airline company should adopt would depend on what reliable information they have at hand in order to pose for easier company valuation and arrive at a decision to bid or not to bid at the earliest time possible. The choice of a valuation method requires thought and contemplation. The valuator should first learn about the business and then select the one valuation method that is the ‘most appropriate’ based on the relationship between the circumstances for understanding the valuation and the assumptions that underlie each of the valuation methods. The valuator should not, in Boger and Link’s (1999) opinion, define ‘most appropriate’ based on the results that follow from the application of several methods. There should be an a priori reason for selecting one valuation method over another. Income-based valuation methods use the businesses or a comparable business's income statement as the starting point for the analysis.
Doing a corporate valuation is not a mysterious process that is open only to the few (Copeland, Koller & Murrin 2000). It does require, however, a different perspective from that taken by many managers. It requires focus on long-run cash flow returns, not quarter-to-quarter changes in earnings per share. It also requires a willingness to adopt a dispassionate, value-oriented view of corporate activities that recognises businesses for what they are – investments in new productive capacity that either earn a return above their opportunity cost of capital or do not. There are many areas in valuation where there is room for disagreement, according to Damodaran (2002). This includes how to estimate true value and how long it will take for prices to adjust to true value. But there is one point which there can be no disagreement: asset prices cannot be justified by merely using the argument that there will be other investors around willing to pay a higher price in the future.
Similarly, asset-based methods use the business's balance sheet at the starting point. However, even when conducting an income-based analysis, the valuator should carefully study the balance sheet, and vice versa. Income statements and balance sheets describe aspects of the financial condition of the business, and hence, both should be examined. In fact, all financial information should be considered in detail. A fundamental and extremely important assumption that underlies all business valuations is that the financial health of the business is accurately characterized by its financial statements. If the financial statements are incorrectly prepared, or if they overstate or understate the true financial picture of the going concern for some accounting reason, then it follows logically that the valuation will be imprecise.
Analysts use a wide range of models in practice, ranging from the simple to the sophisticated. The models enumerated previously belong to the general category. These models often make very different assumptions, but they do share some common characteristics and can be classified in broader terms, which makes it easier to understand where individual models fit into the big picture, why they provide different results, and when they have fundamental errors in logic. Following is the recommended valuation model that fits the need of the North American airline company to aid in its decision whether or not to take a bid for takeover.
RECOMMENDATION
It is deemed that the earnings valuation method is the best model to use for valuing Ryanair. It is, first and foremost, the most common way to valuation. It is an approach to valuing a company by capitalising its earnings, which generally involves multiplying one or another income statement earnings figure by some multiple (Luecke 2002). The earnings-based valuations assume that the value of an entity is equal to the present value of future earnings that will be generated by the business. Further, this method is based on two elements, the price/earnings ratio and the post-tax earnings per share of a business, which, when combined, give the market price per share (Ogilvie 2006). There maybe a different (higher or lower) future earnings estimate based on efficiencies arising from new management (higher earnings) or restructuring costs (lower earnings) that will gave an impact on price negotiations.
Particularly, the Normalised or Average Earnings should be used. This approach, which is similar to that used for cyclical firms, uses an average average-based valuation upon a period when the earnings were healthier as the base-year earnings for analysis (Damodaran 2002). The assumption is that the firm will revert back to health in the near future. As the company’s financial documents offer the year when they have observed a decline in net profit, it will be most useful to use this type of approach to company valuation. When there are difficult choices to make between relevant treatment of accounting items on the balance sheet or income statement, the income statement tends to win out.
The earnings-based formulation has intuitive appeal. It implies that if a firm can earn only a normal rate of return on its book value, then investors should be willing to pay no more than the book value for the stock. Investors should pay more or less than book value if earnings are above or below this normal level. Thus the deviation of a firm’s market value from book value depends on its ability to generate ‘abnormal earnings’ (Damodaran 2002). The formulation also implies that a firm’s stock value reflects the cost of its existing net assets (that is, its book equity) plus the net present value of future growth options (represented by cumulative abnormal earnings). To further strengthen the argument, the AICPA’s Management Advisors Services Practice Aid, Valuation of Closely Held Businesses indicates that the Internal Revenue Service strongly recommends the use of earnings-based valuation models for valuing businesses (as noted by Sipes 2005).
But, as with any other model, the output of an earnings-based valuation model will only be as good as its inputs. To help improve the quality of accounting inputs in the valuation process, earnings should be properly classified according to their components. To further assist in seeing through the potential biases inherent in financial data provided by Ryanair management, it is important to understand the discretion involved in making accounting classifications. As asserted by Hirst & Hopkins (2000), being armed with better knowledge about how accounting data are generated puts analysts in a better position to use the information effectively.
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