The link between valuations and due diligence.
Financial planning (Management)
Tax exemption (Analysis)
Gillman, Luis Frederick
Pub Date:
Name: Academy of Accounting and Financial Studies Journal Publisher: The DreamCatchers Group, LLC Audience: Academic Format: Magazine/Journal Subject: Business Copyright: COPYRIGHT 2002 The DreamCatchers Group, LLC ISSN: 1096-3685
Date: May, 2002 Source Volume: 6 Source Issue: 2
Event Code: 200 Management dynamics Computer Subject: Company business management
Product Code: 9915130 Financial Planning
Geographic Scope: United States Geographic Code: 1USA United States

Accession Number:
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This paper deals with the link between valuations and due diligence in merger and acquisitions. It analyses due diligence in terms of the net asset, the discounting of future cash flows and earnings valuation methods and the residual income method. It attempts to highlight the motives for mergers and acquisitions and converts these into the concepts of valuations, while considering shareholder value. While many authors implicitly understand this, the issue has often been sidelined leading to an overemphasis on less vital matters. The paper examines faults in current due diligence approaches and provides possible solutions to these problems by emphasising the link between due diligence and valuations. The topicality of shareholder value analysis and hence the due diligence valuation link is underpinned by recent empirical findings, its prominence in recent literature and the fact that shareholder value analysis is not being used sufficiently in practice.


A number of sources have stated that mergers and acquisitions often fail. These authors attribute such failures partly to inadequate due diligence procedures (Harvey, Price & Lusch, 1998; "An overview", 1997). Mergers and acquisitions are increasing in the United States of America, (Kroener & Kroener, 1991) however, there is data showing that such reorganisations have succeeded in only half of the instances (Kroener & Kroener, 1991). A failure rate that could be worsened because merger and acquisition activities are becoming more involved (Kroener & Kroener, 1991). There is, therefore, a necessity to develop strategies that increase the likelihood of success in company take-overs. It seems that a likely method of increasing success of merger and acquisitions is improving the "due diligence review" (p. 33), which is by definition a complex fact finding device to form the structure for the acquisition appraisal (Kroener & Kroener, 1991).

The due diligence process should challenge the reasons why mergers and acquisitions fail and devise strategies and procedures to reduce or minimise the risk of failure.


An analysis of merger and acquisition motives will aid in establishing why mergers and acquisitions fail. Motives attempt to justify mergers and acquisitions. If there is a weakness in the motives, the merger or acquisition is almost certainly doomed to fail. It is, therefore, essential that we analyse motives in the due diligence process.

Akason and Keppler (1993) postulate that the acquirer's objectives or motivations can be divided into two broad categories. Firstly, financial motivations: factors such as tax implications, the spreading of risks, purchase of assets at a discounted price, or profiting from fragmenting assets might be considered. Secondly, strategic motivations: factors to be considered include synergy and efficiency of the integration process. Harvey, Price and Lusch (1998) list a number of theories to justify mergers and acquisitions. Among these, they include the "efficiency", the "market power", the "empire building", the "process", the "raider" and "disturbance theory" (p. 18).

There is a common thread amongst all these theories: the acquirer must be in a better position after the acquisition. Rappaport (1998) states clearly that the objective of acquisitions and mergers is to "add value" (p. 33). Dess, Picken and Janney (1998) emphasise that mergers and acquisitions must be considered in light of the following sentiment: that it is often less expensive for an individual on the stock exchange to diversify than it is for a company by means of a takeover. This is because of the high premiums often paid in order to obtain control (Dess, Picken & Janney 1998). A study by Sirower indicates that in order to break even on a premium of fifty percent, the acquirer would have to increase a target's return on equity by twelve percentage points in the second year and maintain this return for the following nine years (Dess, Picken & Janney, 1998). Rappaport (1998) further contends that the aim of mergers and acquisitions - like any other asset acquisition--is to increase shareholder value. Further, he mentions that the following maxim must apply, namely that the purchase price should not exceed the "stand-alone" value of the target plus the value that will be created by future anticipated synergistic benefits (Rappaport, 1998, p. 33). Rappaport (1998) however merely outlines the principles for successful merger and acquisitions and does not integrate these principles into the due diligence principles. It would seem essential to combine the many recent contributions to the theory of due diligence (Harvey & Lusch, 1995, Kroener & Kroener, 1991, Harvey, Lusch & Price, 1998) and the concepts outlined by Rappaport (1998). It is my view that the link between valuations and due diligence is the most appropriate way to achieve this.

Rappaport (1998) also contends that these synergies must be converted into future cash flows. Rappaport (1998) further contends that it is crucial for directors to determine a value for the acquiring company when undertaking share exchange transactions. This may be necessary because the stock exchange may be undervaluing or overvaluing a particular company's share. The accurate valuation of a purchasing company's shares is crucial to determine the actual selling price of the target (Rappaport, 1998). It would appear as if there are two valuations required when undertaking share swaps (Rappaport, 1998). Firstly, the valuation of the target together with the buyer after merger and acquisition. Secondly the valuation of the buyer prior to acquisition (Rappaport, 1998). The valuation of the purchaser in isolation has been ignored in current due diligence literature (Harvey & Lusch, 1995, Kroener & Kroener, 1991, Harvey, Lusch & Price, 1998). This information is crucial in undertaking a conclusive and useful due diligence.

Due diligence should ask the question: does the merger or acquisition add shareholder value? It is essential to determine whether a merger or acquisition adds shareholder value by comparing the purchase consideration against the total value obtained from the transaction (Rappaport, 1998).


Determining the value obtained from the transaction via valuation principles, is a tool one may use to establish whether shareholder value will be added (Rappaport, 1998). Due diligence provides crucial information for determining the value obtained from the transaction. Indeed, Howard (1996) has made this an essential part of his definition of due diligence from a prospective buyer's viewpoint:

Harvey and Lusch (1995) defined seven crucial audit areas of due diligence in their seminal article: the Macroenvironment; Legal/ Environmental; Marketing; Production; Management; Information System and Financial. All these audits focus on an analysis of a company's risks and a determination of the future cash flows or earnings.

Due diligence is intrinsically linked to valuation in the following respects:

1 An asset valuation where certain risks relating to assets are identified by due diligence which ultimately affect the value of the assets and liabilities and hence the value of the company on a net-asset valuation method.

2 The discounting of future earnings where due diligence reviews future earnings and establishes risk factors which then determine the required yield.

Moreover, the discounting of future earnings valuation can be analysed mathematically as in equation 1, by using future earnings as the numerator and the yield as the denominator:

Valuation of Business = Future Earnings / Yield (1)

It is worth mentioning that representations and warranties play a key role in this equation. Firstly, the seller may warrant that certain profits will be achieved or that certain contingencies will not occur. These are the so called "positive" warranties (Murphy, 1998). On the other hand, the seller may inform the buyer that the company contains certain contingencies and risks which are so called "negative warranties" (Murphy, 1998). Both these factors will affect potential yields and earnings and will have a direct impact on valuations.

The discounting of cash flows, where the same principals as the discounting of future earnings apply. The principle can be expressed in equation 2:

Valuation of Business = Future Cash Flows / Yield (2)

The residual income method (RIM) uses current modified financial statement information to determine the value of the net book value of assets less liabilities (Lee, 1999). To this figure, future expected abnormal earnings i.e. earnings in excess of the cost of equity capital are added (Lee, 1999). The above methods with slight variation are used in many brand name products such as Stern Stewarts EVA [TM], Holt Value Associates CFROI [TM] and McKinsey's Economic Profit Model [TM] (Lee, 1999).

With regard to RIM the value of the business can be expressed in equation 3 as follows (Lee, 1999):

Valuation of Business = [B.sub.t] + [Sum.sub.i] { [E.sub.t] [[NI.sub.t+1] - ([r.sub.e] X [B.sub.t+i-1])]/[(1 + [r.sub.e]).sup.i]} (3)

Where [B.sub.t] = book value at time t

[E.sub.t] = expectation based on available information at time

[NI.sub.t+1] = net income for period

[r.sub.e] = cost of equity capital

The net book value of assets, net income, cost of capital and related risks, abnormal returns (mainly through synergies) will all be determined in a due diligence. From the above it is clear that valuations is closely linked into Due Diligence. It is further clear that these links are just as apparent to current, practiced valuation theory as it is to basic valuation principles.

It is logical that due diligence should be so closely linked to valuation because it asks the question: do we buy or merge the company? The answer to this question can only be evaluated in terms of what price is being asked. It is my contention that a well conducted due diligence provides the answer to this question by breaking up the valuation model into constituent parts which should be investigated in the due diligence process.

Forbes and Roosenbloom (1982) emphasise the importance of assessing the valuation on the net asset valuation and discounted cash flow methods during the due diligence process. This valuation process has not, however, been integrated in later work by Harvey and Lusch (1995) and Kroener and Kroener (1991). I suggest that it is essential to see the valuation principles as a catchment area for due diligence risks and opportunities found throughout the due diligence process. I suggest that valuations should not be seen as an after-thought but rather as the linchpin of the entire due diligence process. There may be reluctance within the accounting profession to taking such an approach because then practitioners would have to use considerable skill and judgement in determining the value of a company. It may well be that practitioners are fearful that by doing so they are placing their professional skills on the line. Indeed, there is already evidence that due diligence performers are trying to minimise their liability ("Opponents line up", 1997). Clearly, due diligence should not be undertaken or planned to limit professional liability, but rather to provide the client with a service that is as close to ideal as possible.

The literature emphasises the importance of the investigation of intangible assets (Harvey, Price & Lusch, 1998). Although important, this emphasis might lead to the creation of a practitioner's no mans land where issues like synergy and motives for acquisition can be confined to yet another tangential non valuation based audit area of due diligence. This approach tends to lead the practitioner away from valuations and cause him or her to lose sight of the main issues of a due diligence.

It is interesting to note that a due diligence in the context of small business is equated with an assessment of the value of a target business (Volyn, 1996). Here the author, unlike many who are writing on large ventures, emphasises the importance of valuations. However Volyn (1996) is dealing with a small business in isolation. Obviously, it is far simplier, for one to value a small business particularly when one is valuing it in isolation. Nevertheless, this article (Volyn, 1996) is important because it illustrates that valuation is a key principle on which acqusition decisions are made. I contend that principles of valuations should be the key decision making aid in the context of mergers and acquisitions as well. I further contend that the target business should not be valued in isolation. This, despite the increased complexities of valuing a joint entity after a merger or acquisition.

Many excellent contributions (Harvey, Price & Lusch, 1998; Kroener & Kroener, 1991; Harvey & Lusch, 1995) to the due diligence literature should only be seen as such in the context of a means to better value an acquisition or merger i.e. within the borders of valuation principles well established over the years.

The following additional valuation concepts pertain particularly to a due diligence exercise:

These three subjects will be discussed further.

Factors To Be Considered Before Valuation Can Take Place

"Unless you're gambling, don't rely on audited financial statements alone. As Mercury Finance shows, even Big Six accounting firms can fall down on the job" (Fink, 1997, p. 38). If reliance is placed on past audited financial statements in order to undertake a due diligence the reliability or "integrity" (Blassberg, 1993, p. 12) of the audited financial statements (Gorman, 1998) should be carefully investigated. A statutory audit is performed by the auditor of the target company. The independence (Wriston, Esposito and & Fox, 1996) or competence of the auditor of the target must not be taken for granted (Cheung, 1994). Wines explicitly (1994) challenges the independence of an auditor when he concludes that "there is a potential for an appearance of auditor independence impairment when higher levels of non-audit services are provided to audit clients" (p. 75). This article is important for two reasons: it challenges the independence of the auditor generally and it alerts the due diligence performer to be more alert and wary when a reporting auditor provides other services to the target company.

In day to day practice, the issue of the auditor's independence and competence is often challenged. This notion is supported by the fact that it is well known that auditing firms when performing due diligence, have to review other auditors' working papers (Rigele, 1999).

While the practitioner may be aware that the basis of financial preparation may differ from country to country, it is equally important to realise that there may also be national auditing differences between the acquirer's country's auditing standards and those of rest of the world. For instance, Frost and Ramin (1996) demonstrate that there is a difference in auditing standards between Germany, the United Kingdom and the United States.

Net Asset Valuations: The Reconciliation Between Carrying Values On The Financial Statements And Market Values

"People are starting to realise that when you acquire a company, the due diligence process requires going way beyond accepting financial statements and disclosure documents at face value ... You can't just rely on what you are given ... Is it just garbage in and out?...Buyers have to be a lot more intelligent and really go deeper than just accepting audited statements at face value." (Platt 1993, p. 21) The reconciliation between carrying values on the financial statements and market values must be carefully investigated. Market values must be determined in light of the future acquisition or merger.

As Brown (1992) contends, another essential issue of due diligence involves "asset quality" (p. 19). One must also look at liability quality. The problem with the statutory audit is that various estimates made by management may be inaccurate (Kroener & Kroener, 1991). Even if they are accurate, they may no longer be valid in the light of the acquisition.

These factors include:

Cash Flow And Earnings Valuations And Residual Income Method

I shall now discuss the elimination of exceptional items in the income statement and cash flow in order to predict future profits i.e. the numerator in equations 1 and 2 (see above). The aggregating of risk factors or the yield will then be discussed i.e. the denominator of equations 1 and 2 and part of equation 3 (see above). With regard to the elimination of exceptional items, this information can be largely obtained from the seven audits as mentioned above (Harvey & Lusch, 1995), more particularly the financial audit. The following issues must be considered.

Group Relationships

Difficulties arise when a division or subsidiary is being acquired. It may be difficult to separate a division's profits from the rest of the company because of the unavailability of published divisional results (Begg, 1991). If a separation of revenue and expenses is possible, management will probably have to make many estimates that may not reflect reality (Begg, 1991). Furthermore, if it is possible to separate the division or subsidiary from the group, a further difficulty may arise relating to transfer pricing. Many services and products may be sold or bought from the subsidiary at non-market related prices (Begg, 1991). Even if they are bought from the group at group-market related prices, when the subsidiary or division leaves the group it may not have the same bargaining power to negotiate the same rates for that particular service. A classic example of this is interest on debts. A lender would perceive a massive group as a lower risk compared with a small division or subsidiary. For a large group the risk would be relatively low and lower interest rates would be granted and vice versa (Bowne & Gage, 1994; Begg, 1991).

Another factor that would skew the profitability of the division is management that may be provided without charge to that division. These management services from the holding company would probably no longer be available. Even if they were supplied, they would probably not be provided free of charge when the division leaves the group. The acquirer should therefore ask the question: is the subsidiary or division profitable because of the management of the subsidiary/division or because of the management skills of the holding company / old central management (Bowne & Gage, 1994)? A related factor to consider when calculating future profitability, is whether there are any substantial inter-company transactions that will no longer take place when the division is sold (Bowne & Gage, 1994).

The Identification of Non-recurring Items

The due diligence performer, must identify non-recurring items by comparing and studying past profit and loss statements when calculating maintainable earnings. He or she must also interview senior personnel and review movements in balance sheet reserves. Items of a non-recurring nature include gains on the sale of fixed assets; legal and insurance claims; write downs of accounting reserves (e.g. bad debt reversals), inventory obsolescence; discontinued operations; pension fund termination costs and significant year end adjustments (Bowne & Gage, 1994). Large adjustments in inventory at stock takes could be an indicator of inaccurate sales-margins (Bowne & Gage, 1994).

The objective of calculating current earnings is to allow predictions about future earnings. Forecasts and projections must be differentiated. A forecast represents conditions that management expects to occur in order to present the best assessment of future events. Projections however are based on "hypothetical" (p. 66) assumptions. Forecasts ask the question "what is expected to happen?" while projections ask the question "what will happen if?" (Bowne & Gage, 1994, p. 66). Forecasts play a greater role than projections in the due diligence process as we shall continually be asking the question, what will happen if we undertake the merger or acquisition? It is important, when making forecasts and projections, to establish the "quality" (Fink, 1997, p. 39) of the earnings and to ensure that the earnings have not been "massaged" (Volyn, 1996, p. 28) or manipulated (Fink, 1997, Volyn, 1996,).

Profit / cash flow warranties must be understood because these will have continual bearing on the due diligence process. The potential value of a company should be increased if a financially stable seller offers profit warranties.

The denominator in equation 1, 2 and 3 (see above) should also be considered. Risk factors should be established throughout the due diligence and then be aggregated to form the yield. "Positive" representations i.e. representation in favour of the buyer will decrease risks while "negative" representations will increase risk (Murphy, 1998).

Projections, risks or yields established throughout due diligence should be seen as the link between due diligence and the residual income method and the discounted cash flow/ earnings valuation approaches.

With the data gained from valuations concepts , we should have the tools to help answer the questions: "whether to buy at all; how much to pay; and how to structure the acquisition" (Howard, 1996, p. 17).

In summary, valuations play a crucial role in the due diligence process. Valuations are linked to due diligence, through risks, net asset valuations, cash flows and warranties. This data would be established through the due diligence audit areas which should be subsumed under the Macroenvironment Audit, Legal/ Environmental Audit, Marketing Audit, Production Audit, Management Audit, Information System Audit, Financial Audit (Harvey & Lusch, 1995).

The above valuation concepts should be viewed in the context of future motives and viewing the combined merged entity. Harvey, Price and Lusch (1998, pp. 18-19) proposed additional steps namely, "Due Diligence prior to M&A" and "Due Diligence after M&A". In "Due Diligence prior to M&A" motives for the acquisition were emphasised while "Due Diligence after M&A" (pp. 19-20) provides the structure for the creation of a "joint business plan" (p. 40) (Harvey, Price & Lusch, 1998; Kroener & Kroener, 1991). Both these audit areas emphasise the importance of viewing a combined target company after merger or acquisition.

Thus, due diligence should incorporate valuation techniques emphasising hypothetical and current risk and profit analyses. Due diligence should, always bear in mind the acquirers motives and the ultimate valuation of the merged or joint entity.


In order to lend support to my thesis, I will discuss the various factors that might cause due diligence investigations to fail. I will also outline why the above approach circumvents these shortcomings.

The due diligence investigations focus may be aimed at trivial matters rather than core risk factors (Dopp & Allan, 1996). One can easily become caught up in minor technical issues rather than major or core risk areas. It is for this reason that a valuation approach should be made.

"Superficial Checklist" (p. 32) methods are used rather than risk-based methods (Dopp & Allan, 1996). Again, it requires little imagination and skill on the part of the practitioner to use a standard-checklist. Furthermore, a checklist is designed around a generic due diligence, where the actual objectives for the acquisition might not be considered. The valuation approach has risk assessments at the core of its existence.

Poor follow up of identified potential problem areas (Dopp & Allan, 1996). This may be caused by lack of adequate funds allocated to the due diligence process. It may also be on account of the negligence on the part of the practitioner. Again, the valuation approach gives the practitioner the desired focus.

Due diligence procedures may fail because pertinent questions that could lead to the failure of the deal may not be asked (Dopp & Allan, 1996). Furthermore, often, even if the strategic motivations are taken into account, they are not scrutinised with the same detail as the financial motivations (Akason & Keppler, 1993). The valuation approach forces the practitioner to ask pertinent questions relating specifically to the acquirer's objectives and motives, especially the strategic motivations. This is because such information is required in order to make a proper valuation.

Poor follow up of identified potential problem areas (Dopp & Allan, 1996). This may be caused by lack of adequate funds allocated to the due diligence process. It may also be due to negligence on the part of the practitioner. Again, the valuation approach will give the practitioner the desired focus.

Findings communicated in a nebulous or poor manner may also lead to due diligence failure. Therefore, it may be difficult to act on the report (Dopp & Allan, 1996). The valuation approach to undertaking due diligence will provide a meaningful reporting framework.

Various other factors may lead to failure. These include important answers that may be given so far into the merger or acquisition that they cannot be acted upon. There may also be an inability to understand essential business success factors (Dopp & Allan, 1996). The client, although forewarned, may also not act on the findings (Dopp & Allan, 1996). This may merely be a face-saving exercise on the part of management. After all, they may have spent a great deal of time and effort in the acquisition process only to be told by the practitioner that the risks are too high for the deal to proceed. The strength of these factors as a cause of due diligence failure would be reduced by following the approaches mentioned above.

"CEO hubris" (p. 11) has been cited as an excuse for merger and acquisition failure. Too often vague motives for merger and acquisition such as synergistic benefits are cited (Dess, Picken & Janney, 1998). Closely linked to this is "unrealistic expectations relating to synergistic benefits". "Unrealistic expectations relating to synergistic benefits" have been cited as a result of an inadequate due diligence (Dess, Picken & Janney, 1998, p. 12). A valuation based approach to undertaking due diligence will force chief executive officers to justify a merger or acquisition in the face of hard figures, rather than vague un-quantified assumptions.

Another factor that could lead to the failure of due diligence is the reluctance of the due diligence performer to report on matters which may be uncertain. They might also refuse to commit in writing for fear of litigation on certain issues. On such issues, a "verbal debriefing" is suggested as a means of circumventing the problem. Here, the professional should report to the acquirer verbally instead of confining themselves to a written report alone and hence, from a practical viewpoint, preventing litigation (Harris, 1998). "Verbal debriefing" may not be required if the valuation approach took these uncertain factors into account when formulating a yield used in valuations.


It could be argued that the principles of shareholder value analysis and hence the concomitant importance of the due diligence valuation link are old concepts and have been emphasized sufficiently in the 1980's and early 1990's. Evidence, however suggests that these very principles have to be reiterated. This is because there is:

Lack Of Use Of Shareholder Value Analysis And Management's Commitment To The Principles Of Adding Shareholder Value

This section deals with the question of whether shareholder value analysis is undertaken by executives undertaking merger and acquisitions and obtains an understanding of management's general attitudes towards the use of shareholder value analysis to minimise risk.

In the United Kingdom a study was performed to assess whether the concepts of adding shareholder value were considered in undertaking acquisition and divesture decisions (Mills, 1988).

Only seventeen percent of executives ranked shareholder value analysis as the most important method in forecasting merger and acquisition success. Thus, it would appear as if the principles of shareholder value and the concomitant importance of undertaking valuation are underemphasized by management in the United Kingdom (Mills, 1988).

Perhaps what is of greater import is evidence from a study undertaken in the gold industry in USA, suggests that the risk behaviour of managers is related to personal managerial gain rather than value maximising risk management (Tufano, 1996). Although this paper does not deal with merger and acquisition decisions and is confined to a specific industry, the principles established in this paper cannot be easily ignored.

This section illustrates that shareholder value analysis is not being adequately prioritised. The due diligence valuation link emphasises the importance of shareholder value analysis.

Empirical Research Suggests That There Is No Link Between Strategy And Shareholder Value In A Recent Study

The objective of this section is to assess whether strategic objectives are being achieved in fewer cases in recent studies than in prior periods. This may suggest that there is a deficiency in strategic planning and accentuates the importance of the due diligence valuation link. The literature suggests, as will be shown below, that in the 1980's in the USA there has been a small or no association between strategy and shareholder value (Lubatkin, Srinivasan & Merchant ,1997). This is in contrast to earlier evidence gathered by Chatterjee and Lubatkin. (Lubatkin, Srinivasan & Merchant , 1997). This evidence has important implications on the due diligence process as will be discussed below.

In earlier evidence, Chatterjee and Lubatkin found that mergers between 1962-1979 did indeed add shareholder value (Lubatkin, Srinivasan & Merchant ,1997). It was further found that mergers in related business as opposed to mergers in unrelated business were twice as effective in adding shareholder value. (Lubatkin, Srinivasan & Merchant ,1997). This trend however did not continue in the 1980's as will be discussed below (Lubatkin, Srinivasan & Merchant, 1997).

A study was performed to measure 105 large (the targets subject to merger and acquisition were defined as large because their values exceeded $25 million and they were traded on the NYSE or AMEX) merger's ability in the 1980's to add shareholder value (Lubatkin, Srinivasan & Merchant, 1997). The question of whether mergers of related companies added more shareholder value than unrelated mergers was also investigated. Two measures were used to assess the ability to add shareholder value (Lubatkin, Srinivasan & Merchant, 1997):

Two statistical tests were applied: the ANOVA and regression analysis (Lubatkin, Srinivasan & Merchant ,1997). The results from this study suggest that these merger and acquisitions have added very little shareholder value and furthermore the results suggest at best a slight correlation between merger and acquisition relatedness and shareholder value (Lubatkin, Srinivasan & Merchant, 1997). As mentioned earlier these results are in stark contrast to those of Chatterjee and Lubatkin who studied mergers between 1962-1979 (Lubatkin, Srinivasan & Merchant, 1997).

Thus from this section it can be concluded that the link between merger relatedness and the resulting synergies and other anticipated benefits are not being shown by empirical findings. It is further clear that there was indeed a link between merger and acquisition relatedness in prior periods. It is for this reason that the link between strategy, synergy and mergers and acquisition has to be analysed more stringently in current due diligence practices. This would be achieved via taking a shareholder value analysis approach. It would thus seem appropriate to link shareholder value analysis into due diligence. This would most appropriately be achieved by the due diligence valuation link.

Prominence Of Shareholder Value Analysis In Recent Literature

Shareholder value analysis has been the focus of leading recent research. This is justified by that fact that the seminal writer Rappaport (1998) recently himself reiterated the importance of shareholder value analysis in the leading journal, Mergers & Acquisitions. The point is even more pertinent when we consider that the issues of shareholder value have been emphasized in two recent articles (November 2000) in one edition of Financial Management. (Allan, 2000, Tavakoli, 2000). This contention is further supported by numerous other recent references to shareholder value in the latest literature (Rock, 1996; Anslinger & Copeland, 1996; Bughin & Copeland, 1997; Mills, 1998; Sharma, 1999; Lee 1999; "Why good", 1999; Brewis, 2000)

From the above it would appear as if shareholder value analysis is just as pertinent to recent literature as it is to past literature. Its continued appearance in current literature suggests:

Thus the link between due diligence and valuations provides an ideal forum to emphasize shareholder value analysis.


A number of sources have stated that mergers and acquisitions often fail. These authors attribute such failures partly to inadequate due diligence procedures (Harvey, Price & Lusch, 1998, "An overview", 1997).

Merger and acquisition success can be improved by analysing weaknesses in current merger and acquisition motives. It is essential to view motives in terms of the maxim of Rappaport (1998), namely that the purchase price should not exceed the "stand-alone" (p. 33) value of the target plus the value that will be created by future anticipated synergistic benefits. Rappaport (1998) also contends that these synergies must be converted into future cash flows. Thus it is essential to convert due diligence findings into a valuation model which can be applied within the context of shareholder value analysis in the context of the above maxim.

The above article shows that there is a clear link between the valuation of an entity or combined entity and due diligence. This has been shown by illustrating the link between basic valuation methods and a more-recent, practiced valuation-method.

This article then illustrates that many due diligence shortcomings can be overcome by taking a due diligence valuation approach. It is then shown that the principles of shareholder value analysis, when compared to past periods are as (if not more) pertinent to current circumstances and literature. In conclusion it is essential to link valuations into due diligence to determine whether shareholder value has been added.

The finding of the above paper can be summed up by the following succinct statement:


I would like to thank Dr Mark Gillman for his constructive criticisms and encouragement. I would also like to thank Peter McCrystal for a useful discussion, which helped to crystallise some of my ideas. The financial assistance of National Research Foundation (NRF) towards this research is hereby acknowledged. Opinions expressed and conclusions arrived at, are those of the author and not necessarily to be attributed to the National Research Foundation.


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Luis Frederick Gillman, Aerospeed Couriers, Johannesburg, South Africa
"... due diligence--including legal due diligence--helps answer
      three questions:
        whether to buy at all;
        how much to pay; and
        how to structure the acquisition" (p. 17).

1 Factors to be considered before valuation: The reliability or
"integrity" (Gorman, 1998, p. 37) of the audited financial statements
(Blassberg, 1993).

2 Net asset valuations. A reconciliation between carrying values on
the financial statements and market values.

3 Discounting future cash flows/earnings and residual income method.
The elimination of exceptional items in the income and cash flow
statements in order to predict future profits. This section also
includes the aggregation of risk factors.

1 Debt and leases: Interest rates on debt and leases may more or less
favourable. This will reduce or increase the market value of debt
because market value of debt is determined by future interest and
capital repayments, discounted at a market yield (Bowne & Gage, 1994).
A factor that may be particularly relevant if the acquiring company
chooses or is forced to renegotiate loan agreements.

2 Threatened or pending lawsuits (Bowne & Gage, 1994).

3 Obligations to employees including retrenchment packages, leave
provisions and incentive packages (Bowne & Gage, 1994). Post retirement
benefit obligations may be understated in the financial statements
(Browne, 1997). Pension fund liabilities must not be ignored. In many
corporations, a company's pension fund's assets amount to
approximately fifty percent of the total entire market capitalisation of
the company. If, for example, the pension fund's assets were
insufficient to cover future obligations by, for example twenty percent,
it would mean that the company has a potential unrecorded liability
equal to ten percent of its market capitalisation (Feely, 1996). This
emphasises the importance of obtaining actuarial expertise when
valuing pension fund commitments (Feely, 1996).

4 Guarantees relating to debts of third parties (Bowne & Gage, 1994).

5 Liabilities arising from the return of goods (Bowne & Gage, 1994).

6 Exposure based products liability. Exposure based product liability
arises from products that have a long useful life. For example, a
ladder manufacturer may have to pay claims relating to its ladders for
a long period after they have been sold. The situation becomes more
complex when a company has previously owned a division that
manufactured ladders. Such a company can be held liable for any
failures in their ladders although it no longer has any connection with
their manufacture (Browne, 1997).

7 Environmental Hazards. An environmental audit should be undertaken as
a matter of course whenever there are definite concerns relating to
environmental issues (Williams, 1995). Furthermore, it is essential
that companies be environmentally friendly in order to appease foreign
investors who demand such friendliness. There is a risk of boycott from
potential markets on the basis that certain developing countries, like
South Africa, have an unfair advantage because of lower production
costs from inferior pollution controls (Beecham & Shorten, 1993). This
point raises a very important issue. It is foolhardy to look at the
environmental audit from only a liability point of view; it must be
viewed from a strategic aspect as well. In other words, how can
environmental affairs affect the future profitability of a company? It
is for this reason that environmental issues may affect the discounting
of cash flows and earnings valuation methods as well. Clarke (1998), in
an article called "Buyer Beware, It may look green but is it really?"
(p. 49), states that the UK electricity companies are charging more
for "green" electricity (p. 49). This point illustrates, yet again,
how environmental issues can impact on the audit and on valuations
(Clarke, 1998).

1 A lack of use of shareholder value analysis and management's
commitment to the principles of adding shareholder value.

2 Empirical research to suggest that in more recent merger and
acquisition activity there has been no shareholder value strategy link.
This suggests that strategic plans are not being converted into the
addition of shareholder value.

3 Prominence of shareholder value analysis in recent accounting

A decrease in systematic risk in each party subject to merger meant
   an increase in shareholder value.

   The ability to increase the market value of the share traded.

1 Its importance.

2 The fact that in practical situations it is possibly being ignored.
This contention is supported by further evidence above.

"There's a dollar sign on virtually every issue probed during due
   diligence" (Harvey & Lusch, 1995, p. 15).
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