My December blog introduced how private builders are being valued in today’s market; in light of some of the feedback we received, it appears that the mergers and acquisition discussion causes some confusion. So, I want to revisit the topic and expand upon my previous remarks.
My previous comments included, in part, the following:
While classic finance theory values a company based on its expected future cash flows, today home builders are being value on the fair market value of the assets being acquired.
When a home builder is acquired, the major assets acquired include homes under construction, land owned and lot option agreements... When a home builder looks to acquire another home builder the purchaser views the acquisition as a method to acquire land positions, as land position are usually the most significant asset owned by the seller.
So why are builders not being valued on a discounted cash flow basis? Since the common view is that only assets are being purchased, there is no value being attributed to people, intellectual property, innovation capabilities, brand, and the future cash flows that these can generate. The view of purchasers is one of depletion of the assets acquired rather than acquiring a going concern capable of generating cash flows on a long-term basis. This is akin to the purchase of a mining company or oil and gas companies.
As a result of last month’s blog post, I had a number of builders indicate that they believe the value of their company is the fair market value of the assets plus a portion of the cash flows these assets will generate in the future. Unfortunately, this doesn’t make sense–let’s explore the reasons.
Let’s start with why a purchaser would pay a seller more than the fair market value of their tangible assets. The most common reason would be the result of the acquisition of intangible assets.
Purchasers will value intangible assets if they have real value. Such assets might include a strong customer list, intellectual property, or proven research and development expertise among many others.
Facebook’s acquisition of WhatsApp illustrates a case of gaining access to its 700 million users with a strong global presence. Given the unique nature of home building, home builders don’t have a valuable and recurring customer base. Therefore, a purchaser would be hard pressed to attribute any value to a builder’s customer list.
Cisco is an example of a company that acquires companies to acquire their intellectual property, which they then leverage across its large user base. In September, Cisco announced its intent to acquire Memoir Systems saying “This acquisition will enable the proliferation of affordable, fast memory for existing Cisco switch ASICs and will help advance Cisco’s ASIC innovations necessary to meet next-generation IT requirements.” Unfortunately, home builder’s don’t possess unique intellectual property, and as a result, sellers lack any meaningful intellectual property to sell.
As a third example, last month, Merck acquired OncoEthix, a Swiss-based privately held biotechnology company specializing in oncology drug development. Through this acquisition, Merck gained research and development expertise that it lacked. Up to now, home builders have not invested heavily in research and development and therefore have little to sell.
Today, there is little real intellectual property in home building. Our industry is heavily fragmented where the key assets are controlled land and sales backlog. As a result, home builders’ most significant assets are controlled land and homes under construction. The next question is, what are these assets worth?
Hard assets, such as controlled land (owned and optioned), and homes under construction are worth their fair market value. Fair market value assumes prospective buyers and sellers are reasonably knowledgeable about the asset; they are behaving in their own best interests and are free of undue pressure to trade and a reasonable time period is given for the asset to be marketed.
In home building, assets are valued on a residual basis. The value of an asset is the sales price of a home on the lot less all of the costs, including construction costs, marketing costs, interest and holding costs, less a fair risk-adjusted return. The value that remains, the residual value, is the value of the asset. In determining the value of an undeveloped lot, one would subtract all costs associated with developing the lot including holding costs.
Given that in arriving at an asset’s residual value, the purchaser calculates a fair risk-adjusted profit associated with the purchase, by definition, there is no additional value to be shared with the seller; the seller has received the full value of the asset when it receives fair market value. As such, a purchaser would be unwilling to pay a seller anything in addition to the fair market value of its tangible assets at the time of acquisition. If a buyer did pay more than the fair market value, it would reduce the profit it would earn below the required fair risk-adjusted profit.
As a result, firms purchasing home builders, absent any intangible assets, have little incentive to pay a premium of any kind to the fair market value of a seller’s tangible assets. This is why home builders today are valued at the fair market value of their tangible assets.
I hope I have started a discussion; I invite your comments to continue the conversation.