Has Royal Dutch Shell paid too much for BG?

One of the key aspects of mergers and acquisitions is the valuation of the target firm. How do bidding companies calculate its worth and, more importantly, how do they know they have secured a good deal? A good deal should technically prioritise shareholder wealth maximisation, whilst a bad deal could destroy it. The same could be said for the target company; how do they evaluate offers for the company and ensure they obtain the highest price possible? Due to the differing needs of both a target and bidding firms, a ‘halfway’ figure must be determined; one that is attractive to both the target and bidding firm.

The oil industry is going through a difficult time with oil prices reaching a 6 month low, discussed in a previous blog. Royal Dutch Shell (Shell) has just announced the takeover of BG in a £47bn deal, making it an incredibly large acquisition. However, the market forecasts dramatic cuts in the profits of Shell, so how do they know they can afford the merger? It seems like a very large price to pay for such a clear gamble relying on the recovery of the oil industry. Shell’s share price was down 8% upon the announcement, leading some analysts to claim Shell have paid too much for BG (figure 1). One potential suggestion is that Shell managers are infected with hubris, resulting in them overpaying for BG as they are overconfident in their ability to run it. Paying too much for a target is an easy way to destroy shareholder wealth. It is interesting to consider the method adopted by Shell to come to the valuation of BG.

Figure 1: Royal Dutch Shell Share Price
Data from London Stock Exchange (2015)

One possible method is stock market valuation, which relies on the efficient market hypothesis. Using this method of valuation, the value is simply the multiplication of the number of shares by the current market value. However, the market is not perfectly efficient in reality implying this is a flawed technique. At best, it may have provided Shell with a minimum value of BG. Shareholders usually require a substantial premium on top of this to be attracted to an offer. In most cases this is around 30%. In the Shell-BG merger, this premium was 50% on BG’s share price on 7^th April. This may provide further evidence Shell overpaid for BG.

A more complex method comes in the form of an asset-based valuation, which values a company by deducting assets from liabilities. This can be achieved most easily by using the book value, simply by taking the amount recorded on the financial statements. Whilst this is easy to do, it will not always result in an up to date value of the asset; potentially not the best guide to an assets current worth. Instead, Shell could have used the net realisable value of the assets, also known as the amount the asset could currently be sold at in the market. Although, this can present problems if an asset is unique to the company, as it would not have a market value. This may have caused problems for Shell regarding the intangible assets of BG which substantially increase the value of the company. For example, BG has a large number of oil and gas reserves, which may be difficult to value if they are unexplored. The exploration activity would also be difficult to value. This suggests asset-based valuation may not have been the most appropriate for Shell to use.

Income-based valuation provides an alternative viewpoint and measures value based on hypothetical forecasts. One of the way of achieving this is through the P/E ratio, which is simply the share price divided by the latest earnings per share. This provides an indication of the return on equity shareholders will receive in the future. Despite being widely used, it is a very basic method making it quite limited. It provides a snapshot of one period, assuming this will remain constant but this is unlikely to be the case. The selection of a benchmark P/E ratio can also be problematic. As Shell and BG are in the same industry this method may have been used, with the industry average set as a benchmark. The P/E model has wide practical application which may have encouraged its use.

Discounted cash flow is an alternative forward looking method. This discounts the future free cash flow of the companies, and allows for future changes. However, it is difficult to account for expected synergies which may affect the valuation as the Shell-BG merger is expected to created around $1bn of synergies. Its main benefit is that it acknowledges the time value of money; however, it may be difficult to decide upon a time period and appropriate terminal value.

Ultimately, it cannot accurately be predicted how Shell came to the valuation of BG. What can be suggested is that I believe Shell will have used a wide range of methods before combining these to establish the most appropriate value. Each method has its drawbacks, and they could result in ambiguous results which makes this the most suitable response. The key thing that Shell should have kept in mind is whether the value was going to create shareholder value. As for the critics who are claiming Shell paid too much for BG; time will tell as the merger unfolds and it can be assessed whether Shell manage to pull of this ‘mega-merger’. In my opinion it is definitely a big risk for Shell to take, as its success depends on the full recovery of the oil industry which cannot be guaranteed. The premium of 50% on top of BG's market value also seems an abnormally high figure, suggesting the managers could potentially have been affected by hubris. If it turns out Shell have overpaid for BG, it will be shareholders that bare the brunt of that and ultimately lose wealth.

References

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BBC News. (2015). Royal Dutch Shell to buy BG Group in £47bn deal. Retrieved 15^th April 2015, from http://www.bbc.co.uk/news/business-32213341

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