The three main valuation procedures presented in this article apply to merger and acquisition valuations as well, but there are certain distinctions in M&A valuations related to the goal of the value. In this post, we’ll go over what mergers and acquisitions are, why corporations pursue them, the different sorts of M&A transactions, and the usual M&A valuation methodologies.
What are mergers and acquisitions, and why are there so many of them?
Despite the fact that the terms “mergers and acquisitions” are often used interchangeably, they refer to two distinct types of business transactions:
- A merger is the merging of two businesses into one. Exxon Mobil Corporation, for example, was founded in 1999 when Exxon and Mobil joined in the world’s largest merger at the time, a $73.7 billion deal.
- An acquisition is the purchase of one business by another. Examples would be the Walt Disney Company’s purchase of Pixar Studios and Marvel Entertainment, in 2006 and 2009 respectively.
Those are significant, well-known corporations that have been involved in mergers and acquisitions, but the figures show that tens of thousands of M&A deals take place every year, with the majority of them involving considerably smaller enterprises.
Despite the fact that mergers and acquisitions are technically separate sorts of transactions, they are deemed the same in accounting terms. The Financial Standards Accounting Board (FASB) issued a new standard in 2001 that mandated that all M&A transactions be recorded using the Acquisition Method of Accounting (which is similar to the Purchase Method of Accounting), which treats all M&A transactions as the purchase of one company by another. Prior to the change, merger transactions were normally accounted for using the Pooling of Interest accounting method. This modification has an impact on how goodwill is measured, which will be covered in more depth in a later section of this essay.
Mergers and acquisitions are evaluated by looking for circumstances where one firm (the Buyer) offers cash or its own common stock in return for the other company’s common stock (the Target). In most cases, the Target’s Board of Directors and shareholders must give their consent. The only exception is a hostile takeover, in which the Buyer buys enough of the Target’s stock to seize control of the company against the board’s and shareholders’ interests.
Combining two firms through a merger or acquisition is a business technique for generating value through synergy; the two companies merged are believed to be more valuable or profitable than each business running independently, which is why there are so many M&A deals each year. Synergies can be realized through an M&A deal in a number of ways:
- Revenue synergies: Diversification of revenue sources resulting from new or complementary product or service offerings
- Operational synergies: Greater production capacity due to acquisition of additional facilities and employees
- Revenue/cost synergies: Greater market share and economies of scale
- Financial synergies: Decrease in financial risk and reduced borrowing costs
- Operational/cost synergies: Increase in operational efficiency and/or expertise; increase in research and development programs/expertise
A merger or acquisition might be done for defensive reasons in addition to business synergies. When a large, well-established corporation detects a danger to future market share from a smaller competitor’s stronger product or service offering, or because the smaller company has valuable intellectual property (IP), such as a new technology, this situation is typical. The acquisition of Instagram by Facebook is a fantastic example.
Merger analysis is the process of analyzing the financial profile of a merger after the two companies have merged using models. The main purpose is to see if the Buyer’s earnings per share would grow or decrease as a result of the transaction. The term accretion refers to an increase in predicted earnings, and this form of merger or acquisition is known as an accretive acquisition. Dilution refers to a drop in projected earnings; a dilutive transaction is a merger or acquisition that results in a drop in expected earnings. Accretive acquisitions are far more prevalent for the simple reason that a purchase that lowers the value of the Buyer’s shares is unlikely to be approved by the Buyer’s shareholders. The acquisition price for the Target, as well as the number of shares issued to raise cash to finance the purchase, determine whether the transaction is accretive or dilutive.
These major valuation data points are used in a merger analysis:
- Analysis of accretion/dilution and balance sheet impact
- Analysis of synergies
- Type of consideration offered (cash or stock) and the impact this will have on results
- Goodwill and other balance sheet adjustments
- Transaction costs
These data points are established by answering the following questions:
- Who is the Target or Seller?
- Public or private company
- Percentage of insider ownership vs. publicly held stock
- Who is the Buyer?
- Strategic buyer (an existing company hoping for synergies)
- Financial sponsor (a private equity firm hoping to generate returns through a leveraged buyout)
- What is the transaction context?
- Auction, or privately negotiated sale
- Friendly or hostile takeover
- What are the market conditions?
- Acquisition currency (cash or equity)
- Historic premiums paid for comparable transactions
Each of these data points is used in building the M&A model for the transaction.
Building The M&A Model
The M&A Model can be developed once you have all of the data points from the Merger Analysis. The steps in a typical M&A model are as follows:
- Making acquisition assumptions: Assumptions about how the merger will be financed (cash, stock, debt, or a combination)
- Making projections: Projections about income for each of the companies in the transaction based on income statements and valuation of each company
- Combining the companies: Combining the income statements of both companies, adding together revenue and operating expenses, and adjusting for debt or cash used to finance the merger
- Calculating accretion/dilution: Combining the net incomes of both companies and dividing by the number of shares outstanding yields the earnings per share of the combined companies. If earnings per share are higher than pre-merger, the deal is accretive; if they are lower, it is dilutive.
Once the M&A Model is determined, the next step is settling the purchase price of the Target.
Determining The Purchase Price
In an M&A transaction, the average buyer intends to benefit through boosting shareholder value. The Buyer is willing to pay a control premium to take over the Target company, either completely by purchasing all shares or partially by acquiring enough shares to obtain control. This is the price paid for the Target above and beyond the market price. Consider the following scenario:
Company A offers Company B $20 per share to acquire Company B. Company B’s share price prior to announcement of the offer is $16 per share. Company A’s offer represents a 20% premium over the current market price.
The purchase price for the Target is a major aspect in the examination of mergers and acquisitions; the control premium that will be paid is also critical. Recent comparable deals involving the purchase of similar companies are frequently investigated to establish the magnitude of the control premium. The Target company’s fair value will be determined using one or more of the three basic valuation approaches: Market, Income, or Cost—though the Cost approach is rarely utilized as a merger and acquisition valuation method. Once the Target’s value has been determined, the Buyer’s and Target’s management teams will negotiate the purchase price and control premium.
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