Merger And Acquisition Valuation Methods
Posted by Valentiam Group on June 24, 2020
Mergers and acquisitions (M&A) are common reasons for seeking a business valuation. In 2019, there were 49,849 mergers and acquisitions globally, with 15,776 in North America alone. Merger and acquisition valuation methods rely on the same three basic valuation approaches covered in this article, but there are some differences in an M&A valuation connected to the purpose for the valuation.
In this article, we’ll explain a bit more about mergers and acquisitions, the reasons companies pursue M&A transactions, the types of mergers and acquisitions, and the typical valuation approaches to M&A.
What are mergers and acquisitions, and why are there so many of them?
Although mergers and acquisitions are lumped together as a term, they represent two different types of transactions:
- A merger is the combination of two companies into a single business entity. An example would be Exxon Mobil Corporation, formed in 1999 when Exxon and Mobil merged in a $73.7 billion deal—the largest up to that time—creating the world’s third-largest company.
- 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 large, well-known companies that have been involved in mergers and acquisitions, but as the numbers show, there are tens of thousands of M&A transactions every year, most of them involving much smaller businesses.
Although mergers and acquisitions are technically different types of transactions, for accounting purposes they are treated the same. In 2001, the Financial Standards Accounting Board (FASB) adopted a new standard, requiring all M&A transactions to use the Acquisition Method of accounting (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, the Pooling of Interest accounting method was typically used for merger transactions. This change impacted the way goodwill is accounted for, which will be discussed in further detail in another section of this article.
The evaluation of mergers and acquisitions involves analysis for situations in which one company (the Buyer) offers cash or its own common stock in exchange for the common stock of the other company (the Target). (Tweet this!) In most situations, this requires the approval of the Target’s Board of Directors and shareholders. The exception is a hostile takeover, in which the Buyer acquires enough of the Target’s stock to control the company against the wishes of the Target’s board and shareholders.
As for why there are so many M&A transactions each year, combining two companies through a merger or acquisition is a business strategy for increasing value through synergy; the two companies combined are expected to be more valuable or profitable than each business operating independently. There are a variety of synergies that can be realized through an M&A transaction:
- 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
In addition to business synergies, a merger or acquisition may be transacted for defensive purposes. This scenario is common when a large, established company sees a threat to future market share due to a smaller competitor’s superior product or service offering, or because the smaller company has valuable intellectual property (IP) such as a new technology. Facebook’s acquisition of Instagram is a good example.
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Merger analysis involves the use of models to analyze the financial profile of a merger after the two companies are combined. The primary goal is to determine whether the Buyer’s earnings per share will increase or decrease as a result. An increase in expected earnings is referred to as accretion, and this type of merger or acquisition is known as an accretive acquisition. A decrease in expected earnings is called dilution; this type of merger or acquisition is known as a dilutive acquisition. Accretive acquisitions are much more common for the simple reason that the Buyer’s shareholders are unlikely to approve of a purchase that decreases the value of their shares. Ultimately, whether the transaction is accretive or dilutive is a function of the purchase price for the Target, as well as the number of shares issued for raising capital to finance the purchase.
A merger analysis includes these key valuation data points:
- 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.
Types of Mergers and Acquisitions
There are a variety of types of merger and acquisition transactions. The type of transaction is also taken into account when building the M&A model:
The combination of two companies in the same industry or sector, for example, Exxon and Mobil
A company’s purchase of its supplier or distributor, as when Comcast purchased a controlling share in NBC, one of its suppliers of content
A company’s purchase of another company in a different industry or business sector, such as Amazon’s purchase of Whole Foods
The purchase of a company with the approval of that company’s Board of Directors and acceptance of an acquisition offer
The acquisition of a target company after that company’s rejection of an acquisition offer, usually accomplished through the buyer’s offer to purchase outstanding shares at a premium from shareholders
A private company acquires a public company, avoiding the initial price offering (IPO) process while gaining access to public markets
Building The M&A Model
With all the data points from the Merger Analysis in hand, the M&A Model can be designed. The typical M&A model includes these steps:
- 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
The typical Buyer in an M&A transaction wants to benefit by increasing value for its shareholders. To take over the Target company, either fully by purchasing all shares or in part by acquiring enough shares to gain control, the Buyer is willing to pay a control premium. This is the price paid over and above the market price for the Target. For example:
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.
In the evaluation of mergers and acquisitions, determining the purchase price for the Target is a key consideration; the control premium that will be paid is also critically important. To determine the amount of the control premium, recent comparable transactions involving the purchase of similar companies are often examined. The fair value of the Target company will also be determined through one or more of the three standard valuation approaches: the Market, Income, or Cost approaches—although the Cost approach is rarely used as a merger and acquisition valuation method. Once the value of the Target is established, management of the Buyer and Target will negotiate to reach agreement on the purchase price and control premium.
Calculating Goodwill And Adjusting The Balance Sheet
Goodwill is the premium paid by the Buyer to acquire the Target. In the transaction, some portion of the Target’s assets are often “written up” or increased in value. This appears as an increase in intangible assets on the Buyer’s balance sheet. Transaction and financing fees are added to the amount designated as goodwill.
Under the standard adopted by FASB for mergers and acquisitions, goodwill is a long-term asset that is never depreciated or amortized unless an impairment is found; in that case, a portion of the goodwill is “written off” as a one-time expense. Goodwill impairment testing is covered in depth in this previous article.
Other adjustments to the Buyer’s balance sheet accounts might also need to be made—for example, to account for aligning current value and market value of inventory.
Although M&A transactions can be complex and involve some unique considerations, merger and acquisition valuation methods are the same as the approaches used for other business valuation purposes. Ultimately, what is most important is to seek the services of valuation experts to establish a fair and reasonable value for the purchase of the company being acquired.
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