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.
Although mergers and acquisitions are lumped together as a term, they represent two different types of transactions:
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:
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.
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:
These data points are established by answering the following questions:
Each of these data points is used in building the M&A model for the transaction.
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:
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Horizontal Merger |
The combination of two companies in the same industry or sector, for example, Exxon and Mobil |
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Vertical Merger |
A company’s purchase of its supplier or distributor, as when Comcast purchased a controlling share in NBC, one of its suppliers of content |
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Conglomerate M&A |
A company’s purchase of another company in a different industry or business sector, such as Amazon’s purchase of Whole Foods |
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Friendly Takeover |
The purchase of a company with the approval of that company’s Board of Directors and acceptance of an acquisition offer |
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Hostile Takeover |
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 |
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Reverse Takeover |
A private company acquires a public company, avoiding the initial price offering (IPO) process while gaining access to public markets |
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:
Once the M&A Model is determined, the next step is settling the purchase price of the Target.
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.
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.
At Valentiam, our valuation specialists are experienced in all valuation methods acceptable in accounting practice. We bring collective decades of expertise in valuation and transfer pricing to every project. Schedule a call to see how we can help you with your business valuation and transfer pricing needs.