Mergers and Acquisitions: Valuation Matters
AAA
  1. Mergers and Acquisitions: Introduction
  2. Mergers and Acquisitions: Definition
  3. Mergers and Acquisitions: Valuation Matters
  4. Mergers and Acquisitions: Doing The Deal
  5. Mergers and Acquisitions: Break Ups
  6. Mergers and Acquisitions: Why They Can Fail
  7. Mergers and Acquisitions: Conclusion

Mergers and Acquisitions: Valuation Matters


Investors in a company that are aiming to take over another one must determine whether the purchase will be beneficial to them. In order to do so, they must ask themselves how much the company being acquired is really worth.

Naturally, both sides of an M&A deal will have different ideas about the worth of a target company: its seller will tend to value the company at as high of a price as possible, while the buyer will try to get the lowest price that he can.
There are, however, many legitimate ways to value companies. The most common method is to look at comparable companies in an industry, but deal makers employ a variety of other methods and tools when assessing a target company. Here are just a few of them:

  1. Comparative Ratios - The following are two examples of the many comparative metrics on which acquiring companies may base their offers:
    • Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring company makes an offer that is a multiple of the earnings of the target company. Looking at the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be.
    • Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring company makes an offer as a multiple of the revenues, again, while being aware of the price-to-sales ratio of other companies in the industry.
  2. Replacement Cost - In a few cases, acquisitions are based on the cost of replacing the target company. For simplicity's sake, suppose the value of a company is simply the sum of all its equipment and staffing costs. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost. Naturally, it takes a long time to assemble good management, acquire property and get the right equipment. This method of establishing a price certainly wouldn't make much sense in a service industry where the key assets - people and ideas - are hard to value and develop.
  3. Discounted Cash Flow (DCF) - A key valuation tool in M&A, discounted cash flow analysis determines a company's current value according to its estimated future cash flows. Forecasted free cash flows (net income + depreciation/amortization - capital expenditures - change in working capital) are discounted to a present value using the company's weighted average costs of capital (WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method.

Synergy: The Premium for Potential Success
For the most part, acquiring companies nearly always pay a substantial premium on the stock market value of the companies they buy. The justification for doing so nearly always boils down to the notion of synergy; a merger benefits shareholders when a company's post-merger share price increases by the value of potential synergy.

Let's face it, it would be highly unlikely for rational owners to sell if they would benefit more by not selling. That means buyers will need to pay a premium if they hope to acquire the company, regardless of what pre-merger valuation tells them. For sellers, that premium represents their company's future prospects. For buyers, the premium represents part of the post-merger synergy they expect can be achieved. The following equation offers a good way to think about synergy and how to determine whether a deal makes sense. The equation solves for the minimum required synergy:



In other words, the success of a merger is measured by whether the value of the buyer is enhanced by the action. However, the practical constraints of mergers, which we discuss in part five, often prevent the expected benefits from being fully achieved. Alas, the synergy promised by deal makers might just fall short.



What to Look For
It's hard for investors to know when a deal is worthwhile. The burden of proof should fall on the acquiring company. To find mergers that have a chance of success, investors should start by looking for some of these simple criteria:
  • Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring company makes an offer that is a multiple of the earnings of the target company. Looking at the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be.
  • Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring company makes an offer as a multiple of the revenues, again, while being aware of the price-to-sales ratio of other companies in the industry.
Mergers are awfully hard to get right, so investors should look for acquiring companies with a healthy grasp of reality. Mergers and Acquisitions: Doing The Deal

  1. Mergers and Acquisitions: Introduction
  2. Mergers and Acquisitions: Definition
  3. Mergers and Acquisitions: Valuation Matters
  4. Mergers and Acquisitions: Doing The Deal
  5. Mergers and Acquisitions: Break Ups
  6. Mergers and Acquisitions: Why They Can Fail
  7. Mergers and Acquisitions: Conclusion
RELATED TERMS
  1. Implied Volatility - IV

    The estimated volatility of a security's price.
  2. Plain Vanilla

    The most basic or standard version of a financial instrument, ...
  3. Normal Profit

    An economic condition occurring when the difference between a ...
  4. Theta

    A measure of the rate of decline in the value of an option due ...
  5. Derivative

    A security with a price that is dependent upon or derived from ...
  6. Security

    A financial instrument that represents an ownership position ...
RELATED FAQS
  1. Why do companies release financial figures in terms of fully diluted shares outstanding?

    The value of a company is determined by the number of shares it issues and the price at which these are traded on the stock ... Read Full Answer >>
  2. How does horizontal integration allow companies to share resources?

    In a horizontal integration, a company either acquires another company or merges with that company. This allows the resulting ... Read Full Answer >>
  3. How does the market share of a few companies affect the Herfindahl-Hirschman Index ...

    In economics and commercial law, the Herfindahl-Hirschman Index (HHI) is a widely used measure that indicates the amount ... Read Full Answer >>
  4. Why are the terms 'merger' and 'acquisition' always used together if they describe ...

    The terms "merger" and "acquisition" are used together because they both describe processes by which two companies become ... Read Full Answer >>
  5. Who are Family Dollar's (FDO) main competitors?

    North Carolina-based Family Dollar (FDO) is one of the biggest discount retailers in North America. Competitors include companies ... Read Full Answer >>
  6. What are the different ways I can file my income tax return?

    In contractual law, a letter of intent is a document that represents an agreement between parties before the final agreement ... Read Full Answer >>
  7. What are the key differences between pro forma statements and GAAP statements?

    The U.S. generally accepted accounting principles (GAAP) require companies to adhere to uniform reporting standards that ... Read Full Answer >>
  8. How is a leveraged buyout different from a buyout?

    In finance, a buyout refers to a purchase of voting stock of a target firm by an acquiring company, where the acquirer gains ... Read Full Answer >>
  9. What are some examples of successfully executed leveraged buyouts?

    In finance, a buyout refers to the purchase of a company's voting stock in which the acquiring party gains control of the ... Read Full Answer >>
  10. What happens to the shares of a company that has been the object of a hostile takeover?

    The shares of a company that is the object of a hostile takeover rise. When a group of investors believe management is not ... Read Full Answer >>
  11. Why should investors pay attention to a corporation's selling, general and administrative ...

    Selling, general and administrative expenses (SG&A) are significant elements of many companies' income statements. These ... Read Full Answer >>
  12. What are the major differences between investment banking and private equity?

    Private equity and investment banking both raise capital for investing purposes but tend to do so in very different ways. ... Read Full Answer >>
  13. What can cause a merger or acquisition deal to fail?

    When two large companies announce plans to merge, or when the larger of the two acquires the smaller entity, the surviving ... Read Full Answer >>
  14. What are some of the more reputable private equity firms?

    Private equity firms invest money in companies and attempt to make those companies more profitable. If the private equity ... Read Full Answer >>
  15. What are examples of major companies in the aerospace sector?

    Major companies in the aerospace sector include United Technologies, Boeing, Lockheed Martin, General Dynamics and Northrop ... Read Full Answer >>
  16. What was Rupert Murdoch's role in the wiretapping scandal?

    According to Rupert Murdoch, he had no direct role in the wiretapping scandal involving the now-defunct news tabloid “News ... Read Full Answer >>
  17. What responsibilities does a company take on after an acquisition?

    Most of the attention during an acquisition goes towards valuation, market shares and legalities. Little notice is given ... Read Full Answer >>
  18. What is the best software to use for business analytics?

    The market for business analytics and business intelligence software is dynamic. New products and technologies are constantly ... Read Full Answer >>
  19. What is the difference between a merger and an acquisition?

    A merger occurs when two separate entities combine forces to create a new, joint organization. An acquisition refers to the ... Read Full Answer >>
  20. What are the legal barriers to vertical integration?

    Vertical integration through internal expansion is not vulnerable to legal challenges. However, if the vertical integration ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!