There are many reasons why companies enter into a merger or acquisition transaction. Regardless of the specific drivers, however, the common theme underlying all merger and acquisition deals is the expectation that the combination will increase shareholder value for the acquirer. Ironically, it is estimated well over 50 percent of M&A deals fail – meaning they end up destroying shareholder value instead of creating it. This surprising statistic underscores the difficulty company boards face in determining whether or not a deal is worth pursuing. A greater emphasis on a disciplined and thorough valuation analysis is key to helping boards in their ability to identify and avoid bad deals or to guide them in negotiating and structuring deals that may make better financial sense. This article will discuss what constitutes a disciplined and thorough valuation analysis and how such an analysis can help boards identify companies that could be successful acquisition targets.
Analysis of a Hypothetical Synergistic Deal
For our purpose, we will assume that a public company acquirer has identified a potential target. The target company operates in the same business as the acquirer and serves similar customers. The expected cost savings from the business combination may be compelling due to an overlapping distribution network of both the acquirer and the acquisition target and because production and administrative staff redundancies can be eliminated from the acquisition target. This is a classic example of a synergistic deal. Synergies refer to the ability of the acquirer to add the target company’s revenue to its top line while at the same time eliminating many of the costs associated with achieving that revenue by eliminating duplicate operations and functions, increasing overall profitability.
The first step in the valuation process is to establish the market value of the target company without regard to buyer-specific synergies. While acquirers are ultimately most interested in analyzing the valuation of the combined company, establishing the market valuation of the target on a stand-alone basis should be done first for two reasons:
- To provide the buyer perspective on a baseline valuation that the board of the target company might expect to realize in the transaction.
- To establish a reference point by which the buyer can analyze and evaluate how much additional synergy it brings to the table over and above a market level of synergy.
Establishing the Value of an Acquisition Target
There are several generally accepted approaches for establishing the value of an acquisition target (see the figure below for an overview of commonly used approaches). The first two approaches are used primarily for publicly traded targets. For our purpose, we will assume the acquisition target is a private company, and its value may be established using the other four approaches.
One of the most common approaches relies on the trading multiples of comparable companies in the public markets. Care is required in the selection of public companies to ensure comparability of operations, size or growth prospects with the target company. Another common approach is to look at industry M&A deal multiples for similar targets. For this approach, it may be instructive to distinguish between financial sponsor deals and strategic deals. Strategic acquirers can and often do pay higher multiples for targets due to acquirer-specific synergies. This approach yields a control/synergistic level of value. Value indications for these approaches should be based on applying observed market multiples to the target’s standalone earnings before interest, tax, depreciation and amortization (EBITDA) (or other financial metrics that may be more appropriate) without factoring in any buyer-specific synergies.
If a reliable long-term forecast is available for the target company, the financial advisor will often use a discounted cash flow (DCF) analysis to establish value. It is important to keep in mind, however, that such an analysis is only as good as the underlying financial forecasts used to perform the DCF model. For this reason, a DCF analysis is often underweighted and may even be omitted in some instances. If the financial advisor does choose to conduct a DCF analysis, caution must be used in relying on the financial projections prepared by the target company. One pitfall would be to take at face value any forecast that appears overly optimistic about future performance relative to historical performance. Careful due diligence should be conducted on such a forecast to determine if it is reliable. In some instances, a “haircut” may be applied to the forecast to offset the optimistic nature of the long-term plan, while in other instances the financial advisor may develop a more reasonable set of projections by looking at the historical performance of the target as well as industry norms. In any event, the financial forecast should not factor in any buyer-specific synergies.
Last, if the target company is likely to attract financial buyers, then it would also be prudent to value the company using a leveraged buyout (LBO) analysis. This approach values the target by establishing what a financial buyer would be willing to pay for the company given the financing structure it may implement. In addition to its equity investment, a financial buyer will seek to use debt to finance the acquisition in order to enhance equity returns. If a company is underperforming relative to the industry, the LBO model may also include some assumptions about reorganization to better align the target company’s performance with the overall industry. The financial sponsor may also seek to use the target company as a platform from which to make add-on acquisitions to increase EBITDA and realize value through multiple expansion at exit.
Once all approaches have been performed, the financial advisor will triangulate the various pricing indications to establish an overall baseline valuation range for the target. This analysis provides a useful benchmark to the acquirer in determining a preliminary offer value.
Establishing Value for the Acquirer
The next phase of the valuation analysis involves assessing what the value of the acquirer will be pro forma for the acquisition. This analysis is different than the market valuation analysis because we are now conducting a review from the perspective of a particular buyer and what the value of the acquisition is to that specific buyer. This value may be different for each potential buyer in the market, with the most highly synergistic buyer able to offer the highest purchase price.
In performing this valuation analysis, there are factors that need to be carefully analyzed before determining the viability of the deal. If it is viable, then we determine how much the buyer can afford to pay for the target and still increase shareholder value. Some of these factors include the amount of expected synergies, the costs associated with realizing those synergies, the amount and type of purchase consideration, and the trading multiples for the acquirer’s stock. We will address each of these factors in turn.
Money spent on outside advisors that perform due diligence on the target to estimate the potential synergies of a deal is usually money well spent. Management should be careful in relying on its own estimates of synergies. In many cases, the amount of synergies cannot be estimated with precision and may be a wide range. Because of difficulty in identifying and estimating potential synergies, it is recommended to run a sensitivity analysis to assess the impact of the transaction on the acquirer’s stock price. This is best performed in a sensitivity table that varies both the amount of assumed synergies and the amount of purchase consideration, which provides the board with a visual tool to understand how much it makes sense to pay at varying levels of synergy. With this analysis, the acquirer should keep in mind that for many deals the amount of synergies actually realized is lower than projected. Also, it may take longer than expected to realize those synergies and the associated one-time costs might be higher than expected. From the buyer’s perspective, a good deal is one that is accretive to the acquirer’s stock price even at the low end of the range of expected synergies. An even better deal is one that still increases shareholder value despite synergies below the low end of the estimated range. Conversely, deals that are only accretive at or near the maximum amount of projected synergies will likely end up destroying shareholder value. The same logic applies to the estimated one-time costs necessary to integrate the target’s operation into the acquirer’s and achieve synergies. Similar to the synergies themselves, these one-time costs may also be difficult to estimate with precision, and their range may be wide, and a sensitivity analysis around this assumption may also be required. The idea behind the sensitivity analysis is to look at the financial impact of the transaction on a conservative basis. For example, if the scenario analysis shows that a deal increases shareholder value even if (a) actual synergies realized are at the low end of expectations, (b) one-time costs incurred to realize those synergies are at the high end of the range and (c) the purchase consideration is reasonable relative the market valuation of the target company, then the deal will likely end up good from the acquirer’s standpoint.
Considerations of Other Impacts on Value
It is also important to analyze the impact of the type of purchase consideration on value. How will the acquisition be financed? The purchase price can be financed with available cash, proceeds from newly incurred debt, with stock or with a combination of these. Use of debt will create a drag on future earnings in the form of interest expense. Interest expense is effectively another cost of realizing the transaction synergies that must be considered. If acceptable to the seller, using stock consideration may be advantageous to the buyer. But if stock is used, VRC advises placing selling restrictions on the shares until after the expiration of any transition services agreement so as to incentivize the sellers to ensure a smooth transition and to de-risk any transition issue. While the sellers must wait until they can convert their shares to cash, they will benefit in the run-up in the value of the stock assuming that transaction synergies are realized as planned.
Another factor that needs to be considered is the valuation multiple of the acquiring company. If historically it has been somewhat volatile, it may be advisable to run a sensitivity analysis on the pro forma value of the stock, assuming a range of valuation multiples for the acquirer that is consistent with its recent trading history. The lower the valuation multiple, the lower the increase in value from transaction synergies.
There may also be other factors that need to be analyzed. For example, one assumption underlying most deals where the acquisition rationale is cost synergies is that the target’s revenue will survive the acquisition without any loss of customers or decrease in the level of business from any given customer. However, in many acquisitions, this does not prove to be the case. The acquirer will need to evaluate whether incentives will need to be put in place with those at the target who have key customer relationships or directly with customers to ensure revenue is preserved and relationships transfer. This will be an additional cost that will be an offset to the synergies to be realized.
Having established both the market value of the target and the value of the target to the specific buyer, the acquirer is in a good position to negotiate with the seller. A buyer may be willing to pay up to the market level of synergies, but the buyer should be careful paying for synergies beyond that point.
No board of directors goes into a deal with the intent to destroy value, and yet that is what ends up happening in many deals. In many instances, a greater emphasis on a disciplined and thorough valuation analysis as outlined above can make the difference in helping a board of directors in its ability to distinguish a good deal from a bad one. For an in-depth discussion on how VRC can help develop a valuation analysis that will help your company better understand and prepare for the impact of an M&A deal transaction, we invite you to contact us or your VRC representative.