It is easy to get caught up in the excitement of a deal—the unvarnished optimism of the corporate development team, the bullish spreadsheets from the bankers, the juicy steaks at the closing dinner. The numbers, however, don’t lie. It is estimated that at least half of all merger and acquisition (M&A) deals ultimately fail, destroying shareholder value for the acquirer instead of increasing it. A disciplined valuation analysis—ideally conducted with minimal involvement of the deal team and bankers—can help board members avoid unsuitable matches and support deals that are a good long-term fit.
A Synergistic Match
Assume your company has identified an acquisition target operating in your business and serving similar customers. Cost savings from the combination are expected as the result of an overlapping distribution network and because redundant production and administrative staff can be eliminated. This is a classic synergistic deal, where the acquirer boosts overall profit by adding the target’s revenue to its topline while eliminating many costs associated with achieving that revenue.
The first step in evaluating such a transaction is establishing the market value of the target without regard to buyer-specific synergies. While acquirers are usually most interested in the valuation of the combined company, there are good reasons for first establishing a baseline market valuation of the target on a stand-alone basis:
- It gives the buyer insight on a valuation the target might expect to receive in the deal.
- It provides a reference point the buyer can use to evaluate how much synergy it brings to the table.
Determining Baseline Value
There are several common approaches for deriving the market value of an acquisition target, and an acquirer should undertake as many of them as possible to establish a baseline valuation matrix. The two common techniques for publicly traded entities are straightforward. They entail analyzing the target’s historical stock price and the premium at which its stock trades after the deal is announced. For our purpose, assume the target is not public and review the four valuation approaches commonly applied to private companies.
- One of the most common techniques is by referencing the trading multiples of comparable publicly-traded companies. Care is required in the selection of comparable public companies to ensure similarity of operations, size, and growth prospects with the target company.
- Another common method is to consider recent M&A deal multiples for similar companies. For this approach, make sure to distinguish between financial sponsor deals and strategic deals, as strategic deals frequently pay higher multiples due to acquirer-specific synergies. Value indications from these approaches entail applying observed market multiples to the target’s standalone earnings, typically before interest, tax, depreciation, and amortization (EBITDA).
- If a long-term forecast is available for the target, financial advisors sometimes use a discounted cash flow (DCF) analysis. It should be stressed, however, that this analysis is only as accurate as the underlying forecast, which may be suspect. For this reason, a DCF analysis often is underweighted—and sometimes omitted altogether—from a valuation exercise. Additionally, a “haircut” may be applied to the forecast itself before it is put into the model.
- Finally, if the target is likely to attract financial buyers, advisors may employ a leveraged buyout (LBO) analysis. This approach values the target by establishing what a financial buyer would be willing to pay for the company under the financing structure it might be expected to use—often a combination of debt and equity. If a company is underperforming its peers, the LBO model may also include some assumptions about reorganization and/or add-on acquisitions.
Once as many of the preceding approaches as practicable have been performed, financial advisors triangulate the various pricing indications to establish a baseline market valuation range for the target.
Establishing Pro Forma Value
The next step is assessing the value of the acquirer after acquisition. This analysis is different than the market valuation analysis because it factors in synergies to show the value of the acquisition to that specific buyer. A word of caution: Board members should be wary of synergy projections from bankers or corporate development personnel who are emotionally or financially invested in the deal. Considering the stakes, engaging an outside advisor not connected to the prospective transaction to provide an independent valuation and estimate the potential synergies can be a sensible course of action.
No matter who is performing the pro forma analysis, a number of factors should be evaluated: 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.
Even for a disinterested third party, it is challenging to estimate synergies with accuracy, so it is prudent to perform a sensitivity analysis of the transaction’s impact on the acquirer’s share price. This is best revealed in a sensitivity table that varies both the amount of assumed synergies and the purchase consideration. Layering in an additional variable to the sensitivity analysis, the estimated one-time integration costs incurred to achieve synergies can further enhance precision. These costs can be just as difficult to project as synergies, so a range of estimates is appropriate.
The resulting sensitivity table can provide board members a powerful visual tool to understand how much it makes sense to pay at varying levels of synergy and costs. If the resulting analysis shows that a deal increases shareholder value—even if actual synergies realized are at the low end of expectations and one-time costs incurred to realize those synergies are at the high end—the deal likely will turn out well from the acquirer’s standpoint. An even better deal is one that increases shareholder value if synergies are below the low end of the estimated range and integration costs are above the high end.
Conversely, deals that are only accretive at or near the most favorable ends of the two ranges are likely to destroy shareholder value.
Other Impacts on Value
What about the impact of the type of purchase consideration on value? An acquisition can be financed with available cash, new debt, stock, or some combination of these. Debt financing will create a drag on future earnings in the form of interest expense, another cost of realizing synergies that must be considered. If acceptable to the seller, using stock may be advantageous to the buyer.
A final factor to consider is the valuation multiple of the acquirer. If historically it has been somewhat volatile, it is a good idea to run a sensitivity analysis on the pro forma value of the stock, assuming a range of valuation multiples for the acquirer consistent with its recent trading history. The lower the valuation multiple, the lower the increase in value from transaction synergies.
Know the Difference
Board members are unlikely to bless a strategic acquisition with the intent to destroy value. Yet, too often, that is exactly what ends up happening. A disciplined, thorough, and independent valuation analysis can make the difference in helping a board distinguish a suitable match from a bad one. After establishing both the market value of the target and its pro forma value to a particular acquirer, a buyer is well-positioned to negotiate and—if all goes well—finalize the deal.
Justin Johnson is co-CEO of Valuation Research Corp. where he sits on the firm’s board and is a member of the firm’s Private Equity Industry Group and Financial Opinions Committee. Prior to joining VRC, Johnson held positions with Arthur Andersen, Merrill Lynch, and PricewaterhouseCoopers.