Financial Valuation in Mergers and Acquisitions-

Financial Valuation in Mergers and Acquisitions-

Mergers and acquisitions are terms that have been used interchangeably for a while but are fundamentally different. A business merger refers to an agreement where two companies join their operations to form a new entity. Both companies cease to exist as they were and a new entity comes into being.

In an acquisition, one company buys the shares of the ‘target’ company. It could buy all or a majority of the target company in order to gain control.

Scholars and managers have pointed out numerous reasons regarding the case for mergers and acquisitions. However, the main question to answer is whether a merger or acquisition results in any value or synergy for the companies. Areas where synergies could arise include but are not limited to the following;

·        Being able to increase total production by sharing production facilities and workforce

·        Being able to raise financing more easily by forming a bigger company

·        Being able to invest in bigger research and development ventures

·        Increase market share and marketing economies

·        Greater efficiency in operations resulting in massive cost savings

While the reasons have often been well documented, what remains a puzzle is the correct method of valuation for target companies before an acquisition. Which is the correct way to determine what to pay for every share of a target company? Do you pay their current market price per share if they are a listed company? Should you offer a premium per share?

Different Financial Valuation Methods Used in Mergers and Acquisitions

Below are some of the most popular ways to determine what to pay during acquisitions. Even during mergers, it is important to find out what each business is currently worth. Each method suits a different scenario and both parties need to agree on a method to go with.

i)                  Net Assets Method

This method involves taking into account the net book value of all assets in the balance sheet. From that figure, you subtract all the liabilities of the business to come up with a net asset amount. This method is applicable when the book value of balance sheet items is equivalent to their fair market value.

ii)               Discounted Cash Flow Method

This method is more refined compared to the net assets method and is more likely to be used in the real world. It involves getting historical data on the target company’s cash flow and using it to forecast future cash flows. It is however important to take into account the benefits of expected synergies following the acquisition. The expected cash flows are then discounted to come up with an approximate value for the target company. This method is quite similar to the technique used in evaluating projects in capital budgeting.

iii)             Valuation Based on Strategic Justification

There are cases where that acquiring company may feel that buying the target is very crucial for its future. This happens for instance when the target owns a some important intellectual property or is dominant in a growing niche market. In such a scenario, all other valuation methods may not really capture how much the target is really worth. The acquiring company will be willing to pay over the odds in order to place itself in a strategic position going into the future.

iv)              Savings Made from Not Paying Royalties

This method is applicable when a target company owns numerous patents and licenses. The acquiring company will ask itself how much it would have to pay if it were to be licensed to use such patents by the target company.

v)                Price Earning Ratio

The price-earning ratio is the ratio of a company’s market price per share and the earnings per share. Companies in the same industry tend to have an almost similar price earning ratio when listed in the stock exchange. When valuing a target, take their earnings per share and use the average industry P/E ratio to come up with a fair price per share. This is helpful when a target is not listed in the stock exchange.

vi)              Replacement cost vs Acquisition

There are cases where the acquiring company weighs how much it would cost to build an entity from the ground up. This is applicable when the greatest investment is mainly in tangible assets such as real estate and equipment. In case where the target’s main assets are human talent or unique services, it is impossible to replicate the same and a buy-out is the only option.

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Published on: 22 Aug 2019

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