Valuation - Merger/Acquisition
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Valuation - Merger and Acquisition
Mergers and acquisitions (M&A) are pivotal strategies adopted by corporations to enhance their competitive edge. These transactions serve various purposes such as achieving synergy gains, eliminating competitors, diversifying operations, or addressing operational deficiencies. However, M&A deals are complex, multi-faceted endeavors that require careful consideration of several aspects. One critical aspect is valuation, which forms the foundation of the entire transaction and determines the consideration for the deal.
What is Merger & Acquisition?
While often used interchangeably, mergers and acquisitions differ in their execution:
Merger: Two or more companies combine to form a single entity, often creating a new company distinct from the original firms.
Acquisition: One company acquires another, often resulting in the acquired company losing its separate identity.
Types of Mergers
There are five primary types of mergers:
Conglomerate Merger: Unrelated entities from different industries or geographies merge to achieve synergies, expand market reach, and diversify operations.
Congeneric Merger: Companies in the same market or segment merge to broaden their product lines and access larger consumer bases.
Market Extension Merger: Companies with similar products merge to enter new markets and serve a broader customer base.
Horizontal Merger: Companies at the same stage of production or distribution merge to increase market share and reduce competition.
Vertical Merger: Companies merge with suppliers or customers to streamline operations and control costs across the supply chain.
Importance of Valuation in Merger & Acquisition Transactions
Mergers and acquisitions are strategic moves aimed at enhancing market presence and shareholder value. The valuation of the resulting entity is crucial as it determines the equity distribution and financial terms of the transaction. Precise valuation is especially critical in acquisitions to avoid overpaying for the acquired entity without realizing corresponding benefits.
Need for Valuation
Valuation is essential not only for mergers and acquisitions but also for various corporate actions such as:
- Calculating purchase consideration.
- Corporate restructuring.
- Listing securities on stock exchanges.
- Establishing fair values for employee stock options and similar schemes.
- Company liquidation.
- Assessing the worth of intangible assets like trademarks and patents.
Methods of Valuation in Merger & Acquisition Transactions
Several methods are used to determine the value in M&A transactions:
Discounted Cash Flow Method (DCF): Projects future cash flows and discounts them to present value using the weighted average cost of capital (WACC).
Comparable Company Analysis: Valuation based on financial ratios and performance metrics compared to similar companies in the industry.
Net Asset Method: Calculates value based on the net assets (assets minus liabilities) of the company.
Dividend Discount Model: Values the company based on the present value of its expected future dividends.
Leveraged Buyout Analysis: Used by investors to acquire companies using a significant amount of debt, aiming to increase return on investment through subsequent equity sales.
FAQs
For the valuation of mergers, the most commonly used discount rate is the Weighted Average Cost of Capital (WACC) of the company. Additionally, for internal decision-making purposes, companies also utilize the Internal Rate of Return (IRR). This rate equates the present value of cash inflows to the cash outflows, aiding companies in capital project decisions.
Revenue multiples are more meaningful than EBITDA when a company is operating at a loss, and EBITDA is negative. This approach is particularly advantageous for companies employing deep discount models to attract consumers.
Calculating WACC is straightforward, involving two main components: the cost of equity and the cost of debt. Based on the company’s capital structure, WACC is determined by the formula: WACC = [(Cost of equity * Proportion of equity capital) + (Cost of debt * Proportion of debt capital)] / (Total equity + Debt). If the company has issued preference shares, the cost of preference capital should also be included in the calculation.
The cost of equity, a crucial component of WACC calculation, can be derived using the Capital Asset Pricing Model (CAPM). The formula for CAPM is: Cost of equity (Ke) = Risk-free rate (Rf) + ß x Market risk premium (Rm – Rf).
ß (Beta) measures the relative riskiness of a company’s securities compared to the market. Beta is calculated as: ß = Covariance (market, stock) / Variance (market).
