Valuation - Merger/Acquisition

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Valuation - Merger and Acquisition

Mergers and acquisitions are one of the most effective strategies implemented by corporates to level up their game. The motive can be to benefit from synergy gains, eliminate competition by acquiring them, diversify their business or cover up their shortcomings etc. However, they are multi-facet complex transactions and require consideration of various aspects. One of the key considerations is the valuation of merger and acquisition. It is the foundation for the entire transaction and the basis upon which the consideration is decided. However, what exactly are mergers and acquisitions and what is the role of valuation in merger and acquisition transaction? Let’s find out! 

What is Merger & Acquisition? 

Merger and acquisition are two different terminologies that are often used interchangeably. However, the following is the distinction between the two: 

  • Merger: It is the transaction whereby two or more companies combine into a single company. More often than not, an entirely new company is formed separately from the merging companies.  

  • Acquisition: Acquisition is the transaction whereby one company is acquired by the other company whereby in most cases, the company being acquired loses its existence. 

Kinds of Mergers 

The following are the 5 different types of mergers: 

  1. Conglomerate Merger: This is the merger between different entities who are in unrelated activities. This may be either different industries or different geographies whereby the two merging entities have nothing in common. The idea behind conglomerate mergers is synergy gains, enhancing performance, cost savings, opening new business verticals and expanding into new markets, etc. 
  2. Congeneric Merger: In a congeneric merger, the two companies operate in the same market or segment. There may be similarities in the product line, technology, production process, etc. These are also known as product extension mergers and are usually entered into by the companies in order to add a product line and get access to a larger consumer group. 
  3. Market Extension Merger: This is where the companies that sell the same type of products but in different markets merge together. Their motive is to get combined and expand their markets thereby serving a larger consumer group.  
  4. Horizontal Merger: Horizontal merger is where the companies operating at the same level merge with each other. In most cases, the merging companies have similar offerings for their consumers. This helps them get a larger market share for the same offerings.  
  5. Vertical Merger: This is where the companies merge with other companies that are above or below them in their supply chain. In simple terms, when a company merges with its supplier business or customer business, it is called as Vertical Merger. 

Importance of Valuation in Merger & Acquisition Transaction 

Merger and Acquisition are complex transactions undertaken by the combining entities to expand their value and size in the markets. The value of the resultant entity is often derived through the sum of both the combining entities. Therefore, it becomes important to determine the valuation of merger and acquisition transactions accurately. Merger and acquisition transactions can have a negative impact on the entity in case the estimation is not done precisely. This is especially in the case of acquisitions whereby the acquiring entity may end up paying excess purchase consideration to the taken over entity without receiving adequate benefits, if the valuation is not done precisely. 

Need For Valuation 

Merger and acquisition are some of the key transactions requiring a valuation. There are many other instances whereby the company needs to undertake valuations for different purposes. These include: 

  • Calculating the value of purchase consideration 
  • Corporate Restructuring 
  • Valuation for the purpose of getting the securities listed on a recognized stock exchange. 
  • For the purpose of calculating the fair value of shares for Employee Stock Option Plans and other similar schemes for the benefit of employees. 
  • Liquidation of the company 
  • Determination of value of individual assets, especially the intangible assets like trademarks, copyrights, patents, etc. 

Methods of Valuation in Merger & Acquisition Transaction 

While the valuation methods are many, here are some of the key merger and acquisition valuation methods used for merger and acquisition transactions: 

  1. Discounted Cash Flow Method (DCF) 

This method calculates the value of the company based on the forecasted cash flows. Following are the key determinants for the discounted cash flow method: 

  • Discount Rate: The discount rate is used to bring all the projected cash flows as well as the terminal value to their present value. In most cases, the weighted average cost of capital (WACC) of the company is used as the discount rate for this method. 

  • Projected Future Cashflows: These are the net cash flows of the company for the forecast period. All the cash inflows and cash outflows shall be brought to the present value to determine their value in today’s terms. 

  • Forecast Period: The forecast period is subjective in each case. This is the period whose cash flows will be considered to determine the valuation of the company. The forecast period shall be such that it adequately considers the costs and benefits of the merger and acquisition transaction. 

  • Terminal Value: It is the value of the company at the end of the forecast period. The terminal value takes into consideration all the future cash flows beyond the forecast period. The terminal cash flows assume that the company will not enjoy an abnormal growth rate during the terminal period (period beyond the forecast period) and will grow at a constant pace. 

Thus, under the discounted cash flow method, the projected future cash flows for the forecast period and terminal value are brought to their present value using the discount rate. This shows the earning potential of the company in present terms and that is considered as the worth of the company. 

  1. Comparable Company Analysis: Under this method, the valuation of merger can be derived using similar businesses in the same industry. The data and financial position of the company are evaluated against the industry standards. Valuation is based upon the financial ratios of the company that includes the P/E ratio, EBITDA, EPS, etc. 

For instance, if the EPS of the company is Rs. 100 per share and the industry or comparable company carries a P/E ratio of 7 times, then for a company with one lakh shares, the valuation of the company will be Rs. 700 lakhs (Rs. 100* 1 lakh* 7 times). 

  1. Net Asset Method: Net assets are the total assets less the total liabilities of the company. Under this method, the fair market value of every asset and liability is determined and netted of to derive the value of the company. The netting of assets and liabilities shows the equity value of the company. 

  2. Dividend Discount Model: The dividend discount model shows that the value of the company is the present value of the future dividends. This model considers the current share price of the company, the growth rate for the dividends of the company, the weighted average cost of capital (WACC), and the value of next year’s dividend. 

  3. Leveraged Buyout Analysis: This is specifically employed by investors such as private equity firms whereby they invest huge sums in the company with an intent to gain control with a hope to sell the equity at higher rates in the future. Leverage buyouts imply that such companies assume highly leveraged positions by raising debt financing in order to invest in such companies. This helps them raise funds at a fixed cost thereby increasing their return on investment after the share value increases. 

FAQs about CMA Report

For valuation of merger, the most commonly used discount rate is the Weighted Average Cost of Capital of the company. Apart from that, for internal decision-making purposes, companies also use the Internal Rate of Return (IRR). This is the rate where the present value of cash inflows is equal to the cash outflows. It is commonly used by the company for making a decision regarding their capital projects.

When the EBITDA is negative and the company is loss-making entity, then in such cases, using revenue multiples is more meaningful than EBITDA. This is especially beneficial for companies using the deep discount model for attracting consumers.

Calculating the weighted average cost of capital is relatively simple. It comprises of two components viz. cost of equity and cost of debt. Based on the capital structure of the company, the weighted average cost of capital is derived at. WACC = [(Cost of equity * proportion of equity capital) + (cost of debt * proportion of debt capital)] / (Total equity + Debt) In case, the company has also issued preference shares, the cost of preference capital shall also be considered while calculating WACC.

Cost of equity is one of the components in calculating the weighted average cost of capital (WACC). It can be derived through Capital Asset Pricing Model (CAPM). Following is the formula for CAPM: Cost of equity (Ke) = Risk free rate (Rf) + ß x Market risk premium (Rm-Rf)

ß (Beta) means how many times the securities of a company are riskier as compared to the market. Beta can be calculated as follows: ß = Covariance (market, stock) / Variance (market)

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