Stand‐Alone Value

The stand‐alone value is the worth of a company presuming that it continues to operate on a stand‐alone or independent basis. Most publicly traded companies are valued on this basis, unless there are rumors or expectations that the company is a potential acquisition candidate. The stand‐alone value is computed using the methodologies described in Chapter 22, Business Valuation and Value Drivers. We will illustrate the mergers and acquisitions (M&A) valuation concepts in this chapter building on the Roberts Manufacturing Company example, presented previously in Table 22.1.

Synergies

Synergies are a critical element in valuing acquisitions. Few, if any, companies will be sold on the basis of the value of that company on a stand‐alone basis. Synergies are generally understood to result where the combined results exceed the sum of the independent parts. For purposes of this discussion, we will use synergies to mean the additional economic benefits that will be achieved by combining two companies. The term economic benefit is used here to emphasize that any synergy must be realizable in future cash flows to be relevant in valuation.

Synergies can take many forms. Common types of synergies include higher sales growth, reduced costs and expenses, financial benefits, and improved management practices.

Sales Growth. Sales growth is always an important consideration in valuation. Drivers of sales growth resulting from M&A transactions include:

• Leverage existing distribution channel(s). The sales growth rate of the target may be accelerated if the acquirer can sell the target's products through existing distribution channels (or vice versa). For example, the acquirer may have a strong international distribution organization in a region where the target's presence is weak or nonexistent.
• Address a new market or develop new products with combined competencies. The combination of technical competencies from two organizations may result in a new product, channel, or technology that will accelerate sales growth.

Reduced Costs. Nearly all acquisitions contemplate some reduction in costs. Common examples include:

• Eliminate redundant costs and expenses. The acquirer may not need to maintain the target's procurement or administrative functions. For example, when two publicly traded companies are combined, many of the corporate functions at one of the companies can be eliminated, including the board of directors, investor relations, and financial reporting.
• Leverage scale and purchasing power. The combined purchasing power of the two organizations may result in reduced prices for materials or services.

Financial Synergies. Significant value can be created by leveraging the acquirer's lower cost of capital to the target. This is sometimes viewed as financial engineering by many operating managers. However, the cost of capital is a significant driver of value, and even a modest reduction can result in a significant increase to value. By providing a previously independent firm with the acquirer's access to capital, borrowing power, and lower interest rates, a substantial increase in earnings power and valuation may be realized.

Transferance of Best Practices. The acquiring company may have innovative business practices that can be transferred to the target (or vice versa). For example, a highly effective product development process may reduce the product development cycle and time to market, thereby reducing product development costs and increasing sales. One of the companies may have a highly effective strategic planning framework or experience in improving operations that will lead to tangible improvements in financial performance for its merger partner.

Potential Acquisition Value

The potential economic value resulting from an acquisition is the sum of the stand‐alone value and the value of expected synergies as shown in Figure 23.1.

Accounting and Comparable Methods

Earnings per Share (EPS) Accretive‐Dilutive Test. Since EPS is a critical measure of performance for a company, especially those trading in public capital markets, it is very important to understand the impact of an acquisition on EPS. The basic test is to determine if the acquirer's EPS will increase (accrete) or decrease (dilute) as a result of pursuing a specific acquisition. A rule of thumb used by many managers, bankers, and investors is that a deal should be accretive within a short period of time, often 12 months. The method involves identifying all of the various ways an acquisition will affect EPS. Examples include:

Goodwill arising from an acquisition is carried on the balance sheet and evaluated for recoverability on an annual basis. Historically, prior to 2001, goodwill was amortized and reported as an expense in the income statement. Under current rules, goodwill amortization expense is typically excluded from the income statement, thereby lowering the bar in the accretive‐dilutive test. Since the EPS test does not fully reflect the true cost of capital for the acquisition, it will result in a positive impact on earnings long before earning an economic return. Table 23.2 illustrates the accretive‐dilutive test for the Sheridan Acquisition Co.–Roberts Manufacturing Co. transaction.

This deal as presented would be accretive to earnings in the first full year after the acquisition, since the earnings contributed by the target and expected synergies exceed the financing costs. EPS will increase from $1.03 prior to the acquisition to $1.17 reflecting the acquisition. If the investors are focusing on EPS and using a P/E multiple to value the company (and if the P/E multiple remains constant), the price of the acquiring company's stock will rise from $20.63 to $23.49 per share.

What about the economics of the transaction? What is the hurdle rate implied in this EPS analysis? That is, what is the required rate of return on the capital used to purchase this company to break even on EPS? The hurdle rate implied in this EPS accretion test is 4.0%. If profit after tax (PAT) exceeds the after‐tax financing costs of $9.7 million, the deal will be accretive to (i.e. add to) earnings. Since the total purchase price of the acquisition, including assumed debt, is $243.8 million, the hurdle rate is 4.0%, as follows:

Is 4.0% an appropriate return for shareholders on this transaction? Hardly. Historically, investors could typically earn a higher rate by investing in essentially risk‐free US Treasury notes. In all investment decisions, the hurdle rate should be based on the specific risk associated with the investment. In acquisitions, the hurdle rate should be based on the target's risk profile adjusted for any perceived addition/reduction in risk due to the acquisition.

In spite of the reduced usefulness (under the rules eliminating goodwill amortization) of the accretive‐dilutive metric, bankers, managers, and analysts continue to use it as a primary measure of the financial performance of an acquisition. If you listen to any conference call announcing an acquisition, EPS accretion‐dilution will likely be prominently featured. It is certainly important to understand and communicate the EPS effect of a deal. However, it is not a comprehensive economic test.

Comparable or Relative Pricing Methods: Multiples of Revenues, Earnings, and Cash Flow

Nearly all acquisition decisions will include an analysis of the pricing of similar companies in recent acquisitions. This is an important tool to determine how pricing of a proposed transaction compares with the pricing of other recent deals. This process is no different than evaluating the pricing of residential real estate. Prior to negotiating on the purchase price of a home, real estate brokers provide a “comp listing,” which summarizes transaction prices on recent home sales in the area. In a similar way, investment bankers and corporate development managers will identify recent transactions in the industry and compute key valuation metrics such as enterprise value/EBITDA and EV/revenue. These valuation metrics are then used to set or evaluate the pricing of the deal under review.

Generally, acquirers must pay a “full” or “strong” value (often euphemisms for overpaying) in order to convince the target's management and board that they should sell the company. Sometimes acquirers offer preemptive bids to discourage the target from considering other potential acquirers. Further, many companies are sold through auctions, where they are essentially marketed to a large number of potential buyers. The winner of this process is typically the highest bidder. All of these factors put upward pressure on the transaction prices. Therefore, managers who wish to build economic value through an acquisition program must recognize that the comparable transaction valuation methodology has a strong upward bias on transaction pricing.

Control Premium Analysis. A control or acquisition premium is the difference between the acquisition price and the market value of a public company prior to the acquisition announcement. Control premiums are often measured from the date preceding the announcement of a transaction. If the market is anticipating an acquisition, it is likely that a substantial part of an expected premium is already reflected in the stock price. Therefore, it is important to examine the stock trading history for the target over the past 12 to 18 months. It is possible that investors are expecting an acquisition and have partially or fully reflected an acquisition premium in the price of the stock. Table 23.3 shows the control premiums for the Sheridan Acquisition Co.–Roberts Manufacturing Co. transaction.

SAC's proposed purchase price of $13.75 per share represents a 30% premium over the price the day preceding the announcement of the deal. It represents a 30% premium over the 12‐month high and a 49% premium over the 12‐month low.

Economics‐Based Measures

Despite their shortcomings, both the accretive‐dilutive test and comparable methods are useful tools in the decision process. The danger in placing too much reliance on these methods results from two factors. First, neither method reflects the full economics of the deal, since they do not utilize an appropriate measure of return on the capital invested. Second, the measures do not require explicit assumptions about the total performance of the combined businesses. Therefore, it is difficult to understand the performance expectations that are built into a comparables pricing analysis. How can operating managers understand what performance they are signing up for under these measures?

The use of the EPS accretive‐dilutive test and multiples pricing methods should be complemented by economic tools, including discounted cash flow (DCF). The DCF analysis should include a “base case” valuation and sensitivity/scenario analyses to understand the impact of critical assumptions on valuation. Similarly, acquirers should estimate the expected economic return using return on invested capital (ROIC) or similar measures.

Discounted Cash Flow. Discounted cash flow (DCF) should be an integral element of any valuation and certainly in acquisition analysis. The advantage in using DCF is that it requires managers to make explicit assumptions about future performance. We would start with the discounted cash flow projection presented earlier in Table 22.1. This DCF for Roberts Manufacturing Company would be for a stand‐alone or independent valuation, since we have not yet considered any changes that may result from an acquisition by another company. A simplified version of the stand‐alone DCF for Roberts Manufacturing Company is presented in Table 23.4.

We must now determine the potential value of Roberts Manufacturing Company if acquired by Sheridan Acquisition Co. There are two ways to estimate the economic value of proposed synergies. One method is simply to change the financial projections in the DCF for higher sales growth or reduced costs arising from the acquisition in the DCF analysis and record the revised value (Table 23.5).

The second method is to compute the economic value of each synergy directly. The projected cash flow for each synergy is discounted to estimate the economic value today in Table 23.6. Note that the two methods result in the same value.

Roberts Manufacturing Co.
Cost of Capital	12%
Tax Rate	34%
Synergy Valuation:		EBIT	EBIAT/CF	PV
Revenue	20.0	5.0	3.3	27.5
Cost Savings
G&A		2.0	1.3	11.0
R&D		1.0	0.7	5.5
Material cost savings		1.0	0.7	5.5
lant closings		2.0	1.3	11.0
Total		11.0	7.3	60.5
PV of Synergies			60.5
Less Working Capital on Revenue Growth	30%		−5.4(1)
Implementation Costs (synergies)	2.0		−1.3(2)
PV of Estimated Synergies			53.8		Excess/GAP
Control Premium ($m)			53.7		0.1

Notes

⁽¹⁾ $6m in year 2020, discounted for 1 period

⁽²⁾ $2m pretax in 2019

The value of equity from Table 23.5 is $240.2 million. This is consistent with the sum of:

The advantage in using the detailed synergy method in Table 23.6 is that managers understand the specific contribution to value of each projected synergy as well as the stand‐alone value of Roberts Manufacturing Company. This is useful in evaluating the probability and risks associated with each synergy. Not all synergies are created equal. For example, there may be substantially more risk associated with sales growth expected in three to four years. However, the probability of achieving expected administrative savings should be relatively high.

In addition to estimating the value of each synergy, this analysis indicates that the total value of estimated synergies approximates the control premium in this deal. Presuming that the market is valuing the Roberts Manufacturing Company at a reasonable economic value (indicated by the stand‐alone DCF analysis), the full value of potential synergies is being transferred to the shareholders of the selling firm. Comparing the value of potential synergies to the control premium is a useful test. The dynamics of this macro test are shown in Figure 23.2.

Combining the estimated stand‐alone valuation with the estimates of each projected synergy results in the DCF valuation summary in Figure 23.3.

Economic Profit Test. Another sobering test in M&A analysis is to estimate the economic profit required to earn an acceptable return on the capital invested to acquire the business. Management must earn a return at least equal to the firm's cost of capital to create value for shareholders. Table 23.7 illustrates the economic profit/ROIC test for the Roberts Manufacturing Company acquisition. The total economic purchase price of $243.8 million will include the market value of the target (stand‐alone), the control premium, and assumed debt. Based on the estimated cost of capital of 12%, the required economic profit can be computed and compared to the projections of the target and estimated synergies. In this case, the projected earnings before interest and after taxes (EBIAT) over the forecast horizon doesn't reach the required level to achieve economic breakeven until sometime beyond 2026. Consistent with this result, the analysis also indicates that the ROIC will not achieve the cost of capital of 12% until some point beyond the forecast period.

The management team of the acquiring organization has four options in this situation:

1. Consider reducing the acquisition price.
2. Walk away.
3. Increase the projected performance to justify the price.
4. Proceed with the transaction (and overpay).

Unfortunately, too often managers select either option 3 or 4. Many proceed with the deal terms and argue that the economic analysis is not relevant or indicative of the value in the transaction. Often, they argue that the deal is strategic and that the financial analysis does not properly capture the strategic value. If the financials do not fully reflect the strategic case and expected synergies, then they should be revised. In other cases, the financial projections are increased to support the deal price. Presuming that the base projections were realistic estimates of future performance, this option may increase the risk of failing to achieve the financial results.

Internal Rate of Return and Net Present Value Analysis. An acquisition of a company is a specific and complex form of a capital investment. Therefore, it should be subject to the same tests as a new product proposal, plant expansion, or other capital expenditures described in Chapter 20.

The NPV is a small positive result and the IRR just exceeds of the cost of capital of 12%. This test indicates that the economics of the transaction satisfy the economic tests, although marginally. These results in NPV and IRR are consistent with the economic profit/ROIC test that indicated that breakeven returns would not be attained until sometime after 2026. While technically satisfying the economic tests, management of Sheridan Acquisition Co. should consider whether the value created and returns earned are commensurate with the effort and risk in proceeding with the transaction.

Comparative Summary of Valuation Methods

We have reviewed a number of different valuation methodologies and metrics. It is helpful to summarize the indicated values from these differing methods, as illustrated in Figure 23.4. It is quite common for the methods to result in a wide range of potential transaction values. A useful exercise is to compare and contrast the estimated value ranges and understand the underlying factors resulting in wide valuation ranges and sometimes even inconsistent results.

Day of Reckoning for Underperforming Acquisitions

The goodwill resulting from an acquisition (illustrated previously in Table 18.3) will be tested for recoverability at least annually under the accounting rules affecting most organizations. This test will require an annual review to determine if the acquisition is performing at levels sufficient to justify carrying the assets on the balance sheet. The test utilized is essentially a market‐based valuation, often utilizing discounted cash flow analysis. This annual test has and will continue to result in a day of reckoning for many acquisitions. In fact, since the new standard was adopted, billions of dollars of goodwill have been written off, indicating that the acquisitions did not perform at a level that would earn an acceptable return on the original purchase price.

Poor Strategic Rationale and Fit

Some acquisitions are based on soft strategic cases. On the surface, the acquirer believes and articulates a strategy for the combined companies and points to synergistic benefits. Observers who are knowledgeable of the markets and the companies involved may recognize that the strategic case is weak and that some, or all, of the expected synergies may be difficult to attain. In these cases, a year or two after the deal is closed the company will announce that the acquisition is not meeting expectations and will have difficulty in achieving the strategic and economic goals.

Poor Planning, Communication, Integration, and Execution

Well‐planned and well‐executed integration activities and strong communication plans are essential to achieve the objectives of an acquisition. Most successful acquirers also value speed in integrating acquisitions. Time is money, and getting the benefits of the acquisition earlier is better. More important, there is significant uncertainty and concern in the management and employee ranks about the potential impact of an acquisition. The sooner changes are made, the sooner employees will settle down to the tasks at hand. In the absence of well‐planned, well‐communicated, and timely changes, employees will lose significant productivity to speculation and fear. In addition, many will explore opportunities outside the firm.

Failure to Anticipate and Address Soft Issues

People make acquisitions work. Too often, key managers are excluded from early stages of the M&A process. Unless everyone is in the boat and rowing hard, it will be difficult to make forward progress and achieve the challenging objectives of most acquisitions. Clear, timely, and well‐communicated decisions about organizational structure are essential.

Sound Strategic Justification

Acquirers always present a strategic case for a transaction. The key for managers, directors, and investors is to understand and test the strength of the strategic case. Most deals make sense, at least at a high level. Some questions to consider:

• Is this a move that is consistent with stated strategy and prior actions? Or did it come out of the blue?
• Does the acquisition address a competitive disadvantage?
• Does it leverage a key advantage?
• Does the acquisition accelerate progress on a key strategic initiative?

Discipline in Valuation

The objective of an M&A program is to acquire a strategic asset at a price that will create value for shareholders. It should not be to complete a transaction at any price. It is very useful to establish a walk‐away price at the beginning of an acquisition review. Managers and boards must not view walking away from a potential deal that is overpriced as a failure. After passing on or being outbid on a potential deal, managers do a lot of hand‐wringing and questioning. What is wrong with our valuation methodology? Are we too conservative?

Different buyers will determine value very differently. Some buyers will perceive and are also capable of realizing higher synergies from a potential deal than others. It is also possible that another buyer may not have priced the deal on a rational basis. Remember that most acquisitions are not successful, and many are overpriced. After one particularly emotional postmortem session with a management team over a deal that got away, some members of the team predicted that the buyer would have substantial difficulty in earning an acceptable return at the final price. Within a short time, the management team of the buyer announced that the deal would not meet expectations, wrote off the goodwill, and announced that the company was exploring “strategic options” for the unit. That company was available again, for substantially less than the value that would have been required to win the deal from an irrational buyer the first time around.

Identify Specific Synergies

Synergies must be specific. They must be supported by detailed estimates and implementation plans. There must be buy‐in by key managers, and accountability must be established. Incentive and compensation plans must incorporate key value drivers in the deal, including achieving projections.

Strong Acquisition Process

Companies with solid track records in M&A have a strong acquisition process. Candidates are identified in the context of the firm's strategic assessment and plan. These companies devote considerable attention and resources to identifying, evaluating, and valuing potential targets. Thorough due diligence is conducted, well beyond the legal and financial basics, to confirm key value drivers, including customer relationships and intellectual property. Synergies are confirmed and detailed execution plans are developed. Substantial effort is made to communicate the deal to key constituencies, including employees, customers, and investors. Integration is achieved as quickly as possible and monitored against the detailed implementation plans. Postacquisition reviews are conducted to ensure follow‐through and to identify lessons learned to improve the process for future transactions.

Identify and Address Key Issues before Finalizing Deal

Successful acquirers identify and address key issues before announcing and proceeding with a deal. These issues often relate to posttransaction organization and people issues. How will the combined organizations be structured? Who will be the CEO and CFO of the combined organizations? What will happen to redundant organizations and positions? Will compensation and benefit plans be changed?

Communicate with, Retain, and Motivate Key Human Resources

It is extremely important to reduce uncertainty in the workforce as soon as possible. Details of integration plans and combined organizations should be communicated soon after the deal is announced. Key employees must be signed up and on board on day one to ensure a smooth transition and integration. Employees whose positions will be eliminated should be informed and provided with details of termination dates and benefits.

“Dress Up the Performance”

Most sellers of businesses attempt to improve the performance of the business to increase the potential sales price. Obviously, it makes sense to paint the house and clean the carpets before listing the property. It also makes sense to address any areas that may detract from the value of a business that will be sold. However, no buyer would be happy if a major flaw was hidden by some surface paint. Similarly, potential buyers need to be thorough in their evaluation of businesses. For example, a business may be sold because of an emerging competitive or market risk. Other sellers may reduce investment in R&D or marketing to increase profitability in the short term; this may have a negative impact on the competitiveness of the company and future sales and earnings.

Meet the Current Plan

Sellers are advised to meet or exceed their current operating plan. Falling short of the current plan provides a potential buyer with an opportunity to question future projections and the ability of the organization to execute to those plans. Beware of either modest plans or Herculean, unsustainable actions taken to meet the current plan.

Sell through an Auction Process or Sell to Best Potential Parent or Partner

Sellers and their advisers recognize that they are likely to realize a higher selling price if they create a competitive bidding process. Many establish processes that encourage as many as 20 to 30 companies to consider preliminary bids for a business. Obviously, the relative bargaining position tilts to the seller in these situations. In addition, sellers should identify the best potential parents or strategic partners, since those parties are likely to identify the highest level of potential synergies and therefore to offer a higher price.

Sell into a Strong Market

This is a variation of the investment advice to “buy low and sell high.” Where possible, managers tend to offer businesses for sale at the top of valuation/market cycles. If the company is cyclical, the valuation will be substantially higher at the top of the cycle than at the bottom. There have been dramatic swings in the values of companies over the past 20 years, and only a small part of the variation can be explained by the underlying performance or prospects of the companies.

Effectiveness of M&A Process

Companies that are serial acquirers should look at the performance of each of their acquisitions to evaluate the overall effectiveness of the entire process. Are we achieving the sales, profits, and returns anticipated in the acquisition proposal? What is the level of intangible assets arising from acquisitions? Have these acquisitions resulted in subsequent write‐down of goodwill? This evaluation may identify potential improvement opportunities in the acquisition process.

Actual versus Planned Sales and Profits. Compare the actual sales to the level planned for in the acquisition proposal for the current year. Are the acquisitions achieving the sales estimates in the plan? If not, then the team should identify the reasons for the shortfall and consider these in future acquisition proposals.

Actual versus Planned ROIC. Are the acquisitions achieving the return on invested capital (ROIC) projected in the acquisition proposal? ROIC is an important measure in M&A since it reflects the invested capital in the transaction. Again, what can we learn to improve our process for future acquisitions?

Goodwill and Intangibles Turnover. This measure provides a view into the relative significance of acquisitions to the firm. For highly acquisitive firms, this ratio will likely be low and will have a significant impact on return measures such as return on equity (ROE) and ROIC.

Asset Write‐Offs and Impairment Charges. Goodwill impairment charges result from acquisitions failing to perform to expectations that supported the original purchase price. Significant charges to write off or write down assets may indicate an ineffective decision or implementation process for capital investment. Companies that have frequent asset write‐offs and impairment charges (and other nonrecurring charges) likely have an opportunity to improve capital investment, acquisition, and strategic processes.

Specific Acquisitions

The following measures are intended to provide real‐time feedback on the performance of a specific acquisition. The objective is to select measures that provide a leading indication of progress toward achieving the financial and strategic objectives of the transaction.

Progress on Key Acquisition Activities. During a sound acquisition process, a number of actions are identified that are vital to achieving the objectives of the acquisition. These may include retention of critical human resources, benefits integration, consolidation of the sales force, and manufacturing plants. Progress on these action plans is a leading indicator of being able to achieve the financial goals of the acquisition.

Acquired Sales and Synergies. Most acquisition plans anticipate growing the acquired sales base from the time of the acquisition and realizing revenue synergies from the combined companies. Both components of sales growth should be closely monitored on a frequent basis.

Annualized Cost Synergies Achieved. Cost savings from combining organizations are an important contributor to the economic success of the merger or acquisition. Progress toward achieving the annual synergies included in the acquisition proposal should be tracked frequently (e.g. monthly or quarterly).

Key Human Resources Retention. The success of most acquisitions is predicated on retaining and motivating key human resources. Key human resources may include some or all of the executive team, functional managers, and technical, manufacturing, and customer relationship personnel. During the acquisition planning process, these individuals should be identified and a program put in place to encourage continuation of employment. Success in retaining the key people should be closely monitored.