The principles of valuation do not change when you value acquisitions. However, the fact that two firms are combining can create a potential for additional value from synergy. In some cases, if the target firm is poorly managed, there may also be potential for changing the way it is run and capturing the additional value as the value of control.
The steps are not necessarily sequential. Some firms choose a target and a motive simultaneously. Other firms may base how much they are willing to pay and the mode of payment after choosing the accounting method to use to account for the acquisition.
An acquisition can have more than one motive. If the true motive is managerial self-interest, it will not be presented as the rationale. Instead, managers will concoct another more acceptable motive for the acquisition.
The right target firm will vary depending upon the motive. A firm with a well thought out acquisition strategy will focus on the target firms most consistent with that strategy.
How much value you add to the target firm’s stand alone value will depend upon the motive for the acquisition. The key, though, is that you have to value synergy or control… You cannot pay a premium on faith or story…
You can think of acquisition valuation in these three steps. By doing so, you can clearly isolate the value of synergy and control, which then allows you to answer the key questions: How much is synergy and control adding to value? Who (the bidder or the target) is more responsible for creating this value? How should the increase in value be shared between the bidder and the target?
Note that AT&T paid $14 billion for NCR and justified in on largely unspecified synergies. This analysis suggests that they overpaid. If AT&T paid $11.279 billion, note that the entire benefits of synergy and control accrue to NCR’s stockholders. How would AT&T’s equity value be impacted by the payment of $ 14 billion? We would expect the equity value to drop by $ 2.721 billion ($ 14 billion - $11.279 billion)
There is a selection bias. When a firm offers its stock as currency, there is a much greater chance that the managers of that firm think their stock is over priced than underpriced. Consequently, target firm stockholders should demand larger premiums in stock-based acquisitions (and the evidence suggests that they do…) The zeal on the part of many firms to qualify for pooling and the tax advantages may provide a better set of reasons for the use of stock.
When stock is offered for stock, the key in analyzing who wins and who loses in the acquisition is the exchange ratio.
For decades up until 2001, many firms in the United States preferred to use pooling because there is no goodwill created and no earnings effect in subsequent period. Empirical studies indicate, however, that markets do not punish those firms that chose to use purchase accounting and reported lower earnings in the following periods. Starting in 2001 pooling will no longer be allowed and goodwill gets amortized over a shorter period.
Contrary to widely used rules of thumb, the value of control is not a fixed percent of firm value. It arises from the fact that some firms are not optimally run and changing the way they are run can create additional value. Since control requires changing the way a firm is run, it is more likely to be a factor in hostile takeovers than friendly ones.
Notice that the typical target firm in a hostile acquisition is not a well-run, well-managed firm but a poorly run firm, with sub-par returns on equity, poor stock price performance and little insider holdings. In other words, target firms in most hostile takeovers deserve to be taken over.
Evidence that things change after acquisitions. Target firms become more focused and profitable after hostile takeovers with new management in place.
The return on capital is below the cost of capital and the firm has a low debt ratio….
Status Quo valuation of the firm. We are assuming that the firm’s current return on capital and cost of capital will continue in perpetuity.
We computed the optimal debt ratio to be 20%, which lowers the cost of capital. We are assuming that Digital will take neutral investments (rather than the poor investments we assumed in the status quo valuation).
The value more than doubles….
The key to synergy is that it is created only by the combination of the firms… each firm standing alone would not be able to produce it.
If synergy takes time to take form, it will be worth less…. In simple terms, you would have to discount it back…
You have to do three valuations to value synergy and you have to quantify the impact of synergy into valuation inputs.
The inputs that you will change in step 3 of the last page will depend upon the form that synergy takes. If managers claim not to be able to quantify synergy, I would be skeptical about its existence.
Notice that when shares are used in an acquisition, the price paid will change as the stock price of the acquirer changes on a day-to-day basis.
Fundamentals for Compaq and Digital…
Value of Compaq standing alone.
We quantify the impact of synergy on the inputs to the valuation. Note that we use Digital’s optimally managed inputs to prevent double counting the value of control.
The value of the combined firm with synergy built in…
Leading to a dollar value for synergy. Can the value of synergy be negative? Yes, if the combined firm will result in a less efficient firm…..
This is the maximum price that Compaq can pay. If you were a Compaq stockholder, you would like them to pay less to claim some of the value of control and synergy.
Answer to a: (6963 - 1006)/146.789 = $40.58 per share Answer to b: 40.58/27 = 1.5029 Compaq shares per Digital share
Compaq paid too much….
On the day that this merger was announced, the combined value of these firms increased by $ 14 billion….
Answer to the first question: 155.84/46.38 = 3.36 Traveler’s shares/ Citicorp share Looks like Sandy Weill (Traveler’s CEO) won out.. Too few Traveler’s shares for every Citicorp share.
The increase in value of $ 14 billion can be justified by a 2% increase in return on equity. This sounds fairly small but given the size of these firms, this would require an increase in net income of $ 800 million… Cost cutting alone will not do the trick.
Financial synergies are usually much more focused that operating synergies and easier to value.
There may be value created from diversification at closely held or private firms. Using the total beta calculation in private firm valuation (see notes for private firm valuation), the payoff to diversification will show up in the total beta being smaller after diversification. This will increase the value of the firm.
Firms do have capital rationing constraints, internal as well as external. Firms with excess cash may be able to take over firms without cash and increase value… This motive can be particularly important in poorly developed capital markets (emerging markets, for instance) or in periods of crisis where it is difficult for firms to raise new debt or equity.
The value of the cash slack can be traced to the projects that can be taken after the acquisition that would not have been taken before.
The tax code can have consequences. In fact, poorly written tax code is often the source for at least a few lucrative deals before the government catches on.
Tax benefits assuming instantaneous deduction = 0.36 (2000) = $ 720 million If Best Buys has only $ 500 million in taxable income, I would take the present value of the tax benefits over four years. ($ 180 million a year for four years) The discount rate I use will reflect the uncertainty there is in the level of the taxable income. In general, since the taxable income is equity income (after operating expenses and interest expenses), you should use the cost of equity. Even after valuing the synergy, you should be careful not to add it on to the market price, because the price may already reflect the expected tax benefits from the net operating loss.
The tax reform act of 1980 allowed for a loophole which was exploited to write up the assets. You can no longer do this on all assets in the U.S. In other countries, such as Brazil, this is still allowed.
More than 10% of the total price paid reflects the present value of the tax benefits from the additional depreciation.
This is another potential benefit from diversification…. Of course, if you believe in Miller-Modigliani, the value of this synergy would be zero.
The key is that the firms standing alone have much lower debt capacity (as a percent of firm value) than the combined firm…. The reason that the combined firm may be able to borrow more is because it has less volatile earnings (the diversification effect).
The cost of capital changes slightly over time because the firms are growing at different rates and the weights on the two firms varies over time.
The increase in debt capacity increases firm value by more than $1.5 billion. This increase will be largest in conglomerate mergers of small, risky firms…
There is evidence that the market believes that there is synergy at the time of the merger…..
Though there is little evidence of it in performance post-merger…. The performance of firms after mergers suggests that it is difficult to make mergers work. In general, Mergers of equals are less likely to work than mergers of unequals - the political and cultural clashes are much more difficult to resolve. Cost saving mergers seem to have better odds of success than growth synergy mergers. (Perhaps cost savings are more tangible and easier to deliver) Some of the most successful acquisition strategies have been directed towards acquiring private firms where you do not have to pay a premium on the market price. Mergers are more likely to work when firms plan for synergy before the merger rather than just hope that synergy shows up.
And most synergy benefits end up with the target firm’s stockholders….