Article discusses valuation in a Merger and Acquisition Setting

1. A Mergers & Acquisitions
Valuation Toolbox for
Corporate Development
Professionals
Dominic Brault – dbrault@srr.com – 216.373.2984
Over the last several years, Stout Risius Ross, Inc. valuation tool utilized by management and the
(“SRR”) has completed hundreds of transaction advisory Board of Directors to assess the economic merits
engagements which has provided the opportunity to of a transaction
identify critical valuation success factors employed mostly
■ Finally, comparable market multiples and
by ‘serial acquirers’ that can be applied to improve the
acquisition premiums are used by the more
mergers & acquisitions (“M&A”) process for all corporate
proficient acquirers to validate the final
development professionals. By way of this repository of
contemplated purchase price
experience, SRR knows there are valuation best practices
that produce consistently higher quality financial analyses, Comprehensive Projections
which consequently may help reduce the risk, time and Set the Valuation Foundation ■ ■ ■
costs associated with M&A transactions. Several of these
best practices to better support a target company valuation The best-in-class acquirers focus their initial efforts on
in the M&A arena include: developing very detailed cash flow projections, including
comprehensive synergy and sensitivity analyses. The best
■ Leading companies develop detailed and projections are always fully integrated with income
integrated cash flow projections, including statement and balance sheet projections and result in an
synergies and sensitivities, since they are the automated cash flow statement. The projection time frame
focal point of a complete valuation typically ranges from five years to ten years, with long-
■ Top companies identify the ‘next likely buyer’ term growth expectations (based on market research)
in order to understand the competitive established for the time horizon beyond the discrete
bidding landscape projection period.
■ Best-in-class acquirers employ a thorough Internal The income statement models are built upon detailed
Rate of Return (“IRR”) analysis, which – in conjunc- revenue (e.g., SKUs, price and volumes) and segment
tion with the cash flow projections – provides a ‘build-ups’, supported by specific customers or product
spectrum of potential purchase price alternatives opportunities, as well as industry, competitor and market
and is a critical component of the valuation analysis share forecasts. The best-of-class will also forecast
■ Leading companies also typically develop an expenses on a line-item by line-item basis as well as build
accretion / dilution model, which is an important out comprehensive working capital, capital expenditure
and depreciation estimates.
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2. Any changes to the base case assumptions can greatly alter the have the discipline to not pay more than an acquisition is worth
ultimate target valuation. The ‘serial acquirers’ are aware of this to them, the “art of the deal” is to also not pay significantly more
and use sensitivity analysis to present a best- and worst-case than what the ‘next likely buyer’ could pay even though a higher
scenario. More importantly, they build a rigorous model that price may be justified due to potential certain synergies or a lower
features expected synergy opportunities. This model is compiled cost of financing, etc.
by the corporate development staff or transaction team with
considerable input and execution accountability from operations The ‘next likely buyer’ can be a strategic or financial buyer or
(i.e., sales, human resources, manufacturing, engineering, etc.). both since many financial buyers use strategic portfolio companies
Common synergies include cross-selling opportunities, sourcing to make the acquisition. Since it can create additional value from
savings, headcount reduction, manufacturing rationalization, an acquisition through synergies combined with its typically low
integration costs, process improvements, working capital discount rate, the strategic buyer can oftentimes substantiate a
management and tax savings, among many others. Consideration higher price than a financial buyer. Financial buyers, such as private
of negative market reaction such as potential lost customers is equity firms, use a combination of their firm’s capital and bank
also an important factor. As demonstrated in the chart, sensitivities debt supported by the target’s cash flow to fund acquisitions.
are occasionally performed based on probability of synergy Since this type of buyer aggressively uses bank borrowings in
capture – from “low hanging fruit” to long-term, difficult deals, they tend to be very aggressive bidders for companies with
synergy projects. positive cash flow. Most financial buyers require an annual
return on equity ranging from 20% to 30% over the investment
horizon, usually up to seven years. During the valuation process,
Best-In-Class Typical Cash Flow Scenarios acquirers should run an LBO model using conventional
assumptions in order to gain insight into the likely offer price of
Synergies
a financial buyer. On the other hand, it is much more difficult to
Without Synergies With Synergies
understand a strategic buyer’s offer without conjecture about
Base Best
likely synergies, unless the expected bidder is a direct competitor
Case
Best
Scenario 1 Scenario 2
in which case synergies could be estimated. As an alternative to
predicting synergies, companies can research comparable
Sensitivity
acquisition premiums or precedent transactions (discussed later)
Case
Base
Scenario 3 Scenario 4
in order to assess potential strategic value.
Worst
Case
Scenario 5 Scenario 6
Next Likely Buyer Analysis
Strategic Financial
Most skilled acquirers also determine what synergies are ‘buyer- Typical Required Returns on Equity 10% - 14% 20% - 30%
specific’ and unique to them and therefore would not be realized
by any other possible acquirer, as these synergies should be Use of Leverage Varies >50%
excluded from any analysis applied to derive the purchase price Possible Synergies High Nominal
(discussed later). ‘Buyer-specific’ synergies should only be
Investment Horizon Long 4 - 7 Years
considered in determining the overall return on the investment.
The value of other general synergies, characterized as ‘market-
participant,’ will frequently accrue (to some degree) to the The market environment can also provide insights into the ‘next
selling shareholders in a form of a higher purchase price (i.e., an likely buyer.’ Until recently, a weak economy and flat stock
acquisition premium to intrinsic or stand-alone value). market kept many strategic buyers on the sidelines, even with
record low interest rates. At the same time, private equity funds
A Bid Through the Eyes
competed against each other for targets, driven by large amounts
of the ‘Next Likely Buyer’ ■ ■ ■
of uninvested capital and the favorable credit markets. In many
It is important to identify who the ‘next likely buyer’ is in order cases, the financial buyers outbid strategic buyers despite lacking
to understand the competitive landscape, since there may be vast synergy value. Over the last year, the dynamic has shifted and
differences between the price one company can pay versus the private equity firms are currently having difficulty borrowing
price another can pay. In the end, a critical success factor in money in the wake of the sub-prime mortgage crisis. As a result,
M&A valuation is not only figuring out the maximum price your corporations with strong balance sheets have been able to do
company can pay but also attempting to quantify the maximum deals, in spite of weak equity prices, without as great a risk of
price of the ‘next likely buyer.’ While the acquirer should then getting outbid by financial buyers.
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3. Top Acquirers Set the Price ‘buyer-specific’ synergies or out-performance of the base case
Based on a Returns Analysis ■ ■ ■ projections would be considered ‘deal alpha’ or additional return
that accrues to the acquirer’s shareholders.
To this point in the valuation analysis, the buyer has developed
detailed projections combined with a ‘scenario analysis’ and has The goal of any acquisition is to maximize ‘deal alpha.’
developed a good understanding of the competitive bidding
In other words, in a strategic transaction with any expected
landscape. However, in order to calculate a purchase price offer
synergies, tremendous shareholder value or ‘deal alpha’ is created
and evaluate the potential investment, most leading companies
if the price paid is less than or equal to the stand-alone value.
rely on a detailed IRR or returns analysis. The real challenge is
making sure the price paid does not exceed the economic value The chart below demonstrates how the IRR analysis yields a
to the buyer. spectrum of potential purchase prices. For example, if an
acquirer prices the deal based on its own cost of capital and full
Selecting the proper discount rate is the first step in the IRR
synergy cash flow projections (see ‘Highest Justifiable Purchase
analysis and is critical to making the right pricing decision. The
Price’ on the chart), the purchase price borders overpayment.
discount rate can range from a low of the acquirer’s weighted
This should only be done if the buyer feels the auction is very
average cost of capital (“WACC”) to a high of the target’s stand-
competitive and that the acquisition is integral to their overall
alone WACC. In most instances, the investment hurdle rate falls
strategy. Any price paid based on assumptions below the
somewhere in between. Specifically, an investment’s hurdle rate
acquirer’s WACC or above the full synergy model will likely
is typically equivalent to the acquirer’s cost of capital or WACC
destroy shareholder value. Conversely, a transaction that is based
plus a risk premium to reflect the target’s specific risk characteristics.
on very conservative assumptions and a high expected rate of
The risk premium should include any sources of additional risk
return will almost always be very accretive to the acquirer (i.e.,
that are specific to the target, such as lack of management depth;
high ‘deal alpha’). The red and blue ovals signify the customary
lack of product, industry and geographic diversification, etc. In
range of purchase prices offered by strategic and financial
addition to these factors, a small stock risk premium (above the
buyers, respectively. As illustrated, the financial buyers typically
returns on large-cap companies such as those in the S&P 500)
offer lower prices due to their lack of available synergies and
may be present, since investments in small companies are clearly
leverage limitations.
riskier than investments in large companies, everything else held
constant. In a lot of instances, the size risk premium can be
significant, but is oftentimes ignored by the acquirer, since the Spectrum of Potential Purchase Prices
target usually becomes a subsidiary of a larger, more diversified
organization. Based on information compiled by Morningstar,
Inc., the historical additional size premium on equity for companies
with a market capitalization of less than $365 million is greater
than 6%1. A frequent error made by strategic companies is pricing
transactions at their own WACC exclusive of any extra risk
premium, which ultimately results in potential overpayment and
makes hitting the projections all the more important. The acquirer’s
lower WACC can be considered a financial synergy and utilizing
it to price a deal effectively transfers the financial synergy to the
seller in the form of an incremental purchase price increase.
Another important aspect of the IRR analysis is to identify which
cash flow stream to use in order to develop a purchase price. As
discussed previously, companies should not include ‘buyer-
specific’ synergies in the returns analysis, in order to prevent
these synergies from accruing to the selling shareholders in the
form of a higher purchase price. Instead, the best-in-class Lastly, the most knowledgeable acquirers properly modify
companies will value the target using the base case projections, the IRR analysis for an asset or stock deal structure. In an asset
plus ‘market participant’ synergies (see red oval in the chart). As deal, the value of the target has increased because the buyer is
a result, the calculated purchase price includes a premium to allowed to write up the basis of an asset to the fair market value
stand-alone value, which is almost entirely equivalent to the paid for the asset, which results in lower taxes due to higher
‘market participant’ synergy value. Also, in this scenario, any tax depreciation.
1 Morningstar, Inc., Stocks, Bonds, Bills, and Inflation Valuation Edition: 2008 Yearbook, (Chicago: Morningstar, Inc., 2008).
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4. Accretion / Dilution ■ ■ ■ For example, let’s assume the deal is priced at 10x EBITDA and
implies a 40% premium. How do you know this is reasonable?
Most strategic buyers, especially those that are publicly-traded, The first test is to compare the implied multiple on the proposed
are sensitive to earnings per share (“EPS”) and will not make an transaction of 10x to multiples of: a) comparable publicly-traded
offer that causes EPS to be diluted for an extended period of peers and b) recent similar M&A transactions, keeping in mind
time. As a result, the best-in-class companies build dynamic that the multiples implied by transactions will include some level
accretion / dilution analyses, incorporating cash flow and synergies; of control / synergy premium whereas the multiples of the
form of consideration (i.e., cash versus stock); and amortization publicly-traded peers will not. Under both methodologies,
of intangibles and goodwill; among other considerations. differences between the risk and return characteristics of the
target company and the selected comparables must be considered.
Out of all of the model variables, the purchase price allocation
The second test is to compare the implied deal premium of 40%
has one of the more significant impacts on the accretion / dilution
to premiums observed in acquisitions of publicly-traded companies.
analysis through the identification of amortizing intangible
Such premiums can be examined by type of interest (controlling
assets and the ‘step-up’ of fixed assets, which results in higher
vs. minority), transaction size, industry, type of transaction (e.g.,
depreciation and amortization expense. However, estimating
go private), etc.
post-transaction accounting adjustments can be a complicated
process, as most adjustments are deal specific and dependent Conclusion ■ ■ ■
upon numerous variables (e.g., purchase price paid, specific
assets acquired, expected synergies, asset valuation methodologies, The valuation of a potential target in a competitive process can be
accounting promulgations, etc.).2 As a result, the proficient a complicated exercise. Making it more difficult is the fact that
acquirers often engage a third-party valuation consultant prior to the buyer is simultaneously working with tight deadlines and
the close of the deal in order to obtain an informed estimate of performing a lot of other due diligence. Further, some companies
post-transaction adjustments, which in turn improves the accuracy decentralize the M&A process, where business unit heads take
of any pre-transaction analysis presented to the Board and may the lead, which produces more stress as these individuals have
help mitigate the risk of entering into a potentially dilutive many other operating priorities. In order to streamline the
transaction. For example, the detection of in-process R&D, an process, the best-in-class companies take a comprehensive and
intangible asset that under current accounting conventions must be consistent approach to valuation issues, such as the projections,
expensed at the time of the deal, could make a deal very dilutive. competitive environment, hurdle rate, IRR, LBO, accretion /
dilution, pre-emptive purchase price allocation, and reasonable-
An accretion / dilution analysis certainly has its limitations, as it ness check analyses. By applying these best practices and strict
does not focus on fundamental value and is performed over a valuation process discipline, corporate development professionals
limited time frame (typically 1-2 years). Moreover, the EPS of a and Boards can steer their companies to the best acquisitions at
firm are impacted by accounting conventions and regulations. the right price.
Some argue that the market is savvy or efficient enough to ‘see
through’ this analysis, but the fact is that accretive transactions For many companies, recognizing that the M&A process is
are generally well received in the market. Additionally, the complex, outsourcing key services, such as the valuation, may
market will ‘forgive’ dilutive deals if clear rationale is given or if make sense. An acquirer that hires a third-party valuation expert
the company can earn its way out of dilution within a reasonable that is well versed in these types of transactions can help ensure
period of time. Despite its shortcomings, the leading companies they enter deals that create shareholder value (or generate high
will utilize this analysis since EPS is a key measure on Wall deal alpha), not destroy it.
Street, and it can serve as a proxy for the creation / destruction
of shareholder value.
Results can be Tested Against Market
Multiples and Acquisition Premiums ■ ■ ■
Testing for reasonableness is another best practice that we have
observed in the corporate M&A field. After deriving a purchase
price, the best-in-class companies compare it to prices or premiums
paid in the market for similar assets. It is important to note that
a bid price’s failure to pass the test (i.e., high implied premium)
does not automatically mean the value is unreasonable, rather
further justification is required.
1 Dominic Brault and Jason Muraco. Purchase Accounting: Corporate Development’s Bane. Mergers & Acquisitions Journal (May 2008).
©2008