The final stage of the M&A evaluation is determining how much to pay for the Target. The greatest risk of any deal is paying too much. As such it is imperative to determine what is the fair value of the Target and whether the purchase price is fair and attractive to the Acquirer.
When performing a valuation on the Target, there are several methodologies that should be considered to determine what is a reasonable value. The common methods are the (1) discounted cash flow analysis, (2) internal rate of return analysis and (3) public comparables.
Discounted Cash Flow Analysis
Under the discounted cash flow (DCF) model, the target firm’s intrinsic value is estimated using the future cash flow that is available for distribution to investors of the firm. Free cash flow, as it is known, is derived from taking the operating cash flows and deducting reinvestment in long-term assets and working capital in the future. The free cash flow of the Target is discounted to the present value using the Target’s cost of capital, on the assumption that the firm will continue to operate into perpetuity by using a sustainable long term growth rate. A good estimation of future free cash flows will incorporate both the macroeconomic conditions and understanding of the drivers of the business.
Internal Rate of Return (IRR) Analysis
The concept of the IRR is to estimate what is the implied return on investment that the Target can generate to break even on the initial purchase consideration. This is done in conjunction with the forecasts of free cash flow. The rate of return calculated is compared to the cost of capital that the Acquirer incurs to raise the funds necessary to purchase the Target. The IRR should be equal or more than the cost of funds that the Acquirer incurs to be considered reasonable.
Using this methodology, the fair value is derived from the trading multiples of listed companies that operate in the same industry as the Target. Common multiples include the Enterprise Value to EBITDA ratio and the Price to Earnings ratio. An industry average of the ratios is derived and compared with the Target to estimate how much the public stock market is valuing the Target.
The Acquisition Premium
Fair value represents the minimum price that a rational seller would accept in the exchange for the loss of the benefit of ownership of the firm. Although it is the starting point of a transaction, a premium above the fair value is usually paid by the Acquirer to entice the Target shareholders to relinquish their control.
To justify why the Acquirer would pay more than what the Target is worth, there must be an additional value that arises when the two firms combine. The additional value comes from either revenue or cost synergy. Revenue synergy is created when the combined firm can generate greater sales than if they were separate. This can be achieved through activities like cross-selling of products among the two firms or greater market power. Cost synergy is achieved by having better economies of scale due to a larger volume of activity.
As a rule of thumb, the additional price paid for the Target should not exceed the present value of the synergies of the combined firm. Otherwise, the Acquirer face overpayment which results in loss for their shareholders.
One method to measure how much premium to pay for the Target is to make use of comparable multiples of previous M&A deals that are similar to the Target. Common multiples include the Transaction Value-to-EBITDA ratio and Offer Price-to-Earnings ratio. The process to derive the purchase price for the Target is similar to that of the public comparables method. However, the value derived here includes the premium paid to the Target.
With many methodologies to choose from and difficulty in forecasting a firm’s performance, executives should recognise that valuation is both an art and a science. After all, the true value of a firm lies in the eyes of the beholder as different managers can deploy the assets in unique ways to generate varying returns. The final purchase price decided is dependent upon the negotiation process which varies according to the needs of the parties involved.