M&A Selection Criteria & Evaluation Process: Transaction Analysis

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.

Public Comparables

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.

Transaction Comparables

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.

Subscribe Paloe

Thank you for reading! Like our content?

Sharpen your finance acumen through our FREE WEBINARS. Sign up for our mailing list and we’ll inform you about any future events or webinars.

Free Webinars

Optimise your company’s finance functions with a FREE 1-hr consultation

Related content

Here are similar contents you might like:

Tips to improve your “work from home” productivity

Working from home offers flexibility and convenience, but it also presents unique challenges when it comes to maintaining productivity. With a few simple adjustments to your routine and environment, you can maximize your efficiency and achieve your professional goals. Let’s explore four practical tips that can help you stay on

Read More >

Two types of online shopping and how they can help your business

How the pandemic has affected market preferences in online shopping It is not foreign to hear of people shopping online nowadays, especially after the pandemic has affected other transaction methods except online transactions. The online shopping experience, too, has evolved since then as more users are using c-commerce. There are

Read More >

What does building a full-fledged software looks like?

Imagine one day you woke up with a brilliant idea, and you’re excited to build a software around it, what would be your next step and how can you build a full-fledged, sustainable software product? Building a full-fledged and sustainable software is not just about code development (programming). It is

Read More >
Open chat
Hi I'm Sam! How may I help you today?