MERGERS & ACQUISITIONS

(M&A) VALUATION

In this Mergers & Acquisitions (M&A) Valuation module, we will describe the
background for M&A banking that most investment bankers will need to
know—particularly from the perspective of valuation. We will cover three key
topics:
• M&A Overview
• Building an M&A Model
• Accretion/Dilution Analysis

M&A Overview

There are a variety of ways to value a company. The valuation methods

include:

Each of these topics, including Acquisition Comparables, is very important in

investment banking and is discussed in a previous module in this training
course. In this module, we will concentrate on Merger Analysis, also known as
Merger Consequences Analysis.

M&A BACKGROUND

A merger is the combining (or “pooling”) of two businesses, while an

acquisition is the purchase of the ownership of one business by another.
Pooling of Interest Accounting, which is how mergers used to be
accounted for, is no longer allowed by the Financial Accounting Standards
Board (FASB) in the US, and was also disallowed by the International
Accounting Standards Board (IASB) for international companies. As a result,
M&A transactions must now be accounted for using the Acquisition
Method of Accounting (a slightly revised version of the Purchase
Method of Accounting). This all can be very confusing, because the word
“Mergers” is frequently used to describe either type of combination of two
business, but all combinations must now be treated as the purchase of one
company by another (in other words, as “Acquisitions”).

Regardless, M&A banking involves analysis for scenarios in which one

company (the Buyer) proposes to offer cash or its own common stock in
order to purchase the common stock of another company (the Seller or the
Target). M&A typically requires the target company’s Board of Directors and
its shareholders’ approval (except in the case of a Hostile Takeover, in
which one company acquires enough stock in another company to control it,
against the wishes of the target’s management and/or shareholders).

REASONS FOR PURSUING M&A

M&A is a corporate strategy that may increase value for the acquirer by
creating an important value driver known as Synergies (ways to increase
profit/earnings through an acquisition), among other reasons. Synergies can
arise from an M&A transaction for a variety of reasons:
o Increase and diversify sources of revenue by the acquisition of new and
complementary product and service offerings (Revenue Synergies)
o Increase production capacity through acquisition of workforce and
facilities (Operational Synergies)
o Increase market share and economies of scale (Revenue
Synergies/Cost Synergies)
o Reduction of financial risk and potentially lower borrowing costs
(Financial Synergies)
o Increase operational efficiency and expertise (Operational
Synergies/Cost Synergies)
o Increase Research & Development expertise and programs
(Operational Synergies/Cost Synergies)

The acquisition of another company may also be defensive in nature. For

example, a large company may wish to acquire a small but growing company if
the small company has a substantial competitive advantage over the large
company, such as an important technology or patent, or superior product
offering. This may protect the acquirer from serious competitive
consequences, as the small company may over time be able to grow on its own
and eat into the large company’s business.

MERGER ANALYSIS

Investment bankers put together merger models to analyze the financial

profile of two combined companies. The primary goal of the investment
banker is to figure out whether the buyer’s earnings per share (EPS) will
increase or decrease as a result of the merger. An increase in expected EPS
from a merger is called Accretion (and such an acquisition is called an
Accretive Acquisition), and a decrease in expected EPS from a merger is
called Dilution (and such an acquisition is called a Dilutive Acquisition).
A Merger Consequences Analysis consists of the following key valuation
outputs:
o Analysis of Accretion/Dilution and balance sheet impact based on pro
forma acquisition results
o Analysis of Synergies
o Type of Consideration offered and how this will impact results (i.e., Cash
vs. Stock)
o Goodwill creation and other Balance Sheet adjustments
o Transaction fees

These will all be encapsulated in the M&A Model, discussed in the next
section. An investment banker begins to evaluate a potential M&A transaction
by referring to a set of questions that will likely include the following:

• Who is the Seller?

Publicly traded stock, or privately held?
Insider ownership or sizable public float (i.e., is a large portion
of the company’s shares available for sale in the open market)?
• Who are the potential Buyers?
Strategic Buyer (an existing company able to gain from potential
synergies)?
Financial Sponsor (a Private Equity firm looking to generate an
attractive return via a Leveraged Buyout)?
• What is the context of the transaction?
Privately negotiated sale or auction?
Hostile or friendly takeover?
• What are the market conditions?
Acquisition currency (Cash or Equity)?
Historical premiums paid for Comparable Transactions?

There are also various types of M&A transactions that can occur, both in terms
of the dynamics of the transaction and the structuring of it. An M&A banker
will need to know all the important distinctions among these types of
transactions:
Remember that the M&A Consequences Analysis used by investment bankers
is both an art and a science.

Building an M&A Model

The central piece of the analysis behind M&A advisory services offered by
investment banks is the M&A Model. Any junior investment banker involved
with a potential M&A transaction will spend many hours building and refining
these models! The basic steps to building an M&A Model are as follows:

The Pro Forma Company is the combined entity (the acquirer) after and
assuming that the proposed transaction takes place. The differences in the
financial attributes of this Pro Forma Company relative to the acquirer itself
(before the transaction) will be a key part of the decision whether to go
forward with the proposed transaction (for both the Buyer and Seller).

DETERMINING THE PURCHASE PRICE AND CONSIDERATION

The Buyer in an M&A transaction intends to benefit from transaction by

increasing the value available to its existing shareholders (otherwise, the
shareholders are unlikely to approve it). By acquiring all of the shares of the
Target company (or at least enough shares to gain control of it), the buyer is
willing to pay a Control Premium. A Control Premium is the price paid
above market value for a Target public company in order to gain control of the
company. Here is a simple example of the control premium:

Company X offers to acquire Company Y for $50 per share. The

current share price of Company Y prior to the announcement of
the offer price is $40. Therefore, Company X offers a 25% premium
over the current market price ($50 ÷ $40 – 1) to gain control of
Company Y.

A critical component to evaluating an M&A transaction is to determine

the Purchase Price for the Target company. In particular, how much of a
Control Premium should be paid for the Target (relative to the current
valuation of the target)? One very important method is to look at
recent Comparable (Precedent) Transactions to determine how much of a
premium has been paid for ownership of other, similar companies in recent
M&A transactions. Other methods used to establish a fair value for a target
company in an M&A transaction include:

• Comparable Company Analysis

• Discounted Cash Flow Analysis

• Accretion/Dilution Analysis

Typically, all of these valuation methods will be used to value the equity of the
target company. These methods will hopefully lead to a reasonable, narrow
range of Purchase Prices and Control Premiums for the Target; it will then be
up to the management of both the Buyer and Target (along with their
respective M&A investment banking advisors) to argue for and agree upon a
precise price/premium.

An additional, important issue is the type of consideration being offered to the

Seller’s shareholders. The Buyer can offer Cash, Equity (shares of the Buyer’s
common stock) or a combination of both as the consideration for the Purchase
Price. Which should the Buyer use? Typically, if the Buyer’s current stock
price is considered undervalued relative to its peers, the Buyer may decide to
not use Equity as consideration, because it would have to give the
stockholders of the Target a relatively large number of shares to acquire the
company. On the flip side, the Target shareholders may want to receive Equity
consideration in this case, because they might feel it is more valuable than
receiving Cash.

Conversely, if the Buyer feels that its current stock price is trading at high
levels, the Buyer will likely want to use Equity for the consideration of the
Purchase Price, because issuing new stock for the transaction is relatively
inexpensive (i.e., the stock has a high value in dollar terms). The Target,
meanwhile, might be hesitant to receive the Equity as consideration in this
case; depending on the terms of the deal, the Seller’s shareholders may end up
suffering a loss on the sale relative to Cash consideration in the event that the
Buyer’s stock price falls between the time that the deal is announced and the
time that the acquisition is completed (usually several months, but in some
cases closing can take as long as a year).

As you can see, finding a combination of consideration that is agreeable to

both the Buyer and the Seller is an important part of structuring the deal.

TRANSACTION ASSUMPTIONS

An important step in building an M&A Model is to make assumptions about

important parameters affecting the deal, and as a vital step in determining a
feasible range for the Purchase Price/Control Premium:

• Current Share Price & Number of Shares Outstanding for the Buyer

• Current valuation information for the Seller

• Expected Purchase Price/Control Premium for the Seller in the

proposed transaction

• Portion of consideration arising from Equity/Cash

• M&A transaction fees

• Financing Fees from new Equity and/or Debt issuance

• Expected interest rate on new Debt

Below is an example of a simple transaction assumptions tab from a M&A

Model, in which a Purchase Price range is calculated, as well as an exact,
proposed Purchase Price. This proposed Purchase Price will be used in the
following sections for discussion.
NOTE: The blue numbers are independent variables or an investment
banker’s assumptions. The rest of the numbers are linked to numbers in the
model or are calculated from them.

BUILDING THE “SOURCES & USES” TABLE

The Sources & Uses section of an M&A Model contains the information
regarding flow of funds in an M&A transaction—specifically, where the money
is coming from and where it is going.

An investment banker determines the amount of money raised through

various equity and debt instruments, as well as from Cash on Hand (i.e.,
existing Cash owned by the Buyer to help pay for the transaction) to fund the
purchase of the Target. This represents the Sources of Funds. The Uses of
Funds will show the cash that is going out to purchase the Target, as well as
various fees needed to complete the transaction. Importantly, the total
Sources of Funds must always balance with the total Uses of Funds.

Using the diagram from the previous section as an example, let’s start with the
Sources of Funds side. Assume that Company X, the Buyer, will raise $30
million in New Senior Debt and $60 million in new Equity in order to raise
money to purchase the Company Y, the Target company. This will trigger fees
for the financing of this Debt and Equity, and these figures are located in the
boxes on the left. On the Uses of Funds side, we see that the buyer will
purchase the Equity of the target business, which is approximately $91.2
million. M&A transaction fees are 2.0% of the Purchase Price (i.e., the
purchase of the Target’s Equity), or approximately $1.8 million. Financing
fees include 4.0% of the $30 million in new Senior Debt raised and 6.0% of
the $60 million in new Equity raised. These fees will total $1.2 million and
$3.6 million, respectively.
Note that the total capital raised is only $90 million. The rest of the money
used to pay for the transaction will have to come from Cash on Hand. To get
the Sources of Funds to equal the Uses of Funds, we build the following “plug”
formula for Cash on Hand:

Cash on Hand = Total Uses of Funds – Total Sources of Funds

excluding Cash on Hand
= (Purchase of Equity + Transaction Fees + Financing Fees) –
(Newly Raised Equity + Newly Raised Debt)

Thus, approximately:

Cash on Hand = [$91.2 million + $1.8 million + ($1.2 million + $3.6

million)] – [$30 million + $60 million]
= ($91.2 million + $1.8 million + $4.8 million) – ($30 million + $60
million)
= $97.8 million – $90 million = $7.8 million

In this scenario Company X will need to use approximately $7.8 million of

Cash from its own Balance Sheet to complete the transaction.

CALCULATING GOODWILL

Goodwill is an asset that arises on an acquiring company’s Balance Sheet

whenever it acquires a Target for a price that exceeds the Book Value of Net
Tangible Assets (i.e., Total Tangible Assets – Total Liabilities) on the Target’s
Balance Sheet. As part of the transaction, some portion of the acquired assets
of the Target will often be “written up”—in other words, the value of the assets
will be increased upon transaction close. This increase in asset valuation will
appear as an increase in Other Intangible Assets on the Buyer’s balance sheet.
This will trigger a Deferred Tax Liability, equal to the assumed Tax Rate times
the write-up to Other Intangible Assets.

Without getting into too much additional technical detail, here is the formula
used to determine the additional Goodwill created in an M&A transaction:

New Goodwill = Excess Purchase Price of Equity over Book Value –

(Write-Up of Assets – Deferred Tax Liability from Write-Up of
Assets)
= [Purchase Price of Equity – (Tangible Total Assets – Total
Liabilities)] –Write-Up of Assets × (1 – Assumed Tax Rate)

In this case we must add the Transaction Fees and Financing Fees to arrive at
the Goodwill figure. Thus, approximately:
 New Goodwill = [($90 million + $1.8 million + $4.8 million) –
($30.3 million)] = $96.6 million – $30.3 million = $66.4
million (after rounding)

Note that in this transaction, Asset Write-Ups are ignored for the sake of
simplicity. Here is a detailed technical explanation of Goodwill and other
Transaction adjustments, including Asset Write-Ups and Deferred Tax
Liabilities.

Note also that Goodwill is a Long-Term Asset but is never depreciated or

amortized unless an Impairment is found—in other words, if it is
determined that the value of the acquired entity clearly becomes lower than
what the original Buyer paid for it. In that case, a portion of the Goodwill will
be “written off” as a one-time expense—in other words, the Goodwill asset will
be decreased by an amount equal to the amount of the Impairment
charge. The write-down of Time Warner’s acquisition of AOL is an extreme,
well-known example of such an Impairment charge.

ADJUSTMENTS TO THE PRO FORMA BALANCE SHEET

When Company X acquires Company Y, the Balance Sheet Items of Company

Y will, for the most part, be added to those of Company X. There will be some
adjustments to this, however, and these adjustments must be accounted for.
We’ve already discussed one such adjustment: Goodwill. Besides Goodwill,
there are additional adjustments that need to be made to the Buyer’s Balance
Sheet to account for the transaction. Here is an example of all of the Balance
Sheet adjustments that will occur using the adjustments made to the Pro
Forma Balance Sheet that reflects the “Transactions Assumptions” illustration
given above.
In the illustration above, the adjustments are as follows ($ in thousands):

Company X, the Buyer, issues $60 million and $30 million in

capital. Net of the Equity and Debt financing fees, the Company
receives $83,375 in Net Proceeds. Net Proceeds is a financing
adjustment that is added to the historical Cash balance. Then the
historical cash balance is adjusted for the transaction purchase price of
$90,000 (net of the Cash Proceeds of $1,241 on Company Y’s Balance
Sheet). Therefore, the cash balance is affected by the following
calculation:

Pro Forma Cash & Equivalents = Company X and Company Y

Current Cash & Equivalents of $2,072 and $1,241, respectively +
$83,375 Financing Adjustment – $90,000 Transaction Adjustment

The Equity raise of $60,000 is added to the Additional Paid-in

Capital and the Debt raise of $30,000 is added to Notes Payable.
Company Y Book Value is subtracted from the Accumulated
Income/(Deficit), also known as Retained Earnings. In other words, the
Book Value of Company Y’s Equity is zeroed out.
Finally, Goodwill is adjusted by the Goodwill amount of $66,373
created in the proposed transaction.

Accretion/Dilution Analysis

After the transaction has closed, the Buyer will own all of the assets, as well as
the financial performance (Profit/Loss), of the Target company.
Accretion/Dilution Analysis is used to determine how the Target’s financial
performance will affect the Buyer’s Earnings Per Share. As we discussed
earlier, a transaction is accretive if the buyer’s expected future EPS increases
as a result of the acquisition. On the other hand, the transaction would be
dilutive if the buyer’s expected future EPS declines as a result of the
acquisition. Thus it is important to estimate the Accretion/Dilution potential
from a deal before the Buyer can agree to the proposed transaction.

If the consideration used for the acquisition of the Target company is the
Buyer’s common stock, the transaction will often be dilutive to the buyer’s
EPS due to the fact that the new shares issued to buy the Target will increase
the number of outstanding shares of the Buyer. If that is the case, a
combination of Equity and Cash may be used to for the consideration of a
Purchase Price to minimize the effect of dilution on EPS.

Additionally, an Accretion/Dilution Analysis will attempt to measure the

impact of expected Synergies from the transaction (both in terms of increased
revenue and decreased costs). Typically these Synergies are represented as a
percentage increase/decrease in the Revenue/Costs for the Target’s financial
performance, not that of the Buyer.
For example, here is a hypothetical accretion/dilution analysis in the event
that Google (Ticker: GOOG) had acquired Salesforce.com (Ticker: CRM) in
2011:

The above acquisition scenario assumes 100% consideration in Cash, and once
estimates from Synergies are included, the acquisition is accretive to Google’s
Earnings Per Share in 2011E and 2012E by $0.15 and $0.56, respectively.
(Note that in this scenario Interest Expense increases, because Google would
need to issue new Debt to pay Cash for the shares in CRM.)

By contrast, the above acquisition scenario assumes 100% Equity

consideration. As a result, 37.222 million new shares need to be offered to
CRM to fund the Purchase Price; this is dilutive to Google’s Earnings Per
Share in 2011E and 2012E by ($3.23) and ($3.26), respectively.

Note that if a Buyer with a relatively low Price/Earnings Ratio acquires a

Target company with a relatively high Price/Earnings Ratio, the transaction
will generally be dilutive to the Acquirer on a pro forma basis. This is because
for each dollar of Price used to acquire the Target company, the Buyer is
receiving fewer dollars of Earnings.

Additionally, if the Buyer has an Earnings Yield ([Earnings Per Share ÷

Share Price], or simply [1 ÷ Price/Earnings Ratio]) that is lower than the
expected Cost of Debt (the interest rate on new Debt, after accounting for
the tax shield from the Debt), then using Equity as consideration will be more
accretive (less dilutive) than using Cash. This is because a lower Earnings
Ratio necessarily implies a high Price/Earnings Ratio. As a result, the higher
the Price/Earnings Ratio of a company, the more likely it is that that company
will want to pursue an acquisition strategy, and the more likely it is that that
company will want to use Equity as consideration for the deal (all other things
being equal, of course).