Techniques Used To Value An M&A Deal

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Mergers & acquisitions (M&As) involve the purchase and sale of companies, making the valuation of the targets an essential part of the process. Valuing a deal is a complex process that requires to use of multiple techniques and strategies. Knowing which technique to use in different situations can be the difference between a successful deal and one that fails to generate (the expected) value. The most common techniques used to value a deal are discounted cash flow analysis (DCF), comparable company analysis (CCA), precedent transactions analysis, and sum-of-the-parts analysis (SOTP).

DCF analysis is a method used to value a business by projecting future cash flows and then discounting them back to the present value using a weighted average cost of capital (WACC). The goal of CCA is to compare the target company or asset to similar businesses or assets that were recently sold to come up with a reasonable valuation. Precedent transactions analysis is similar to CCA, except the focus is on transactions in the same industry as the target company. Lastly, a sum-of-the-parts analysis gets used to value a business that has multiple distinct businesses and/or assets. It involves valuing each component separately and then summing up the values to arrive at the overall value of the company.

Determining which technique is best for a given situation can be a difficult task. It requires careful consideration of the goals, objectives, and resources available.

Comparable Company Analysis (CCA)

One of the most widely-used techniques to value an M&A deal is Comparable Company Analysis (CCA), also known as comparable multiple analysis. CCA is a relative valuation methodology that uses publicly-available financial data to value comparable companies and derive the value of the target company. CCA is used most often for public companies, as the data for these companies can be easily accessed.

The process of CCA begins by identifying comparable companies based on public financial data such as market capitalization, EBITDA, and other financial metrics. The data from the comparable companies are then used to calculate a range of financial ratios, such as price-to-earnings or enterprise value-to-EBITDA multiples, which can be used to compare the target company to the comparable companies.

Once the financial ratios are calculated, the values of the comparable companies are used to make an informed estimate of the value of the target company. This estimate can then be used as the basis for negotiations between the buyer and seller.
CCA is an effective and commonly-used valuation technique that is used to estimate the value of a target company in an M&A transaction. The data used in CCA can be easily accessed, making it a useful tool for buyers and sellers alike.

Discounted Cash Flow Model

Discounted cash flow (DCF) analysis is one of the most common valuation models used to value a deal. It’s also one of the most widely accepted and most widely used methods to value a company because it takes into account all types of relevant factors and uses straightforward calculations, making it easy for investors, managers, and company directors to use. In many cases, DCF analysis can be seen as an extension of earnings before interest and taxes (EBIT) because more information can be gathered from this model than from other models.

It is based on the concept of predicting future cash flows and discounting them to their present value. This model helps companies identify potential deals that have the highest return on investment, as well as identify areas for cost savings. By using this model, companies can make informed decisions about which deals are worth pursuing and which ones should be avoided. This model can also help companies identify potential synergies between two entities that could result in additional value creation.

Sum-Of-The-Parts Analysis (SOTP)

Another method used to value an M&A deal is Sum-of-the-Parts Analysis (SOTP). This method is a form of discounted cash flow (DCF) valuation that is based on the principle that the value of a business is equal to the sum of the fair market values of its assets and liabilities.

SOTP analysis in M&A deals allows buyers to understand the value of each part of the target company, which can help them negotiate a fair price for the acquisition. It can also be used by sellers to showcase the value of their company’s business units or assets, which can help them attract potential buyers.

The first step in the SOTP analysis is to identify and determine the value of each component of the company. These can include assets like property, equipment, and intellectual property, as well as liabilities such as debt, tax obligations, and other contractual obligations.

Once the value of each component has been determined, the total value of the company can be calculated by summing the values of all the parts. This sum can then be discounted to account for the time value of money and to reflect the fact that the total value of the company may not be realized in a single transaction.

By applying the SOTP analysis in M&A deals, companies can effectively communicate the value of their business units to potential buyers or investors, ultimately leading to more successful transactions.

The SOTP Struggle

Why breaking up interconnected businesses is harder than you think?

When companies merge or acquire each other, one of the most common strategies to unlock value is to separate or spin off some of the businesses to create a leaner and more focused organization. This approach is known as “SOTP” (sum-of-the-parts) analysis and is popular in M&A deals. However, executing a successful SOTP strategy is harder than it looks.

Breaking up interconnected businesses is difficult because companies are often complex and interdependent systems. For example, imagine a company that operates in several different industries, such as technology, manufacturing, and retail. These businesses may seem separate, but in reality, they may rely on each other in many ways. The technology division may supply critical components to the manufacturing division. The retail division may rely on the technology division for its online platform.

If a company tries to break up these businesses, it must first identify all the interdependencies between them. This can be a complex task, as some connections may be obvious, while others may be more subtle. For example, the technology division may be providing support to the manufacturing division that is not immediately apparent.

Once the interdependencies have been identified, the company must determine which businesses can be separated without disrupting the others. This requires a careful analysis of the financial, operational, and strategic implications of each business unit. It may be that some businesses cannot be separated without affecting the overall performance of the company.

Another challenge in executing a SOTP strategy is the potential impact on employees, customers, and suppliers. Breaking up businesses may require layoffs or changes to the supply chain, which can be difficult to manage. Customers may also be affected if their favorite products or services are no longer available.

Finally, there is the issue of valuation. The value of a company is often greater than the sum of its parts, as there may be synergies between the businesses that cannot be easily replicated. This means that a company may be worth more as a whole than it would be if its businesses were separated and sold individually, due to the synergies and efficiencies created by the interconnection of its businesses.

Weighted Average Cost of Capital (WACC)

For professionals in the M&A field, understanding and effectively utilizing Weighted Average Cost of Capital (WACC) analysis can make a significant difference in maximizing the potential synergies and overall success of strategic transactions.
WACC analysis enables you to evaluate the cost of capital for a company, taking into account its debt and equity structure. By incorporating WACC analysis into M&A strategies, you can mitigate risks, identify potential deal breakers, and unlock hidden value. Additionally, it enables you to make informed decisions by considering the cost of capital and the expected returns for shareholders.

As Warren Buffett said, “You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ.” (“Warren Buffett Speaks: Wit and Wisdom from the World’s Greatest Investor”. Book by Janet Lowe, 1997). Indeed, WACC analysis offers a practical and straightforward approach to assessing the value of M&A opportunities.

Now, let’s explore some practical tips for unlocking this value:

Accurate estimation of WACC 

Proper estimation of WACC requires a thorough understanding of the company’s capital structure, including equity and debt components. Utilize reliable data sources and industry benchmarks to ensure accurate inputs.

Sensitivity analysis

Conducting sensitivity analysis on WACC assumptions allows for a comprehensive evaluation of the deal’s potential outcomes under various scenarios. This helps identify key value drivers, assess risk factors, and refine decision-making.

Integration of strategic objectives

Linking WACC analysis with the strategic objectives of the M&A transaction is crucial. Consider the synergies, market opportunities, and growth potential to assess the alignment of the deal with the company’s long-term goals.

Post-transaction tracking

Continuously monitor and reassess the WACC and its impact on the M&A deal post-transaction. Identify any deviations from the initial analysis and take corrective actions to ensure value realization.

To delve deeper into this topic, you can use the following resources:

Book: “Valuation: Measuring and Managing the Value of Companies” by McKinsey & Company.

This comprehensive guide provides a detailed exploration of valuation techniques, including a comprehensive section on WACC analysis.

Online WACC Calculators:

These tools allow you to estimate the WACC for a company by inputting the relevant financial data. It’s a handy resource for quick calculations and comparisons.

Remember, M&A transactions are complex and demand a holistic understanding of both qualitative and quantitative factors. WACC analysis serves as a powerful tool in this regard, providing a structured framework for evaluating the financial aspects of a deal.

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