Link between Valuation and Value creation in M&A transaction

Introduction

  1. Valuation is the most important part in M&A transaction. It is also the most negotiated activity in a M&A transaction.In the current market environment, especially where more companies are demanding high prices, valuing a target company in M&A becomes far more important.No acquirer wants to overpay for a target and then realize that the future projected cash flows estimated as the result of the proposed acquisition is not to the expectation. This would be detrimental for public companies as this would affect the shareholders returns which inturn would crash their stock price.For Private Equity, most of their capital raised is through leverage and they would like the future cash flows to cover the high interest payments along with enough earnings in order to exit at an higher multiple.
  2. Valuing a target does not involve only the number crunching skills but one needs to justify or have a story behind every number deployed in the financial model.It is not necessary that these estimates would result in accurately valuing the company, but there should be enough logic behind these estimates for one defend the valuation hypothesis.
  3. Valuation bias and Valuation gap play a prominent role in not able to come up with a neutral view of the intrinstic value of atarget company. Valuation bias generally happens when the acquirer has already decided to proceed with the deal and tweak the financial model to defend its decision.Valuation gap happens when seller overestimates its value or its future earning projections and demands a higher price for its company from the buyer.Both Valuation bias and Valuation gap destroy any value addition that the deal can bring about.

Link between Valuation and Value creation

  1. Any valuation model that is built would be based on a simple hypothesis that the future projected cash flows that is discounted over the time period from an investment/an acquisition exceeds the cost of capital.The cost of capital for a company might involve both equity and debt.If the company wants to project the future cash flow to equity holders then it shall reduce the free cash flow with the interest payments to debt holders.This is primarily to look at the return for equity holders that are holding the acquirer stock.Generally when projecting the future cash flows, the acquirer looks at the cash flows to the firm which shall include the debt value or EBITDA number.This is then discounted with cost of capital to arrive at the intrinsic value of the target company.
  2. The acquirer also needs to ensure that even though the acquisition might be profitable or attractive, the question is, whether this is the best investment option available at that time.This is done by discounting the projected cash flows with a hurdle rate.An hurdle rate represents the opportunity cost for an acquirer to deploy the capital.An acquisition needs to give a return higher than the hurdle rate in order to generate higher shareholder returns.Many acquirers look at payback period for the acquisition which is essentially the time taken when the earnings exceed the initial investment.This may not be a right metric because even though the acquisition has become profitable, it has not generated returns higher than hurdle rate to give higher shareholder value.

Limitations in Valuation

  1. Many accounting methods currently followed are either outdated or it gives acquirers enough room to manipulate in order to show higher accounting returns.
  2. The capital invested for the acquisition is entered as Book capital in the balance sheet of the acquirer company.The Book value of a company does not take inflation into account which might skew the returns in favor of the acquirer.Any restructuring charge or share buybacks that the acquirer does in the future reduces the book value further which would inflate the return of the acquisition.
  3. Currently, most companies prefer Share buybacks as this will inflate the EPS of the firm in short term.This will drive the share price of the company.The companies also feel that buying their own equities at this time is the best investment option available as against looking at a capital expenditure or an acquisition.This infers that most targets in the market are over valued.
  4. In case of a strategic acquisition, the acquirer needs to identify the synergies from the acquisition and the future cashflows that would be realized as part of the synergies.It is easier to identify and execute the cost synergies but in case of revenue synergies, there are lot of factors outside the control of acquirer.For instance, whether a customer is ready to buy cross sell service offerings of the target/ acquirer.
  5. The historical performance of a target company is not an indicator of its future projected earnings.In this volatile market conditions, where the current business is disrupted by new business models as well as technologies, historical margins of a target company cannot be a reason to demand high valuation.In addition, startups or companies that have a great technology product or value proposition might be facing a low valuation as it has still not break even, but have a great potential to grow in future.
  6. Intangibles like R&D cannot be capitalized till it starts generating revenues.This means that companies which are investing its capital on cutting edge technology will have negative earnings as R&D costs will be considered as expenses.As per traditional valuation metrics, this target may not be attractive.
  7. Companies that have subscription or recurring revenues are more valued than other companies.This is because of the low sales costs required to generate incremental revenues.This hypotheses need not be correct, as a market disruption or entry of a new player can considerably erode the subscription base as evidenced in the recent fall in Netflix stock.

Conclusion

  1. Valuation is neither an art nor a science.Like science, Valuation does not yield a right number everytime or like art, it is not always in the eye of beholder.
  2. Not all valuations are done with a neutral point of view on whether the investment would add value.Most of the valuations suffer from a bias which causes a valuation gap between the buyer and seller.This is further exacerbated by bankers who act as advisors but whose payoffs depend on the closing of the deal.


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