Building a M&A Model

Importance of a M&A model

M&A is derived from the corporate strategy where the acquirer look for synergies from the target company in order to improve their profitability and market share. It is necessary to build a M&A model that The synergies that acquirers look at can come under variety of reasons.

  1. Revenues Synergies – Increase and diversify sources of revenues by the acquisition of new and complementary product/service offerings.
  2. Operational Synergies – Increase production capacity through acquisition of workforce and facility.
  3. Combination of Revenues and Cost Synergies – Increase market share and economy of scale
  4. Combination of Operational and Cost synergies – Improve operational efficiency and R&D expertise

Some acquisitions can be defensive. For instance, a large company can acquire a growing startup which has a substantial competitive advantage over the large company such as technology, patents or superior product offering. The large company would want to acquire these startups to prevent them from becoming their potential competitors in the future. Google and Facebook have acquired many startups using this strategy.

Merger Analysis

Merger models are built to analyze the financial profile of the two combined companies and then figure out whether the buyers EPS will increase or decrease after the merger.
The merger analysis is done based on the following valuation outputs.

  1. Analysis of accretion/dilution and balance sheet
  2. Analysis of synergies
  3. Type of consideration offered – cash vs stock
  4. Goodwill creation and other balance sheet adjustments

Building a M&A Model

The basic steps to building a M&A model are as follows:

  1. Assumptions on Merger Financing – Cash, Stock, Debt or combination
  2. Project the income statement of each company to arrive at valuation
  3. Combine the income statements of both companies by adding Revenues and Operating expenses and adjusting for cash/debt used to finance the merger
  4. Combining net incomes and dividing by the new shares outstanding will give the proforma EPS of the combined merger.

The proforma company is the combined entity after the transaction has taken place. The difference in the financial attributes of the proforma company relative to the acquirer will be key to determine whether to go forward with the proposed transaction.

Determining the Purchase Price and consideration

The acquirer enters into a M&A deal with a hope that the transaction would increase the shareholder value. When the buyer acquires a majority stake in the target company, it is willing to pay a control premium. A control premium is the price paid above market value for the target company in order to gain control.
A critical component to determine the purchase price for the target company is how much of the control premium should be paid for the target relative to it’s current valuation. In order to arrive at the control premium, it is necessary to determine the valuation of the target company. The valuation methods used here are DCF, Comparables and Precedent Transactions method. Once the acquirer narrows down the purchase price and the control premium for the target, it will be then upto the management of the buyer and target to negotiate and agree upon the right purchase price.
An another important issue is the type of consideration being offered to the sellers shareholders – cash or equity or both. Depending upon whether the buyer equity is trading at par, premium or discount, the deal structure will be decided. If the buyer shares are trading at a discount then the buyer would choose cash or debt instead of equity where as the seller would prefer buyer’s equity. Hence it is necessary to find the right deal structure which is suitable for both the buyer and seller.

Transaction Assumptions in M&A model

It is necessary to make important assumptions about important parameters affecting the deal to determine the feasible range for the purchase price and control premium. These assumptions are:

  1. Current share price and number of outstanding shares for the buyer
  2. Current valuation information of the seller
  3. Portion of the consideration arising from the equity/cash
  4. Interest rates for the debt taken

Building the Sources and Uses Table

The sources and uses table basically provides information regarding the flow of the funds. One needs to determine the amount of money raised through equity/debt/cash in hand to fund the purchase of the target. This represents the Source of the 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. The sources of funds and uses of funds will always balance each other.

Calculating Goodwill in M&A model

Goodwill is an asset that arises on the acquirer’s balance sheet when it acquires target for a price that exceeds the Book Values of Net Tangible Assets on the target’s balance sheet. As part of the transaction some portion of the target assets are marked up at the transaction close. This increase in asset valuation will appear as an increase in other intangible assets on the buyer balance sheet. This will inturn trigger a deferred tax liability equal to the tax rate times the mark up value to intangible assets.
When the value of the acquired entity reaches below the goodwill value, then goodwill is impaired and ia written off. This is shown as an one time expense.

Adjustments to the Proforma Balance sheet

When the acquirer buys the target company, the balance sheet items of the target company will be added to the acquirer balance sheet. There will be some adjustments needed to be made in the buyer balance sheet to account for the transaction. One such adjustment is Goodwill.

Accretion/Dilution Analysis in M&A model

After the transaction is closed, the buyer will own all the assets as well as the financial performance of the target company. Accretion/dilution analysis will determine how the target financial performance will affect the buyer’s earning per share. A transaction is accretive if the buyer’s future EPS increases as a result of the acquisition and is dilutive if the buyer’s future EPS reduces as a result of the acquisition.
If the consideration used for the acquisition of the target company is the buyer’s common stock then invariably the transaction will be dilutive because the buyer needs to issues new additional shares to buy the target company. To minimize dilution, the buyer can use a combination of cash and equity.
An accretion/dilution analysis will also measure the impact of expected synergies from the transaction. The synergies are represented as percentage increase/decrease in revenues/costs for the target’s financial performance.
A buyer with a low P/E ratio acquires a company with a higher P/E ratio, then the acquisition will be dilutive to the acquirer on a proforma basis. This is because for every dollar used by the buyer to acquire the target company the acquirer gets fewer earnings. A company with a higher P/E ratio will be more likely to go for an acquisition strategy and will want to use equity as a consideration for the deal.