Valuations of Mergers and Acquisitions

The basic principle for valuing a business combination is similar to capital budgeting of projects. If the present value of incremental cash flows from the merger exceeds the present value of the amounts paid, than the investment should add value. This concept is referred to as Net Present Value. In order to calculate Net Present Value (NPV), you must:

• Determine the expected cash flows of the target company.
• Determine the effect the merger will have on the combined cost of capital of the new entity.
• Determine the amount that will be paid for the target company. A higher price should only be paid if there is definite synergy values.

Estimates of cash flows can be seriously distorted if management has plans to change the future operations of the combined entity. Make sure you have a good understanding of future strategic plans. Your estimate of cash flows should include any additional cash outflows that will be incurred from the issuance of new debt. Cash flow estimates need to be based on sensitivity analysis of how NPV changes when a critical variable is changed. Using a decision tree model will help determine the expected value from a range of possible values.

Most deals seem to involve three to five adjustments for normalizing the cash flows or benefit stream involved. A good example would be non-recurring items. For example, a revenue source or a specific expense that will not continue into the future will get adjusted out to arrive at the forward looking benefit stream used to arrive at valuing the deal.

The discount rate you should use in discounting the cash flows should be the Cost of Equity of the combined company or the target company; depending upon which cash flow stream you are measuring. Remember you are buying the equity or ownership of the target company. You may need to adjust the discount rate for additional risks incurred from the use of funds. If you are using the Capital Asset Pricing Model, you will need to determine a new Beta coefficient. Finally, don't forget to include an estimate for terminal values beyond your forecasted cash flows.

Obviously this overview touches on the very basics in acquiring the equity of another company. A good book on valuing companies is Valuation: Measuring and Managing the Value of Companies by three consultants with McKinsey & Co.