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Technical
Reference
Bulletin
No. 105
Putting a Realistic Dollar Value on Acquisition Synergies
Discounted cash flow techniques can quantify true synergies from a merger or acquisition and help determine the right purchase price.
What are synergies? Finance textbooks often teach that synergies represent value created through the combining of two companies – that is, the value of the whole is greater than the sum of the values of the parts. However, many corporate analysts benefiting from firing-line experience might argue in more stark terms that "synergy" really is a euphemism for, "The CEO got carried away and paid too much." In that real-world view, synergies - frequently real but all too often exaggerated - are used to justify a price that most value measurements signaled was out of line. Since overvaluing synergies is arguably one of the most common reasons buyers pay too much, making sure that the synergies of a specific deal meet the textbook definition is critical.
Many sources exist to find incremental value that may be created by combining two companies. The point is to specifically identify the genuine sources available to support a realistic valuation rather than cling to a vague notion of benefits that may or may not be achievable. These identifiable areas can form a baseline for the valuation. The next step is to choose the right methodology.
Perhaps the most common valuation practice, particularly in pricing private companies, is to build the synergies into a discounted cash flow (DCF) projection. The projection that is discounted to estimate a purchase price combines the cash flows that the target would generate on a stand-alone basis for a non-synergistic buyer with the cash flows related to the perceived synergistic benefits for a strategic acquirer. This approach risks overpricing the target. Why? Because it tends to overestimate the magnitude and timing of synergistic cash flows while underestimating their associated risks, and it inadequately evaluates an appropriate "split" of synergistic value between buyer and seller.
An attractive alternative is to partition the pricing analysis into two pieces. A DCF valuation based on the cash flows the target might generate to a non- synergistic buyer. A separate cash flow analysis that places a "value" on the synergies for a strategic buyer.
By separately analyzing synergies, the acquirer can evaluate the sensitivity of their "value" to changes in both the timing of projected cash flows and the key variables affecting cash flow magnitude.
Thus, the two-tier analysis can help temper what might otherwise be an overly optimistic cash flow projection. Further, this framework allows the projected synergistic cash flows to be discounted at a higher rate than the stand-alone target, thereby capturing the perceived higher risk associated with realizing the synergies. Capturing synergistic benefits within a range of "value" facilitates examination of suggested prices resulting from various "splits" of the synergies.
Simplified Synergy Analysis
Several points related to stand-alone valuations should be incorporated in the process of valuing synergies to ensure its accuracy.
Discretionary owner cash flows that appear on a target's income statement as expenses - a situation common to private companies - should be added back to cash flow (to the extent that they can be verified as legitimate) in pricing a target. For example, while expenses associated with a full management team usually are appropriately included in a "stand-alone" valuation, the valuation process should add back any salary monies that are perceived to be in "excess" of market pay. Such items do not represent synergies but are important adjustments needed to sketch a true picture of the target's cash flow.
The DCF model that arrives at the pricing of a stand-alone company should utilize an "optimal" capital structure which reflects the target's cost of funds on a stand-alone basis rather than the acquirer's cost of funds. This is not necessarily the financing inherited or actually contemplated after the acquisition. But use of the optimal structure ensures that the investment and financing decisions are kept separate and that the structure is based on the premise that any buyer could put an "optimal" capital structure in place.
A corporate acquirer needs to be cognizant of situations in which the competing bidders for a target are individuals rather than other corporations. This most often happens when the target is a small manufacturer that typically is a "one-man show" lacking a strong management team or a market niche.
Individuals are frequently limited in the price they can pay for a target, because generally 65% to 85% of the purchase price is financed with debt, and cash flow from the business must service this debt. A Seller that insists on receiving all cash from an individual buyer often must accept a 10% to 50% discount in price.
The corporate buyer offers the seller the advantage of all cash up front. Further, because the DCF valuation of a stand-alone company excludes specific financing considerations that may depress value, the indicated DCF value may well exceed the best alternative bid from a competing individual, even before synergies are considered. A prudent corporate buyer will bear this in mind when formulating an offer.
It seems self-evident that an acquirer should pay for only a small percentage of the value of synergies that no other buyer could realize. Conversely, an acquirer will probably have to pay for more than 50% of the value of synergies when several other potential buyers could realize these benefits.
Benefits tend to be smaller and take more time to realize than originally anticipated.
About the author:
Daniel W. Bielinski was a manager in the Enterprise Group and Valuation Services Group of Arthur Anderson & Co. in Milwaukee. He acknowledges the contribution to this article by Dean A. Polenz, a
valuation manager in Milwaukee, and John H. Lax, a valuation principal in Houston, both of Arthur
Anderson.
Exchange is a publication of: BEC Advisors & Private Equity Services LLC
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