Valuation and related matters in mergers and acquisitions
Beginner Stock Market Investing, Stock Market Investing Advice
As we have noted elsewhere, mergers and acquisitions are a very important part of global corporate finance activity and happen on a daily basis. Mergers and acquisitions executed for a number of different reasons but, without exception, that they are based on the principle that the combined business entity can create more value for the shareholder than the businesses individually. What is important to the investor is to decide whether investing in the company that is planning to take over another company will be profitable in the long run. In order to be able to achieve this, what the investor needs to determine is the value of the business that is being merged or acquired.
It goes without saying that the two sides to will have different ideas about valuation with the buying company trying for the lowest possible value while the selling company will try to achieve the highest possible value. There are a number of different ways in which the company can be valued of which one common method is to look at the value of a comparable company in the same industry. Here are some of the valuation tools that can be used.
Financial ratios.
- Using a price/earnings ratio, the offer can be made as a multiple of the earnings of the target company. An examination of the P/E ratios of all the companies in the same industry will give the buying company an indication of what kind of price to offer.
- Using an enterprise value/sales ratio, the offer can be based on a multiple of the sales keeping in mind the price/sales ratio of other comparable companies in the same industry.
Replacement cost is sometimes used as a valuation tool to determine the pricing for a target. This is a simplistic method of valuing the company because it assumes that all the acquired has to do to threaten the target by setting up a competitor is to duplicate the investment in assets like plant and equipment and factories. This is almost impossible for a service company where the main assets are people and intellectual property are almost impossible to value and difficult to develop on a long-term basis. Moreover, the method does not take into account the time and trouble involved in setting up a competitor rather than going through with the merger or acquisition.
Discounted cash flows are probably the most valuable and accurate of all the valuation tools. In this method, a forecast is prepared of the future free cash flows that the target company will generate and are discounted back at the rate that equals the weighted cost of capital of the company. This is not an easy calculation to perform but can provide an accurate estimate of value if it is correctly done.
Valuation is critical to a good assessment of mergers and acquisitions. It is a well-known statistic that over two thirds of all mergers and acquisitions fail to meet their objectives partly or completely. The primary reason for this is incorrect valuations where acquiring companies pay far too much for the target companies. In many reasons for this overvaluation but once a target company comes into play and there is competitive trading bidding, it would appear that he who takes over and reason goes through the door.
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