Considering what is at stake, any viable merger and acquisition needs to have a valuation of the business being acquired. For mergers, a thorough understanding of the value of both businesses should be considered essential. There are many reasons for this but the primary concern is to first establish whether or not the merger or acquisition represents a good spend of money (i.e. will it bring investors a return?). There is no way of answering this without completely understanding what assets and liabilities the company is question has amassed. There could be litigation overshadowing the company which could lead to incredible losses post M&A or the existing debts could be more than the business itself was able to cover. You might even find that the entire reason for the business looking to merge or sell out is due to one of these liabilities.
Companies have a choice between hiring a professional valuer or valuation company or taking the matter into their own hands by using business valuation model software, which is essentially an excel sheet with calculation equations saved that make defining a company’s value a fairly straight forward event. There are different types of valuation methods that are used, as seen below.
Reaching mutual agreement regarding a valuation can be difficult to attain, as the buyer of the company would prefer a lower valuation on the business they are buying and the seller of the business would obviously prefer the most substantial valuation they can gain. This is why valuers will use one of a number of agreed methods, such as comparison to other businesses in the same industry. Price to earnings (P/E) ratios are often used in this regard, as well as enterprise value to sales (EV/S) ratios. Another way of valuing the business is that of considering the replacement cost, which is to add the sum of each asset together including the cost of employees and any other assets the company has. Discounted Cash Flow (DCF) is another popular valuation method, where future cash flow is determined and considered and discounted to determine a present value. The DCF method could arguably be considered the most difficult to value.
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Why Should I Value the Business Prior to a Merger or Acquisition?
Once it is established that a business holds a set value based on one of these methods it is easier for a company to enter an M&A and explain to investors that the move will prove to be beneficial. Whichever method is used, a premium is added to the final price which is the draw for a business to sell. It would not be in the best interest of a company to sell something that they could make future profits from for the price of the business assets only, so a premium is added to make the transaction attractive. It is expected that any successful merger or acquisition will create synergy between the companies and as such the value of stock on the open market is only used as a base price; it is expected that post M&A the value of both company’s stocks will increase, so the selling company is compensated with a view to this increase.
A company could find through valuing a business prior to merging with them or acquiring them that the business is not competitive within their own industry, or needs to upgrade facilities and machinery. They could also find that the assets of the business are close to being worthless through depreciation or that key employees that are considered integral to the merger/acquisition do not have contracts that would ensure their skills stayed with the company post M&A. Also, the employment contracts could be written to allow for increases in wages that need to be accounted for and considered against the overall value as they could account for a substantial amount.
Identifying where assets and liabilities lie within the business is a key to understanding the value of any business that another is considering merging with or acquiring. It may be the case that the company is cash rich but asset poor or vice versa, creating either a beneficial or a problematic concern for the buying company. Creating synergy and cohesion between companies post-merger or acquisition is best done through understanding which company brings which skills and assets to the table in order that they may be reorganized and maximized to the best effect.
The point of partaking in a merger or an acquisition for the most part is the future strategy and intent of the purchasing company – whereas many companies could be bought which would gain a positive dividend for investors, the true reason a company chooses to merge or acquire a new company is when they see that their future strategy has a hole in it, and that hole can best be filled through a strategic purchase of a company that held either the patent to the key, the employees that could bring about the key, or the market related to the key to creating strategic positioning in the future. It is for this reason that is makes the most sense for a company to consider the potential investment of buying another company very seriously.
Remaining competitive means ensuring that the bottom line is not diluted and that the company operates at their point of optimization. If through buying another company the end result is that the business is devalued for any reason (perhaps too much market segmentation) then it would not be considered a good purchase or in the best interests of the shareholders. Due diligence in any pre-merger or acquisition scenario can only mean fully valuing the potential investment company by understanding what they offer, how they compete in their own industry, what debts will be brought along with the transaction and what income can be derived from the purchase in the future. Being assured that a merger or acquisition is the best spend for a company brings confidence from shareholders as well as the market the business operates in.