Once a firm has an acquisition motive, there are two key questions that need to be answered. The first relates to how to best identify a potential target firm for an acquisition, given the motives. The second is the more concrete question of how to value a target firm.
Choosing a target firm
Once a firm has identified the reason for its acquisition program, it has to find the appropriate target firm.
- If the motive for acquisitions is under valuation, the target firm must be under valued. How such a firm will be identified depends upon the valuation approach and model used. With relative valuation, an under valued stock is one that trades at a multiple (of earnings, book value or sales) well below that of the rest of the industry, after controlling for significant differences on fundamentals. Thus, a bank with a price to book value ratio of 1.2 would be an undervalued bank, if other banks have similar fundamentals (return on equity, growth, and risk) but trade at much higher price to book value ratios. In discounted cash flow valuation approaches, an under valued stock is one that trades at a price well below the estimated discounted cash flow value.
- If the motive for acquisitions is diversification, the most likely target firms will be in businesses that are unrelated to and uncorrelated with the business of the acquiring firm. Thus, a cyclical firm should try to acquire counter-cyclical or, at least, non-cyclical firms to get the fullest benefit from diversification.
- If the motive for acquisitions is operating synergy, the typical target firm will vary depending upon the source of the synergy. For economies of scale, the target firm should be in the same business as the acquiring firm. Thus, the acquisition of Security Pacific by Bank of America was motivated by potential cost savings from economies of scale. For functional synergy, the target firm should be strongest in those functional areas where the acquiring firm is weak. For financial synergy, the target firm will be chosen to reflect the likely source of the synergy – a risky firm with limited or no stand-alone capacity for borrowing, if the motive is increased debt capacity, or a firm with significant net operating losses carried forward, if the motive is tax benefits.
- If the motive for the merger is control, the target firm will be a poorly managed firm in an industry where there is potential for excess returns. In addition, its stock holdings will be widely dispersed (making it easier to carry out the hostile acquisition) and the current market price will be based on the presumption that incumbent management will continue to run the firm.
- If the motive is managerial self-interest, the choice of a target firm will reflect managerial interests rather than economic reasons.
Valuing the Target Firm
The valuation of an acquisition is not fundamentally different from the valuation of any firm, although the existence of control and synergy premiums introduces some complexity into the valuation process. Given the inter-relationship between synergy and control, the safest way to value a target firm is in steps, starting with a status quo valuation of the firm, and following up with a value for control and a value for synergy.
1. Status Quo Valuation
We start our valuation of the target firm by estimating the firm value with existing investing, financing and dividend policies. This valuation, which we term the status quo valuation, provides a base from which we can estimate control and synergy premiums. In particular, the value of the firm is a function of its cash flows from existing assets, the expected growth in these cash flows during a high growth period, the length of the high growth period and the firm’s cost of capital.
2. The Value of Corporate Control
Many hostile takeovers are justified on the basis of the existence of a market for corporate control. Investors and firms are willing to pay large premiums over the market price to control the management of firms, especially those that they perceive to be poorly run. This section explores the determinants of the value of corporate control and attempts to value it in the context of an acquisition.
Determinants of the Value of Corporate Control
The value of wresting control of a firm from incumbent management is inversely proportional to the perceived quality of that management and its capacity to maximize firm value. In general, the value of control will be much greater for a poorly managed firm that operates at below optimum capacity than for a well managed firm. The value of controlling a firm comes from changes made to existing management policy that can increase the firm value. Assets can be acquired or liquidated, the financing mix can be changed and the dividend policy reevaluated, and the firm can be restructured to maximize value. If we can identify the changes that we would make to the target firm, we can value control. The value of control can then be written as:
Value of Control = Value of firm, optimally managed – Value of firm with current management
The value of control is negligible for firms that are operating at or close to their optimal value, since a restructuring will yield little additional value. It can be substantial for firms operating at well below optimal, since a restructuring can lead to a significant increase in value.
3. Valuing Operating Synergy
There is a potential for operating synergy, in one form or the other, in many takeovers. Some disagreement exists, however, over whether synergy can be valued and, if so, what that value should be. One school of thought argues that synergy is too nebulous to be valued and that any systematic attempt to do so requires so many assumptions that it is pointless. If this is true, a firm should not be willing to pay large premiums for synergy if it cannot attach a value to it.
While valuing synergy requires us to make assumptions about future cash flows and growth, the lack of precision in the process does not mean we cannot obtain an unbiased estimate of value. Thus we maintain that synergy can be valued by answering two fundamental questions.
(1) What form is the synergy expected to take? Will it reduce costs as a percentage of sales and increase profit margins (e.g., when there are economies of scale)? Will it increase future growth (e.g., when there is increased market power) or the length of the growth period? Synergy, to have an effect on value, has to influence one of the four inputs into the valuation process – cash flows from existing assets, higher expected growth rates (market power, higher growth potential), a longer growth period (from increased competitive advantages), or a lower cost of capital (higher debt capacity).
(2) When will the synergy start affecting cash flows? –– Synergies can show up instantaneously, but they are more likely to show up over time. Since the value of synergy is the present value of the cash flows created by it, the longer it takes for it to show up, the lesser its value.
Once we answer these questions, we can estimate the value of synergy using an extension of discounted cash flow techniques. First, we value the firms involved in the merger independently, by discounting expected cash flows to each firm at the weighted average cost of capital for that firm. Second, we estimate the value of the combined firm, with no synergy, by adding the values obtained for each firm in the first step. Third, we build in the effects of synergy into expected growth rates and cash flows and we value the combined firm with synergy. The difference between the value of the combined firm with synergy and the value of the combined firm without synergy provides a value for synergy.
4. Valuing Financial Synergy
Synergy can also be created from purely financial factors. We will consider three legitimate sources of financial synergy – a greater “tax benefit” from accumulated losses or tax deductions, an increase in debt capacity and therefore firm value and better use for “excess” cash or cash slack. We will begin the discussion, however, with diversification, which though a widely used rationale for mergers, is not a source of increased value by itself.