When a company is involved in mergers and acquisitions, either as a buyer or a target, analyzing the prospective transaction to determine if it makes sense for shareholders is critical. Knowing the basics of when or if a deal makes practical and financial sense is helpful, but seeking help from a qualified professional to analyze the pros and cons in depth is a must.
A merger is the combining of two businesses, and an acquisition is the purchase of the ownership of one business by another. Basically, one company, the buyer or acquirer, proposes to offer cash or its own common stock in order to acquire the common stock of another company, the seller or the target. Usually, the target company’s board of directors and shareholders approve the transaction. If that approval isn’t or can’t be obtained, the M&A is called a “hostile takeover,” which results in one company acquiring enough stock of the target to control it against the wishes of the target’s management and/or shareholders.
Managing the Analysis
To analyze the potential for an M&A deal, one goal is to try to determine whether the buyer’s earnings per share (EPS) will increase or decrease as a result of the deal. An increase in expected EPS from a merger is called “accretion,” and the acquisition is called an accretive acquisition. A decrease in expected EPS from a merger is called “dilution,” and the acquisition is called a dilutive acquisition. Other key factors to evaluate are:
- Balance sheet impact and adjustments.
- Type of consideration offered (i.e., cash versus stock).
- Goodwill creation.
- Transaction fees.
Reasons for an M&A Transaction
One reason for M&As is to increase value for the acquirer by creating “synergies,” or ways to increase profit/earnings. Examples of synergies include:
- Revenue synergies. Increasing and diversifying sources of revenue by the acquisition of new and complementary product and service offerings.
- Operational synergies. Increasing production capacity through acquisition of workforce and facilities.
- Revenue/cost synergies. Increasing market share and economies of scale. ● Financial synergies. Reduction of financial risk and potentially lower borrowing costs. ● Operational and cost synergies. Increasing operational efficiency and expertise or research and development expertise and programs.
Acquiring another company also may be defensive to protect the acquirer from potential competition in the future. For example, a large company may acquire a small but growing company if the small company has a substantial competitive advantage over the large company, such as technology or a patent or a superior product.
Purchase Price and Considerations
The M&A buyer generally wants to increase shareholder value available, and one way to do that is to not overpay for the acquisition. Thus, determining an appropriate purchase price is important.
One component of purchase price is the “control premium,” that is, the price paid above market value for a target company in order to gain control. Therefore, knowing how much of a control premium should be paid is critical. Methods used to establish a fair value for a target company in an M&A transaction include:
- Comparable company analysis.
- Discounted cash flow analysis.
- Accretion or dilution analysis.
Another important factor is the type of consideration being offered to the target’s shareholders. In consideration of the purchase price the buyer can offer:
- The buyer’s common stock, known as “equity.”
- A combination of both.
Typically, if the buyer’s current stock price is considered undervalued relative to that of peers, the buyer may not use equity as consideration, because it would have to give the stockholders of the target a relatively large number of shares in order to acquire the company. On the flip side, the target shareholders may want to receive equity because they feel it is more valuable than receiving cash.
This is just the tip of the iceberg! If you’re contemplating a merger or an acquisition, be sure to get professional advice from the very beginning from Bott & Associates, Ltd!