Valuation for Mergers and Acquistions: An Overview
What do Daimler-Benz, Hewlett-Packard (HP), Microsoft, Quaker Oats, and Sprint have in common? They are all multinational companies with established brands and products. But they have something else in common: They have all made bad acquisitions! In 1994, Quaker Oats acquired Snapple for $1.7 billion; it sold Snapple to an investment company for only $300 million two years later. Daimler purchased Chrysler for $36 billion in 1998; it got only $7.4 billion when it sold 80 percent of Chrysler to a private equity firm nine years later. HP, Sprint, and Microsoft also failed to make their acquisitions of Electronic Data System, Nextel Communications, and aQuantive work. These companies had to write off a significant portion of the price they paid for their targets—58, 86, and 98 percent, respectively. Unfortunately, these examples are not exceptional. Bad acquisitions happen in all countries, in all industries, and during both bull and bear markets.
Acquisitions fail for different reasons, but one recurrent theme is that acquirers overpay for the target. They overestimate either the target’s value, the expected synergies associated with the acquisition, or both. When the benefits of the acquisition fail to materialize, an acquirer has to write off part, and sometimes all, of the purchase price. Some companies, such as Quaker Oats and Daimler, might be able to recoup at least a small portion of the loss; others are not so fortunate and end up shuttering the business they acquired.
Do not conclude, however, that all mergers and acquisitions (M&As) are bound to fail. Some of the strongest companies as of this writing are the result of large M&As: The combinations of Exxon and Mobil in 1998, Vodafone and Mannesmann in 1999, Pfizer and Warner Lambert in 1999, and JPMorgan Chase and Bank One in 2004 created leaders in the oil and gas, telecommunication, pharmaceutical, and banking industries, respectively. Acquisitions that are well planned and well executed offer companies the opportunity to grow successfully.
One of the critical aspects of the planning stage is the valuation of the target and the expected synergies between the acquirer and the target. As this book illustrates, overestimating the target’s value and/or the expected synergies associated with the acquisition is a sure path to overpaying and reducing the likelihood of making the acquisition a success.
Probably no question in the financial community is asked more often than “What is this investment worth?” Whether the investment is a share of stock, a bond, or a company, assessing the value of an investment is often the ultimate objective of the corporate executive or analyst.
The fundamental tenet of valuation is well established in corporate finance: The value of an asset (or bundle of assets) today is the present value of the future cash flows that the asset is expected to provide its owners during its economic life. Thus, a significant aspect of valuation involves modeling the future cash flows associated with an investment and then deciding how to value those cash flows. Because financial modeling can be time consuming and often imprecise, analysts frequently turn to shortcut techniques that (they hope) yield similar results. Alternative valuation methods have also emerged because not all investments have sufficiently predictable cash flows to permit effective financial modeling. The chapters that follow consider a variety of valuation methods: discounted cash flow models, price and enterprise value multiples, economic value analysis, and real option analysis. We consider each of those valuation methods in the context of corporate valuation for M&A purposes, although they can be used for a variety of objectives.
This chapter addresses the following key questions:
- What are the principal reasons companies merge with or acquire one another?
- Do M&As create shareholder value?
- Why do acquirers pay a premium to take control of a target?
- What are the typical steps to follow when valuing a company?
- What are the most frequently used valuation methods for assessing a company’s value?