Mergers and Acquisitions

A common measure used for valuation is the price-earnings ratio (P/E Ratio) in which the price of a share of stock is divided by the company's after-tax earning per share. A $100 share earning $10 per share a year, is said to have a 10:1 ratio. The market, in other words, is willing to pay $10 for every $1 of earnings. A company with an annual after-tax earnings of $500,000 and a P/E Ratio of 7 would thus be valued at $3.5 million.

Another ratio used is the enterprise value to sales ratio (EV/Sales Ratio). Enterprise value is calculated by taking the company's outstanding stock, adding its debt, and deducting its cash or cash-equivalent assets. This value is then divided by the company's sales (not earnings) to arrive at an EV/Sales Ratio. The concept here is to treat both stock and debt as values that need to be paid back with sales. If the ratio is low, the value of the company is high. If the company has a lot of cash, the ratio may be negative, indicating that the target can be bought using its own cash.

The most common method of valuation used in M&A is discounted cash flow (DCF) analysis. The method is described in detail in this volume (see Discounted Cash Flow). It involves projecting the financial performance of the company over some period, typically ten years, and then calculating net cash flow for every year. The analyst then discounts (reduces) future earnings using the purchaser's actual rate of return on capital. The logic here is that capital invested now would earn the buyer interest in future years. That same interest is deducted from the projected cash flows. The sum of discounted cash flows is then viewed as the acquisition target's current value. The analyst usually assumes that the company will be sold in the 11th year for a conservative multiple of earnings; this residual is also discounted and added. The drawback of DCF is its complexity—above all the need to project all of the complex financial flows into the future. Its benefits are greater detail which typically requires a very full understanding of the candidate.

In virtually all valuations of companies, the prospective buyer also factors in so-called synergies which will help it increases in market share and sales, lower costs, and increased profitability. Projected synergy gains are then used as part of the valuation. Following many acquisitions, large layoffs are announced because the merger of functions eliminates duplications. Such layoffs are an example of a "synergy"; often the announcement lifts the stock.

SUCCESS AND FAILURE

Are mergers and acquisitions a success or a failure? The answer is that results are mixed. Many smaller companies are successfully sold to larger operation and, transformed (often beyond recognition), continue to operate and grow. Larger deals are evidently less successful. Investopedia.com, in its article regarding M&A states: "Historical trends show that roughly two thirds of big mergers will disappoint on their own terms, which means that they will lose value on the stock market. The motivations that drive mergers can be flawed and efficiencies from economies of scale may prove elusive. In many cases the problems associated with trying to make merged companies work are all too concrete."

Results for stockholders depend on which side of the deal they are on. There is substantial empirical evidence that the shareholders in acquired firms benefit substantially. Gains for this group typically amount to 20 percent in mergers and 30 percent in tender offers above the market prices prevailing a month prior to the merger announcement. Most small company owners realize substantial gains when selling successful, privately-held corporations to a public buyer. The gains of stockholders of acquiring firms are difficult to measure, but the best evidence suggests that shareholders in bidding firms gain little. Losses in value subsequent to merger announcements are not unusual. In post-acquisition periods, managements are often distracted with cost cutting and integration processes and spend less time on the business, sometimes with unfavorable results. This seems to suggest that overvaluation by bidding firms is common. Managers may also have incentives to increase firm size at the potential expense of shareholder wealth. If so, merger activity may very often happen for structural, "legacy," and other reasons as already indicated above.

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