Valuation and pricing of companies in M&A transactions

Butterflies - Odilon Redon

Regarding business acquisitions (M&A) we need to separate the economic valuation of the company to be acquired (target) and the price that the buyer (bidder) is committed to pay.

While it is true that the valuation of the company can vary widely depending on the calculation method used and the performance of the due diligence, the amount resulting from such valuation is theoretically equal whatever the bidder.

As opposed to the economic valuation, the price paid can vary widely according to each bidder. This means that the valuation focuses on the object (the target) while the price focuses both on the object and the acquirer subject (bidder). In this regard, it is important to note that the price paid depend more on the economic advantage that the bidder can obtain due to the acquisition, especially because the so-called synergies, than the economic capacity of such bidder. Therefore, the maximum price that the bidder can pay will be higher than the value of the target, probably with a control premium and, this increased value (price) will be higher or lower depending on the synergies resulting from the integration between the bidder (buyer) and the target (seller), among other variables.

Another important fact to take into account is that sometimes the benefit of the transaction is not to make a profit but to avoid a loss. In this sense, a company may acquire another that does not imply a direct profit but a way to avoid future losses.

The difference between value and price is due to the following formula:

PP = V + P + Co + Cf

Where:

PP is the purchase price

V is the value of the company prior to the acquisition (pre-money value)

P is the premium or control premium

Co (initial costs) is the transaction costs, including financial and legal advisors, Notary public fees, taxes, borrowing costs, etc.

Cf (final costs) is the cost of the integration between companies

As it can be seen with the formula, the value of the company (target) is only one variable among others to obtain the total price of the transaction. The valuation method is not 100% objective but need to follow this path. However, the premium will depend on each sector (the more competition exists between bidders in M&A transactions of one sector, the higher is the premium) and the economic benefit that the acquirer can obtain because the integration of the target (synergies). According to this, some companies will be able to obtain more synergies than others, so then the premium is higher or lower depending, in especial, on the bidder and its economic benefits, more than due to its economic capacity.

During these competitive processes risk-benefit relation also plays an important role. Therefore, the bidder willing to assume higher risks may come up with a better price than another company with more resources. All these circumstances explains the reasons why M&A transactions study is a social science.

As the formula shows, in addition to the valuation and premium, to determine the total price it is also required to determine transaction costs. These costs can be separated between those resulting from the execution of the transaction and those resulting after the transaction closing.