Stock market issues

The shareholder value approach is the most effective method for both the buyer and the seller to determine the value of a company, as well as the value created by a potential transaction.  In also clarifies whether or not the transaction is strategically sound and dictates what information is required to make an informed choice. 

The shareholder value approach determines the likely price range during negotiations, where the price might settle, and the value captured by each party.  With this information, both the buyer and the seller enter negotiations with a richer understanding of an appropriate deal price, and conduct negotiations with a better chance of creating value for their shareholders.  This ensures that the acquisition does not fail to create shareholder value due to wrong strategy, wrong information, wrong price or wrong implementation plan.

Acquisitions create value when the value of the businesses combined is greater that the sum of their stand-alone values.  The amount by which the combined value exceeds the individual values is commonly referred to as the value of synergies, or simply “synergies.”  If synergies are not significant, there is a good chance that the parties involved are employing the wrong strategy, the first pitfall.

Synergies represent increases in value to both the target and the buyer, and arise from many sources including:

• Access to new markets, production capacity, distribution channels, knowledge or technologies

• Economies of scale

• Elimination of duplicate costs

• Defensive synergies (the value associated with not allowing a competitor to complete the transaction).

Whenever synergies exist, the target company is worth more to a potential bidder than to its current shareholders.  This creates an opportunity for both the buyer and seller to create value by striking a deal at a price somewhere between the values to each party.  The range of prices is referred to here as the negotiating range. 

The stand-alone value of the target represents the lower end of the negotiating range.  This value also represents the seller’s “walk-away” price since no board would consider selling their company for less that its worth to its shareholders.

The stand-alone value of the target plus the anticipated synergies to both the buyer and target set the upper end of the negotiating range.  This represents the buyer’s “walk-away” price; above this price the buyer is paying more for the target than it is worth to his shareholders, and therefore is destroying shareholder value.

Therefore, determining the correct acquisition price involves using the shareholder value approach to define the negotiating range and to estimate the division of synergy values between the buyer’s and seller’s shareholders.  This avoids the third pitfall-wrong price-, provides a road map for achieving synergies, and aids in preventing the fourth pitfall-wrong implementation plan.

Defining the Negotiating Range

Again, the target’s value as a stand-alone entity determines the low end of the negotiating range.  For public companies, this can be estimated by multiplying the target’s current stock price by the number of outstanding shares, and then adding the value of debt.  This calculation results in a value that incorporates the market’s expectations of the target’s future performance.

If the market expects that the company will continue to operate as a stand-alone entity, this is a quick and economically reliable way to estimate the target’s stand-alone value.  However if the market expects that the company will be acquired, there may be an “acquisition premium” built into its price.  This premium reflects the market’s assessment of both the probability of a deal and the potential synergies that the deal will create.  Adding estimated synergies to this over-stated stand-alone value could result in double counting synergies and overpaying for the target.

To avoid this, a recent date must be identified when the market first became aware of the potential for a transaction (eg the date information about a potential deal leaked to the market), and the target’s stock price just before the date should be used to estimate its stand-alone value. 

An even more effective method to estimate the stand-alone value of a target is to use shareholder value. This involves estimating the target company’s value drivers and cash flows, and employing the generally accepted and well proven discounted cash flow approach to calculate value.  High quality value driver analysis prevents companies from the second pitfall of acquisitions-wrong information.

To estimate the upper end of the negotiating range, the value of synergies has to be added to the target’s stand-alone value.  Synergy values can be estimated by analyzing each synergy’s impact on a firm’s value drivers, and re-running the shareholder value calculation.

Once synergies are estimated, their expected values are summed to estimate the total value of synergies arising from a transaction. 

While this is easily said, identifying and quantifying synergies often requires extensive interviews with key managers, analysis of company and peer group data, and comprehensive financial modeling.  However, buyers often are too optimistic about the timing and magnitude of synergies to consider these factors, resulting in an inappropriately high price.

This can be avoided by contacting the people actually involved in the creation of each synergy and reaffirming that they are truly able and motivated.  Confirming that key manager’ “buy in” to achieve the synergies, before the transaction. Then linking their compensation to the results is the best way to ensure that synergies will actually be realized.

Finally, it is important to estimate the costs associated with, and timing required to, realize each synergy.  All synergies are not created equally.  Typically it is easier to achieve cost synergies (head count reductions, supplier consolidation) than revenue synergies (cross-selling, bundling).

Utilizing Scenario Analysis

Another useful tool in defining the negotiating range is scenario analysis.  To apply scenario analysis, possible events that could favorably or unfavorably impact the target’s value must be identified (a competitor enters or leaves the industry), and then the probability of their occurrence must be assessed.  Key managers and industry experts are often good sources for this information.  Next, the impact of each scenario on the target and synergy value drivers must be estimated, and shareholder values associated with each scenario must be calculated.

As more and more scenario values are calculated, one develops a “value probability distribution,” which reflects the best understanding of the uncertainty in the target’s value.  This value probability distribution illustrates the range of values the target could achieve, and the estimated probability that it will assume each value.   Considering this range in negotiations is far better than hoping that all possible conditions were taken into account and captured in a single final target price.

This analysis helps buyers avoid over-bidding, allowing them to set their walk-away prices according to the probability of actually creating value at that price.  For example, these distributions can answer questions such as, “If we pay $X for Target Y, what is the probability that we will end up creating value?”

In addition, this analysis services as a road-map or prioritization for the post-acquisition integration process.  While many companies take a “wait and see” approach to integration, the best method is a “full speed ahead” approach in order to capture synergies.  The scenarios or sensitivities that create the most value must be the highest priority in the 90 days post acquisition.  If most of the value is in cross-selling products to the target company’s customers, the focus must be the highest priority in the 90 days post acquisition.  If most of the value is in cross-selling products to the target company’s customers, the focus must be on marketing and sales, while the synchronization of the information systems departments can wait. 

The combination of scenario analysis and the shareholder value approach has two other important applications.  First, the above question can be turned around to ask, “If the seller wants a price of $x, what do we have to believe in terms of synergies in order to create value?’  The question can then be answered in concrete, value driver terms (revenue growth rates of 10% and/or operating margin improvements of 5%).  This tool is particularly useful when constructing contingency based deals such as those in which drivers form the payout formula.  Management can then more easily assess the probability of these operating improvements actually occurring.  Unless the proposed acquisition is a blockbuster, buyers must be leery of value driver forecasts that have never been achieved in the history of the industry by any competitor-industry dynamics limit business performance.

One example of the analysis is to understand the combinations of sales growth and profitability to justify an acquisition price, relative to existing performance.

Second, a buyer can apply value driver analysis to other bidders to determine their likely walk-away price.  This is particularly useful in auction situations in which a great deal of effort is sometimes consumed chasing a deal that has a low probability of occurring.

The buyer must simply ask how likely a competing bidder is to achieve the same value driver enhancements that he is trying to achieve.