Mergers and Acquisitions

Valuing the Target and Setting the Price

To prepare an appropriate bid for a target company, the buyer has to accurately value the target company through the due diligence process.

Valuation of the Target Company

To prepare an appropriate bid in the mergers and acquisition process, the buyer must be able to value the target company accurately. This valuation process is referred to as due diligence. Due diligence examines a potential target for merger, acquisition, privatization, or a similar corporate finance transaction – normally by a buyer. Due diligence involves a reasonable investigation focusing on material future matters and the asking of certain key questions, including how do we buy, how do we structure the acquisition, and how much do we pay? Moreover, due diligence is an investigation on the current practices of process and policies and an examination aiming to make an acquisition decision via the principles of valuation and shareholder value analysis. The due diligence process framework can be divided into nine distinct areas:

1. Compatibility audit: This deals with the strategic components of the transaction and, in particular, the need to add shareholder value.
2. Financial audit.
3. Macro-environment audit.
4. Legal/environmental audit.
5. Marketing audit.
6. Production audit.
7. Management audit.
8. Information systems audit.
9. Reconciliation audit: This links/consolidates other audit areas together via a formal valuation to test whether shareholder value will be added.
   
   

WIPO Headquarters in Geneva: Intellectual property is an asset of a business that must be included in the overall business evaluation. This photo is of the headquarters of the World Intellectual Property Organization in Geneva, Switzerland.

In business transactions, the due diligence process varies for different types of companies. Areas of concern other than the ones listed above include intellectual property, real and personal property, insurance and liability coverage, debt instrument review, employee benefits and labor matters, immigration, and international transactions.

It is essential that the concepts of valuations (shareholder value analysis) be linked into a due diligence process. This is in order to reduce the number of failed mergers and acquisitions. The five most common methods of valuation are:

1. Asset valuation
2. Historical earnings valuation
3. Future maintainable earnings valuation
4. Relative valuation (or comparable transactions)
5. Discounted cash flow valuation

Professionals who value businesses generally do not use just one of these methods, but a combination of them, to obtain a more accurate value. As synergy plays a large role in the valuation of acquisitions, it is paramount to get the value of synergies right. Synergies are different from the sales price valuation of the firm, as they will accrue to the buyer. Hence, the analysis should be done from the acquiring firm's point of view. Synergy creating investments are started by the choice of the acquirer and, therefore, they are not obligatory, making them real options in essence.