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Mergers and Acquisitions- Valuation Models

Mergers and Acquisitions- Valuation Models

Costs of mergers and acquisitions are an important and integral part of mergers and acquisitions process. Before going for any merger or acquisition, both the companies calculate the costs of mergers and acquisitions to find out the viability and profitability of the deal. Based on the calculation, they decide whether they should go with the deal or not.

In mergers and acquisitions, both the companies may have different theories about the worth of the target company. The seller tries to project the value of the company high, whereas buyer will try to seal the deal at a lower price. There are a number of legitimate methods for valuation of companies.

Valuation Models in Mergers and Acquisitions

There are a number of methods used in mergers and acquisition valuations. Some of those can be listed as:

Replacement Cost Method

In Replacement Cost Method, cost of replacing the target company is calculated and acquisitions are based on that. Here the value of all the equipments and staffing costs are taken into consideration. The acquiring company offers to buy all these from the target company at the given cost. Replacement cost method isn’t applicable to service industry, where key assets (people and ideas) are hard to value.

Discounted Cash Flow (DCF) Method

Discounted Cash Flow (DCF) method is one of the major valuation tools in mergers and acquisitions. It calculates the current value of the organization according to the estimated future cash flows.

Estimated Cash Flow = Net Income + Depreciation/Amortization – Capital Expenditures – Change in Working Capital

These estimated cash flows are discounted to a present value. Here, organization’s Weighted Average Costs of Capital (WACC) is used for the calculation. DCF method is one of the strongest methods of valuation.

Economic Profit Model

In this model, the value of the organization is calculated by summing up the amount of capital invested and a premium equal to the current value of the value created every year moving forward.

Economic Profit = Invested Capital x (Return on Invested Capital – Weighted Average Cost of Capital)

Economic Profit = Net Operating Profit Less Adjusted Taxes – (Invested Capital x Weighted Average Cost of Capital)

Value = Invested Capital + Current Value of Estimated Economic Profit

Price-Earnings Ratios (P/E Ratio)

This is one of the comparative methods adopted by the acquiring companies, based on which they put forward their offers. Here, acquiring company offers multiple of the target company’s earnings.

Enterprise-Value-to-Sales Ratio (EV/Sales)

Here, acquiring company offers multiple of the revenues. It also keeps a tab on the price-to-sales ratio of other companies.