Eyes on the Price: How to Value Mergers

Four finance executives reveal some of the best practices they use to avoid overpaying for an acquisition.
Vincent RyanFebruary 8, 2013

If Silver Lake Partners and Michael Dell pull off their leveraged buyout of Dell Inc. at a 25% premium, they’ll be getting a bargain if their price sticks: at least as merger and acquisition premiums go. In merger deals involving U.S. nonfinancial companies in 2012, the average premium paid was near 41%, according to data from S&P Capital IQ. (Only deals above $50 million were counted.)

Dig down, though, and maybe the Dell deal is not the steal it appears. In that S&P Capital IQ data set, only 89 companies paid a premium of 25% or more, down from 108 in 2011 and 122 in 2007, prior to the financial crisis.

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Dell aside, clearly many companies are still paying a healthy amount above a target’s intrinsic value, even in a tepid climate for M&A. And because M&A is cyclical, in a more vigorous global economic recovery premiums could swell, experts say. That’s because when banks lend more and executives brim with confidence, companies tend to pay too much for acquisitions, hurting their return on investment. “The best returns from M&A come from transactions during recessionary periods; the worst when the economy is very strong,” says Andy Rose, CFO of metals manufacturer Worthington Industries.

But companies can develop competencies in M&A that avoid that trap. Says Rose, who has spent years in private equity and orchestrated $500 million in deals at Worthington the past three years: “Where you differentiate yourself is the discipline you use in negotiating the price and not overpaying.”

What rules, principles, and axioms do CFOs (and M&A advisers) live by when valuing prospective deals and coming up with the right price? Some experienced finance executives share tips from their M&A playbook:

Curb your enthusiasm. No hunter wants to return home having missed his shot at a big deer. Executives’ interests in owning a trophy business and bolstering their image as a deal maker can overwhelm reasonable thinking about price, and as Aaron Gilcreast of PricewaterhouseCoopers’s transaction services practice points out, “Bankers are not motivated by doing deals; they are motivated by closing them.”

The bias to get a deal done can obscure the red flags. In one of the worst large M&A deals in recent history, Royal Bank of Scotland executives pursued the takeover of ABN AMRO through a long, competitive battle without having conducted due diligence on the Dutch bank’s balance sheets or risk-management practices. The board rubber-stamped the $97 billion deal even though it was told execution risk was high and integration would be more difficult than with RBS’s past deals. In addition, because U.K. law allowed it, ABN AMRO actually rebuffed some RBS requests for information necessary for due diligence.

With enthusiasm building for a deal, the CFO often has to be the objective voice in the room. “Chief executives have big visions, which sometimes result in narrow consideration of alternate views,” wrote Gilcreast in a 2012 paper on deal valuation. But the CFO can also make it easier for executive management and a board of directors to walk away from an expensive transaction. That means not putting the company in a position in which it is counting on one deal to determine its future, says CFO Rose. “If I have a pipeline of 20 opportunities, I can walk away and go to the next deal on the list,” he says. Worthington Industries has an executive who flies around the world to identify companies, meet owners of businesses, and fill that funnel with opportunities.

Don’t pay for synergies (mostly). Many M&A advisers counsel against paying for synergies: the notion that two particular businesses combined can be greater than the sum of their parts. Particularly dangerous is baking synergies into the target’s valuation, the theory being that when the buyer does so, the deal’s synergy benefits accrue to the seller rather than the buyer’s shareholders. But some CFOs think it’s OK to figure in certain kinds of synergies.

Cypress Semiconductor bought Ramtron International in 2012 in a $116 million tuck-in deal (the acquisition of a company made for the sole reason of merging it with a division of the acquirer). In buying a small public company in a similar business, Cypress CFO Brad Buss included in his calculations the cost savings from eliminating parts of the management team, the board of directors, and other expenses that go with being a public firm, as well as some manufacturing efficiencies.

But Buss says he would not pay for synergies if Cypress were entering an entirely new line of business. “You can model yourself to death in spreadsheets, but on a new line of business, [achieving synergies] is very hard to do,” he says.

The biggest synergy myth buyers fall victim to is that they are acquiring new customers that will be ready-made targets for their existing product portfolio, says Buss. But the buyer can’t count on that synergy’s realization. “It could take years, and the first year or two you’re so involved with the sales team just bringing this pig in the door that you have no time to focus on these alleged synergies,” he says.

If a company plans to pay for any kind of synergy, it needs to consider the probability of achieving it, experts say. Because Worthington Industries is one of the largest buyers of steel in the country, a firm it acquires can lower its steel costs immediately. And “that automatically drops to the bottom line,” says Rose.

On the other hand, if Worthington projected that a larger, merged sales force would increase its market penetration by 10%, says Rose, it might only pay a percentage of the value the synergy could create. “One of the things we emphasize around here is, ‘You show me the list of synergies and I also want to see your confidence level on achieving those synergies,’” he says.

If a company includes synergies in its calculation of a deal’s value, it also must account for the other side: the costs of the acquisition process itself. Cypress’s Buss says it’s critical to know the fully loaded cost of any transaction. The semiconductor company’s deal with Ramtron was a hostile takeover, which means Cypress and Ramtron spent a lot of money on lawyers and bankers that could have gone to shareholders. But with any deal, Buss advises, things like management layoffs, severance packages, and stay bonuses­ have to be factored into the target price.

Keep financial models honest. Most acquirers value targets using roughly the same financial models, but CFOs can’t assume such models are bulletproof. “A decent number of spreadsheets contain errors,” says PwC’s Gilcreast. What’s more, errors in logic are more common than the math kind, and “they’re harder to find: it’s something you have to see in the formulas.”

The assumptions that go into a model are even more important than the model itself. When figuring how much of a premium above intrinsic value to pay, for example, some M&A teams compare what other acquirers in similar deals have paid and use the average of those premiums as a floor. But Gilcreast says the buyer shouldn’t assume it needs to pay the average premium or above, and that comparable deal premiums should only be used as an input.

Two big drivers of a target’s valuation are sales and margin growth. But Rose indicates caution is warranted here, too. “A lot of times when investment banks put the books together, sales are going up and margins are going up. But something has to be a catalyst to drive the margin growth: most customers don’t get excited when you raise a [product’s] price,” he says. (And if prices rise, sales can easily fall.)

Most valuation models are based on cash flows. Although most CFOs can do a discounted cash-flow model in their sleep, they sometimes have an incorrect notion of how to factor the likelihood of different scenarios into the expected cash-flow numbers, says Gilcreast. The “base case” scenario for a target’s cash flows may not be the right number to put in the valuation model, for example. That’s because the “downside” scenario — if the target’s cash flows plummet — may be much farther from the base case than the most optimistic “upside” scenario. “If you have a most likely cash flow of 100 (base case), a downside of 70, and an upside of 105, the expected value would be lower than 100,” he says.

Finally, sticking to a model’s output might be the toughest part of valuation. But companies that are highly acquisitive often excel at drawing that line in the sand. CBIZ, a tax and accounting services and employee-benefits company, did 10 M&A deals last year. Ware Grove, the company’s finance chief, goes into every potential transaction with a price target of 6 to 7 times earnings before interest, taxes, depreciation, and amortization (EBITDA). That valuation enables the company to hit its 12% to 13% hurdle rate. While Grove admits that some competitors are willing to pay 8 to 10 times EBITDA, he says CBIZ has found sufficient opportunities in its value range, “and we think for the right seller the opportunity to join CBIZ offers certain advantages and upsides long term.”

Similarly, at Cypress Semiconductor, “We have a very finite price that we won’t cross, no matter what happens,” says CFO Buss. “We all agree on that up front, the board agrees, so we go into [negotiations] very disciplined.”

Hedge the deal. Assigning a value to a seller’s future performance is perhaps the most difficult part of calculating a takeover price. The vast majority of acquirers hedge the risk, however, by making contingent payments, or earn-outs, part of a takeover’s consideration.

Delaying part of a payment and tying it to the target’s performance postdeal is a smart move, especially since so many M&A deals fail. In a study of 342 acquisitions last year totaling $55.3 billion, about $7.7 billion of the total deal value was part of an earn-out consideration, according to Shareholder Representative Services.

Anthony Vigorito, finance chief at Billtrust, a billing-process outsourcer, uses a contingent payment in every transaction. “Anytime we talk to sellers, they talk about what the business will become, so the contingent payment puts the money where their mouth is,” he says.

Even better for Billtrust, the businesses it has acquired in electronic billing and invoicing and other markets have all been profitable, so Vigorito uses the cash flow from the seller’s business to fund the future contingent payments. “It’s sort of like seller financing,” he says.

Likewise, CBIZ makes half of the purchase price contingent on the seller hitting milestones over two to three years. The contingent payment is usually at least 10% in CBIZ stock, says CFO Grove. “The consideration is self-correcting: if the seller doesn’t hit the targets, we pay less. So that protects our shareholders and gives the target a clear incentive to work hard,” he says.

Don’t overpay. Contingent payments assume that the buyer can track the performance of a merged entity cleanly. That’s tough to do, but for estimating a deal’s actual return after a few years it can be invaluable. Indeed, it’s part of the finance religion at Cypress Semiconductor. An $800 million company, Cypress treats every product division as a stand-alone unit, with separate profit-and-loss statements. In takeovers in which it uses debt, like the Ramtron deal, it assumes that the acquired business must pay back all the debt with its own cash flow. The length of time it will take to do so factors into the return on the deal. Separating out the acquired business also comes in handy if the business doesn’t succeed and Cypress decides to sell it: a strategy Buss uses if a unit is underperforming.

Even with precise tracking, however, it can be hard to tell if you could have landed a company for a lower price. First, most businesses contain intangible value that doesn’t fit into a financial model. So although the valuation of a target may be technically flawless, it still might not totally support the price the acquirer ends up paying. Second, as Gilcreast points out, deal success doesn’t always mean earning an outsized return, which he defines as “paying for nothing and getting something in exchange or paying less than the fair value of the target.”

If the hurdle is that high, a CFO might walk away from an acquisition that, although it may not create huge amounts of value, conserves the value of the purchaser’s existing business. “The joining together of the buyer and a target [may position] the combined company to compete, but, alone, the buyer’s business may decline,” according to Gilcreast.

Price and value, then, are two different things. In the gap, says Gilcreast, is where CFOs become expert deal makers.