How to Build a Merger Model
A merger model is the analysis of the combination of two companies that come together through the M&A process. A merger is the “combination” of two companies, under a mutual agreement, to form a consolidated entity. An acquisition occurs when one company proposes to offer cash or its shares to acquire another company. In all cases, both companies merge to form one company, subject to the approval of the shareholders of both companies. Below are the steps of how to build a merger model.
Screenshot: Merger Modeling Course.
The mains steps for building a merger model are:
- Making Acquisition Assumptions
- Making Projections
- Valuation of Each Business
- Business Combination and Pro Forma Adjustments
- Deal Accretion/ Dilution
Each of these steps will be explored in more detail below.
#1 Making Acquisition Assumptions
The first step of how to build a merger model is to create an operating forecast for both companies and determine the feasible range for the proposed purchase price. The acquiring company can offer cash, stock, or a combination of the two as consideration for the purchase price.
Where the buyer’s stock is undervalued, the buyer may decide to use cash instead of equity since they would be forced to give up a significant number of shares to the target company.
In contrast, the target company may want to receive equity because it might be perceived as more valuable than cash. Finding a consideration agreeable to both parties is a crucial part of striking a deal.
Key assumptions include:
- Purchase price of the target
- Number of new shares to be issued to the target (as consideration)
- Value of cash to be paid to the target (as consideration)
- Synergies from the combination of the two businesses (cost savings)
- Timing for those synergies to be realized
- Integration costs
- Adjustments to the financials (mostly accounting-related)
- Forecast/financial projections for target and acquirer
Screenshot from CFI’s M&A Modeling Course.
#2 Making Projections
Making projections in a merger model is the same as in a regular DCF model or any other type of financial model. In order to forecast, an analyst will make assumptions about revenue growth, margins, fixed costs, variable costs, capital structure, capital expenditures, and all other accounts on the company’s financial statements. This process is known as building a 3-statement model and requires linking the income statement, balance sheet, and cash flow statement. Build this section just as you do with any other model, and repeat it twice: once for the target and once for the acquirer.
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#3 Valuation of Each Business
Step 3 of how to build a merger model is a DCF analysis of each business. Once the forecast is complete, then it’s time to perform a valuation of each business. The valuation will be a discounted cash flow (DCF) model that is also compared and contrasted against comparable company analysis and precedent transactions. There will be many assumptions involved in this step, and it is probably the most subjective. Therefore, this is an area where having a highly-skilled financial analyst can really make a difference in terms of producing extremely accurate and reliable numbers.
The steps in performing the valuation include:
- Performing comparable company analysis
- Building the DCF model
- Determining the weighted average cost of capital (WACC)
- Calculating the terminal value of the business
Screenshot from CFI’s M&A Financial Modeling Course.
#4 Business Combination and Pro Forma Adjustments
Where company A acquires company B, the balance sheet items of company B will be added to the balance sheet of company A. Combining the two companies’ financials will require several accounting adjustments, such as determining the value of goodwill, value of stock shares, and options, and cash equivalents. This section is also where various types of synergies come into play.
Key assumptions include:
- The form of consideration (cash or shares)
- Purchase Price Allocation (PPA)
- Goodwill calculation
- Any changes in accounting practices between the companies
- Synergies calculation
An important step in building the merger model is determining the goodwill resulting from the acquisition of the assets of the target company. Goodwill arises when the buyer acquires the target for a price that is greater than the Book Value of Net Tangible Assets on the seller’s balance sheet. If the book value of the acquired entity is lower than what the acquirer paid, then an impairment charge will arise. As a result, the goodwill asset will be decreased by a value equal to the goodwill impairment charge.
Read more: Merger Factors and Complexity
Learn more in CFI’s Mergers and Acquisitions Course.
#5 Deal Accretion/ Dilution
The purpose of accretion/dilution analysis is to determine the effect of the acquisition on the buyer’s Pro Forma Earnings per Share (EPS). A transaction is deemed accretive if the buyer’s EPS increases after acquiring the target company. Conversely, a transaction is viewed as dilutive if the buyer’s EPS declines as a result of the merger. The buyer should estimate the effect of the target’s financial performance on the company’s EPS before closing a deal.
Key assumptions include:
- Number of new shares issued
- Earnings acquired from the target
- Impact of synergies
Image from CFI’s Merger Modeling Course.
As you see in the example above, this deal is dilutive for the acquirer, meaning their Earnings Per Share is lower, as a result of doing the transaction, than their Earnings Per Share were before the deal. Such a situation – in isolation – would argue against the acquisition being a good deal for the acquirer but, of course, many other considerations factor into the final decision on whether or not to pursue a merger deal.
Read more: Accretion Dilution Analysis.
Learn more about M&A
Thank you for reading the CFI guide on how to build a merger model. CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)® designation. To continue learning and advancing your career, these additional free CFI resources will be helpful: