What is Synergy Valuation?
When a company acquires another business, it is often justified by the argument that the investment will create synergies. The primary source of synergy in an acquisitionMergers Acquisitions M&A ProcessThis guide takes you through all the steps in the M&A process. Learn how mergers and acquisitions and deals are completed. In this guide, we'll outline the acquisition process from start to finish, the various types of acquirers (strategic vs. financial buys), the importance of synergies, and transaction costs is in the presumption that the target firm controls a specialized resource that becomes more valuable if combined with the acquiring firm’s resources. There are two main types, operating synergy and financial synergy, and this guide will focus on the latter.
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Types of Synergies
Synergy can be categorized into two forms: operating synergy and financial synergy.
1. Operating synergy
Operating synergies create strategic advantages that result in higher returns on investment and the ability to make more investments and more sustainable excess returns over time. Furthermore, operating synergies can result in economies of scale, allowing the acquiring company to save costs in current operations, whether it be through bulk trade discounts from increased buyer power, or cost savings by eliminating redundant business lines.
Types of operating synergies to value include:
- Horizontal Integration: Economies of scaleEconomies of ScaleEconomies of Scale refer to the cost advantage experienced by a firm when it increases its level of output.The advantage arises due to the inverse relationship between per-unit fixed cost and the quantity produced. The greater the quantity of output produced, the lower the per-unit fixed cost. Types, examples, guide, which reduce costs, or from increased market power, which increases profit marginsNet Profit MarginNet profit margin is a formula used to calculate the percentage of profit a company produces from its total revenue. The profit margin ratio of each company differs by industry. Profit margin = Net income ⁄ Total revenue x 100. Net income is calculated by deducting all company expenses from its total revenue which is and salesSales RevenueSales revenue is the starting point of the income statement. Sales or revenue is the money earned from the company providing its goods or services, income.
- Vertical Integration: Cost savings from controlling the value chain more comprehensively.
- Functional Integration: When a firm with strengths in one functional area acquires another firm with strengths in a different functional area, the potential synergy gains arise from specialization in each respective functional area.
2. Financial synergy
Financial synergies refer to an acquisition that creates tax benefits, increased debt capacity and diversification benefits. In terms of tax benefits, an acquirer may enjoy lower taxes on earnings due to higher depreciation claims or combined operating loss carryforwards. Second, a larger company may be able to incur more debt, reducing its overall cost of capital. And lastly, diversification may reduce the cost of equity, especially if the target is a private or closely held firm.
Using the Financial Synergy Valuation Worksheet
The Synergy Valuation Excel Model enables you – with the beta, pre-tax cost of debt, tax rate, debt to capital ratio, revenues, operating income (EBIT), pre-tax return on capital, reinvestment rate and length of growth period – to compute the value of the global synergy in a merger.
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Steps to value financial synergies
- Enter the assumptions for the risk-free rate and the risk premiumEquity Risk PremiumEquity risk premium is the difference between returns on equity/individual stock and the risk-free rate of return. It is the compensation to the investor for taking a higher level of risk and investing in equity rather than risk-free securities.. The worksheet default contains sources for the base assumptions, using the US 10-year Treasury rate as a proxy for the risk-free rate and the US risk premium from market-risk-premia.com
- Enter the inputs for both the target and acquiring companies. The model will be driven by the variables described above.
- The combined firm’s financial metrics are calculated as follows:
- BetaBetaThe beta (β) of an investment security (i.e. a stock) is a measurement of its volatility of returns relative to the entire market. It is used as a measure of risk and is an integral part of the Capital Asset Pricing Model (CAPM). A company with a higher beta has greater risk and also greater expected returns.:
- Estimate the unlevered betas for both the target and acquiring companies
- Estimate the unlevered betaUnlevered Beta / Asset BetaUnlevered Beta (Asset Beta) is the volatility of returns for a business, without considering its financial leverage. It only takes into account its assets. It compares the risk of an unlevered company to the risk of the market. It is calculated by taking equity beta and dividing it by 1 plus tax adjusted debt to equity for the combined firm by taking an enterprise-value weighted average
- Estimate the levered beta for the combined firm using the debt to equity ratio of the combined firm
- Pre-tax cost of debtCost of DebtThe cost of debt is the return that a company provides to its debtholders and creditors. Cost of debt is used in WACC calculations for valuation analysis. Learn the formula and methods to calculate cost of debt for a company based on yield to maturity, tax rates, credit ratings, interest rates, coupons, and: EV weighted-average pre-tax cost of debt of both firms
- Tax rate: EV weighted-average tax rate of both firms
- Debt to capital ratio: EV weighted-average debt to capital ratio of both firms
- Revenue: Sum of both firms’ revenues
- EBIT: Sum of both firms’ EBITEBIT GuideEBIT stands for Earnings Before Interest and Taxes and is one of the last subtotals in the income statement before net income. EBIT is also sometimes referred to as operating income and is called this because it's found by deducting all operating expenses (production and non-production costs) from sales revenue.
- Pre-tax return on capitalROICROIC) (Return on Invested Capital) is a profitability or performance ratio that aims to measure the percentage return that investors in a company are earning from their invested capital. The ratio shows how efficiently a company is using the investors' funds to generate income.: EV weighted-average pre-tax return on capital of both firms
- Reinvestment rate: EV weighted-average reinvestment rate of both firms
- The output section computes the base assumptions that will be used to value both firms standalone and combined:
- The cost of capital uses the WACC formulaWACCWACC is a firm’s Weighted Average Cost of Capital and represents its blended cost of capital including equity and debt. The WACC formula is = (E/V x Re) + ((D/V x Rd) x (1-T)). This guide will provide an overview of what it is, why its used, how to calculate it, and also provides a downloadable WACC calculator and will be used to discount future cash flows
- The expected growth rate estimated by the product of the after-tax return on capital and the assumed reinvestment rate.
- The valuation section computes the enterprise value of both firms standalone and combined:
- The present value of free cash flowsThe Ultimate Cash Flow Guide (EBITDA, CF, FCF, FCFE, FCFF)This is the ultimate Cash Flow Guide to understand the differences between EBITDA, Cash Flow from Operations (CF), Free Cash Flow (FCF), Unlevered Free Cash Flow or Free Cash Flow to Firm (FCFF). Learn the formula to calculate each and derive them from an income statement, balance sheet or statement of cash flows to both firms standalone and combined is calculated by taking NOPATNOPATNOPAT stands for Net Operating Profit After Tax and represents a company's theoretical income from operations. Examples, formula, how to calculate NOPAT. Simple form: Income from Operations x (1 - tax rate) or Long form: [Net Income + Tax + Interest Expense + any Non-Operating Gains/Losses] x (1 - tax rate) (EBIT * 1 – tax rate) and multiplying it by the reinvestment rate. The present value of a growing annuity formula is applied, grown using the expected growth rate and discounted by the cost of capital computed above.
- The terminal value of both firms standalone and combined is calculated by applying the growing perpetuity formula to the terminal year’s free cash flow.
- The enterprise value is the sum of both firms standalone and combined present values of free cash flows and the present value of terminal valuesTerminal ValueThe terminal value is used in valuing a company. The terminal value exists beyond the forecast period and assumes a going concern for the company..
- The value of financial synergies is determined by taking the difference in enterprise values of both firms standalone and combined.
Key Takeaway
The valuation method described above allows us to determine the financial synergies of the combined company. From the analysis, the primary driver of financial synergies is the benefit implied by combining the cost of financing of both companies. The value of financial synergies can be analyzed further by finding the proportion of the value of synergy attributable to the specific sources of synergies discussed above.
Additional Resources
Thank you for reading this guide to financial synergy valuation. To continue learning and advancing your career, these additional resources will be helpful:
- Merger Consequences AnalysisMerger Consequences AnalysisMerger consequences analysis assesses the financial impact a merger or acquisition may have on a company. These must be carefully considered before
- Valuation MethodsValuation MethodsWhen valuing a company as a going concern there are three main valuation methods used: DCF analysis, comparable companies, and precedent transactions. These methods of valuation are used in investment banking, equity research, private equity, corporate development, mergers & acquisitions, leveraged buyouts and finance
- Types of Financial ModelsTypes of Financial ModelsThe most common types of financial models include: 3 statement model, DCF model, M&A model, LBO model, budget model. Discover the top 10 types of Excel models in this detailed guide, including images and examples of each. Financial modeling is performed for many reasons including to value a business, raise money
- Become a Certified Financial AnalystCertified Financial AnalystCFI Financial Modeling & Valuation Analyst program is your path to become a certified financial analyst. With 12 required courses on topics ranging from accounting and finance fundamentals to financial modeling, valuation and advanced Excel skills, the CFI financial analyst certification will help