Financial Statement Analysis in Mergers and Acquisitions
Howard E. Johnson, MBA, CA, CMA, CBV, CPA, CFA
Campbell Valuation Partners Limited
Financial statement analysis is fundamental to a corporate acquirer’s assessment of an acquisition or merger candidate. As part of its due diligence investigation, a corporate acquirer typically analyzes the current and prospective financial statements of a target company. This analysis is used in estimating the ‘value’ of the shares or net assets of the target company, and in determining the price and terms of a transaction the acquirer is prepared to offer and accept.
This paper will address the practical applications of financial statement analysis typically performed by corporate acquirers in open market valuation and pricing exercises. This paper is not intended to be an all-inclusive discussion, and some of the items discussed may not be applicable in a given situation. Every open market transaction is unique, and judgment is required to determine the appropriate nature and level of financial statement analysis that should be undertaken in each case.
Determining value and price
The principal determinants of the value of the shares (or underlying net assets) of a target company in an open market transaction are:
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• the quantum and timing of prospective (after-tax) discretionary cash flows that will be generated. This typically includes discretionary cash flows to be generated by the target company from its operations on a ‘stand-alone’ basis as well as discretionary cash flows that a buyer anticipates will arise in the form of post-acquisition synergies; • the acquirer’s required rate of return given its perceived level of risk of achieving said discretionary cash flows and its perception of the target company’s ‘strategic importance’;
• redundant (or non-operating) assets that are acquired as part of the transaction; and • the amount of interest-bearing debt that is assumed by the acquirer. As a simple example, assume that the acquisition of Company X is expected to generate $10 million of prospective discretionary cash flow per annum (including anticipated postacquisition synergies), and that the prospective acquirer considers a 12% capitalization rate to be appropriate based on its cost of capital, and its assessment of Company X’s operations, the industry in which it operates, and the risk of generating said discretionary cash flows. Further assume that Company X will sell redundant assets with a net realizable value of $2 million and that the acquirer will assume $25 million of Company X’s interest bearing debt obligations. It follows that the value (normally defined as fair market value) of the shares of Company X generally would be estimated as: - 3 -
Prospective annual discretionary cash flow $10 million
Divided by: capitalization rate 12%
Equals: capitalized cash flow $83 million
Add: redundant assets $2 million
Equals: enterprise value $85 million
Deduct: interest bearing debt ($25 million)
Equals: fair market value of the shares of Company X $60 million The actual price (and related transaction terms) that a corporate acquirer might be prepared to pay for the shares (or underlying net assets) of Company X may be higher or lower than its estimate of fair market value. This is due to such things as the negotiating positions of the parties involved, the number of acquirers interested in Company X at a point in time, and numerous other factors that may only come to light during the course of negotiations.
An analysis of the historical and forecast financial statements (where available) of a target company is used when assessing each of the determinants of its equity value. In addition, the terms of an open market transaction normally stipulate that adjustments to the agreed price may be required pending the results of the buyer’s final due diligence investigation.
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Prospective Discretionary Cash Flow
Businesses typically are...