How much premium to pay for synergy?

Value of a target firm is estimated as the sum of the value of stand-alone target firm, value of the synergy expected by the acquirer and value of liquidity and control premium.

The synergy can be either of operating or financial in nature. Operating synergy results from revenue and cost synergy that would have impact on cash flow.

Market believes in cost synergy as it is under acquirers’ control and hence possible to achieve. For example, reducing COGS or SG&A through economies of scale, elimination of overlapping operations and headcount reduction through right-sizing can be explained and achieved in a short span of time.

However, revenue synergy is affected by a number of external parameters such as economic outlook and competitive response and hence it’s is difficult to achieve. So market doesn’t believe in revenue synergy. Because of the same reasons, to value a business for higher discount rate is used for revenue synergy and lower for cost synergy.

In case of merger, assets of target are transferred at book value, whereas in case of acquisition assets are transferred at market price. For example, book value of an asset may be Rs 60 however market value could be Rs 100. So in case of acquisition, the acquirer would recognize this asset at market value in his balance sheet and apply depreciation on new price. This means, the acquirer would get tax shield that would enhance his cash flow.

Say, the market value of a target is 1000 and an acquirer offers 1200 with 20% premium. The shareholders of the acquirer may argue that they can get the same company at 1000 so how can premium be justified? Well, the acquirer is paying premium because of the expected synergy that would result by the combination of the two businesses which, it hopes, would give superior return than that acquirer shareholders can get by purchasing the shares of the target firm themselves. However, the market price of the target’s share already captures the growth rate of the target. The acquirer has a challenge of extracting superior performance from the target to justify the premium.

So, what’s the relation between premium and performance?

Say,

MV = market value if the target i.e. sum of stand-alone value and the premium and is the price offered by the acquirer

BV = business value (book value) of target

PV = present value of target

Where,

n = number of years taken to recoup the premium

Ke = Expected rate of return

ROE = Return on equity, the profitability that the acquirer would expect to realize from the acquisition of the targets

The acquirer would try to achieve ROE > Ke otherwise PV = BV and recouping premium would be difficult. In efficient market, PV = MV.

This ROE is called implied ROE. Higher premium means higher implied ROE. Premium above 40% becomes extremely difficult to justify.