Evaluation of Synergy
When a company buys another, they often say it makes sense because the two businesses will work better together. The main source of synergy in an acquisition is the assumption that the target firm has a specialised resource that makes the resources of the acquiring firm more valuable when combined with them. Operating synergy and financial synergy are the two main types. This guide will focus on the latter.
Value can be created in many ways, such as by increasing sales, lowering costs, increasing operating cash flow, helping managers make better decisions, or selling assets that are no longer needed. But the value created by proposed synergies may also require more money to be invested.
Synergy comes in the form of more money coming in and less money being spent.
When two companies in the same industry, like two banks, join together, their combined sales tend to go down. This is because their businesses overlap in the same market, and some customers stop doing business with both of them.
For shareholders to benefit from the merger, there should be ways to save money to make up for the drop in revenue. In other words, the value gained from the merger must be more than what was lost at first.
As a general rule, synergy is when two business ideas work together to make five.
When pricing or valuing a possible target, however, many analysts don’t take into account these “hidden” or “additional” investments or costs. When people don’t think about the hidden costs, they often overvalue a potential target. This can lead to destroying value instead of creating it.
Synergy, which came about because of an acquisition, should lead to better results than were expected at first.
Acquisition process should be well-planned. Mark Sirower, the US leader of the Merger & Acquisition Strategy and Commercial Diligence practice, named 4 components which should take place in order to achieve successful synergies:
- Strategic vision
- Operating strategy
- Systems integration
- Power and culture
The buyer should pay out the premium to shareholders of merged company. The higher the premium, the lower the potential benefit for the buyer. Therefore, synergies should not be intangible. It should be carefully forecast and discounted from net cash flows which are feasible within the chosen time frame.
Besides the positive impact of revenue enhancements, cost reductions, and other efficiencies, valuation analysts need to price them in, too.
