The Merger Modeling

The Three statement financial models and discounted cash flow models are considered to be basic from a financial modeling point of view. On the other hand, financial modeling for mergers and acquisitions is said to require a lot of skill. Merger modeling is extremely complex. This is also the reason why investment banks across the world are willing to pay top dollar for people who have learned and perfected this skill.

Merger modeling is quite different compared to the standard DCF financial modeling as well. In this article, we will understand the various steps involved in merger modeling in order to understand the differences and complexities.

Project the Combined Financials

Merger modeling involves projecting two sets of financial statements instead of one. Combining the financial statements of two separate entities is not as simple as adding them up. This is primarily because of a concept called synergy. In simple words, synergy basically means that when two companies merge together, they become more efficient. This efficiency could be expressed in a variety of ways. For instance, this efficiency could be expressed in the form of increased revenues or even decreased expenses.

Projecting the combined financials takes a lot of skill. This is because the combined revenue per unit may go up since a merger between two large companies could mean significantly less competition. Similarly, the operating expenses of the combined entity could also go down significantly. This could be because the administrative expenses of the combined entity could be cut down.

Each line item has to be carefully projected, taking into account the effect of synergies. This requires a lot of skill and experience. Analysts must also verify their calculations with the actual post-merger figures of similar companies.

Using the Contribution Analysis

During merger modeling, the financial modeler is obviously only expected to create combined financial statements. However, in the very next step, the same financial modeler is expected to break down the numbers and apportion them amongst the merging companies. This is called a “contribution analysis.”

A contribution analysis is basically done in order to understand which of the two merging companies is bringing more value to the table. Every line item which was carefully created after considering the impact of synergy has to be broken down once again.

The contribution analysis is generally not straightforward. For instance, when Apple acquired Intel’s modem business, they were basically acquiring Intel’s patents. Hence, even though Intel’s modem division was the smaller company during the merger, it was bringing in significant value to the combined entity because of its patents which Apple could exploit better than any other player in the market. The capabilities of each company are explored during the contribution analysis. This helps both companies understand their relative bargaining power.

Arriving At the Enterprise Value

Companies which are publicly traded almost never trade at their book value. Hence, in order to propose an acquisition price, a financial modeler has to first understand what the current enterprise value of the firm is. Enterprise value means the value of equity, as well as debt, is considered. This is done if the acquirer wants to take over all the existing debt obligations of the target company as well. If the acquirer is only looking buying the assets and not the liabilities, then the calculation may have to be done differently.

The enterprise valuation of a firm is determined by adding together several values. First, the value of outstanding equity shares is considered. Then, the value of preferred shares needs to be added. Finally, the most complex part needs to be done. Financial modelers need to put a price tag on the stock options and stock equivalents which the company has floated in the market. For this, they need to understand how many of those options are “in the money” if the current strike price is considered. Then, the financial modeler has to use an option pricing model to put a value to these financial instruments. The sum of these three values provides the enterprise equity value. The net outstanding debt has to be subtracted from this value to finally arrive at the enterprise value.

Now, expressing the enterprise value as a lump sum amount makes little sense. Hence, it needs to be expressed on a per-share basis. For this, the number of shares outstanding has to be calculated. Once again, equity and preference shares need to be added. Once again, the number of shares likely to be added after the options are exercised need to be considered.

The result of this extremely complex financial calculation is the per share enterprise value which the financial modeler derives. Needless to say that like all other financial models, the merger model also relies heavily on assumptions. If the assumptions are tweaked even a little bit, then this value also changes significantly. Once the value is derived, then the financial modeler also needs to help decide the premium that the company can afford to pay for the acquisition. This premium is derived after closely looking at the contribution analysis mentioned above.

Determine and Apportion to Purchase Price

Finally, the financial modeler has to apportion the purchase price to the assets being acquired. Once again, the apportioning must not happen based on the purchase price or book value. Since the acquirer is acquiring the company at market value, the prices must be apportioned based on the market value. The residual amount must be apportioned to an intangible asset called goodwill. This helps the company determine the amount of premium which is being paid.