Merger and Acquisition Modeling
Prior to an acquisition or merger, a merger model (a type of financial modeling) will be used to analyze the combination of the two companies in a proposed deal. The primary objective of M&A modeling is to determine how the acquisition may impact the earnings per share (EPS) of the acquiring company, and how this EPS would compare with others in the same industry. However, M&A models can offer deeper financial insights in any given deal. The financial insights and projections arrived at within the model can help inform whether or not to proceed with a merger or acquisition.
Most financial models will include financial statements, a forecast projection, and additional analysis to help evaluate the most meaningful data for the potential merger or acquisition. This comprehensive analysis of each business’ financial health and how they may work in conjunction is a great resource to aid in the decision-making process. Financial modeling has become an essential skill for many investment bankers, and when done properly it has the potential to effectively predict success and outcomes for a variety of M&A scenarios.
How Are M&A Models Constructed?
As many assumptions and estimations about future performance must be made within the construction of an M&A model, the process of financial modeling is not an exact science. The assumptions that are made within the M&A model can greatly influence the valuation of a company and the viability of any deal, making financial modeling an incredibly important exercise that carries significant implications.
Here are the primary steps for building out a merger model to help determine a viable range for the purchase price. Creating an operating forecast for both companies is necessary during this phase.
- Acquisition Assumptions: Assumptions regarding the acquisition method must be built out, such as the number of shares to be issued to the target (as consideration) or the value of cash to be distributed to the target (as consideration), etc. Cost-saving opportunities for combining the businesses, integration costs, and more should also be reflected in this financial modeling. Separate models may be constructed to demonstrate how different acquisition variables may shift financial projections for the acquiring company.
- Making Projections: Using the available financial data at hand from each business’ income statement, balance sheet, and cash flow statement, a financial projection for the proposed merger will be generated.
- Valuation of Each Business: A discounted cash flow (DCF) analysis of each business will be conducted using available data and key assumptions to land on a valuation price for each business. This method estimates what an asset may be worth using projected cash flows, as well as how much may be needed to invest to achieve the desired return in the future.
- Combination and Adjustments: The balance sheet items from the acquired company will be combined with the balance sheet of the purchasing company. Adjustments and assumptions in the form of consideration, Purchase Price Allocation (PPA), goodwill calculation, and any changes in accounting practices between each business will be made.
- Deal Accretion / Dilution Analysis: Before closing a deal, it is important to make an estimate on what effect the deal will have on the buyer’s Pro Forma Earnings per Share (EPS). Deal accretion/dilution involves combining the net incomes of both parties and dividing the new shares outstanding. An M&A deal is considered to be accretive if the combined EPS is higher than the buyer’s standalone EPS prior to the transaction being finalized. Alternatively, an M&A deal will be dilutive if the EPS is lower after combining each company’s EPS, and it is neutral if the EPS remains the same.
This is a crucial aspect of financial modeling for M&A, as it can give indications on the profitability of a deal. However, having a dilutive combined EPS is not necessarily a deal-breaker. In fact, acquisition deals frequently are dilutive in the short term due to costs associated with integrating the companies together. As the dust settles over time and associated integration costs decrease, synergies will hopefully take hold and propel the business to an accretive state.
Financing Impact on M&A Models
The accretion/dilution analysis and the associated effect on the EPS is largely influenced by how any given M&A deal is financed. There are three primary methods for financing an M&A deal, and these financing costs tend to reduce EPS prior to the company realizing any gains from target earnings or realized synergies:
- Cash on the acquiring business’ balance sheet. Using their own cash has the lowest “cost” to the company, but they lose any interest income they would have made on that cash. Still, this method has the best chance to be accretive.
- Debt the acquiring company raises from the capital markets. Interest will need to be paid on this debt which will reduce the earnings potential of the acquiring company.
- Equity the acquiring company issues (i.e. delivering shares to the target company). This method does not incur a “cost”, however, when these issuances increase the total share count the associating EPS will decrease.
- An alternative fourth option for financing an M&A deal is a combination of each of these methods.
Who Builds the M&A Models?
The responsibility of building out financial models for mergers or acquisitions typically extends beyond the corporate development team and may incorporate a number of specialists and analysts. There are also different types of financial models that vary as the situation demands. Depending on what is needed, this collaborative effort may include investment bankers, equity research analysts, credit analysts, risk analysts, data analysts, portfolio managers, investors, and members of the management team. By sharing the responsibilities amongst professionals with separate (but complementary) areas of expertise, and M&A model can more accurately portray the financial forecasts of any given deal in a holistic manner.
When companies enter into exploring mergers and acquisitions it must make sense for both parties. This is especially true for the acquiring company which would be taking on much of the burden of risk during an M&A deal. Financial modeling is an indispensable resource for determining the viability of a deal as well as the purchase price. By constructing thorough and accurate estimates regarding the financial impact of the deal, company executives will be better equipped to make an informed decision that will impact their long-term vision and success of the business.