What is Acquisition Analysis?
Acquisition Analysis is a quantitative method of evaluating the value of a company and its future potential. It uses data from a company’s financial statements to predict the future performance of the business. Justification for acquiring a business should be based on a clear focus on what value the acquisition can bring to the Acquirer and its shareholders. Key motivators include enhancing competitiveness by gaining market share and industry-specific expertise; diversifying risk through acquisitions of complementary businesses; achieving economies of scale by reducing costs through internal integration; and finding ways to diversify revenues by increasing exposure to different markets and different customers etc.
What is the process of an Acquisition Analysis?
Acquisition Analysis is a process to evaluate the merit of an investment by quantifying the positive or negative “value add.” The Acquisition Analysis process does this by measuring if the value at acquisition exceeds, equals, or falls short of the value at sale. The goal is to acquire assets that are then sold for more than they were purchased for. Otherwise, it’s a loss.
When do you need an Acquisition Analysis?
Fintalent’s Acquisition Analysis consultants agree that the analysis can be applied to all sorts of investments, both tangible and intangible, including real estate, equipment, intellectual property and contracts. Factors such as projected cash flows and property tax rates have significant bearing on whether a particular investment makes sense in terms of calculable return on investment (ROI).
Acquisition Analysis is an important component of Business Valuation, and can be carried out by a business valuation consultant.
A key component of the process is the classification of acquisitions. There are two classes: A, which represents an acquisition that exceeds what was paid for the target; and B, which represents an acquisition that exceeds what was paid for the target by more than 10%. The term “target” is defined as follows: when looking to determine whether an acquisition was successful it is assumed that all cash flows in perpetuity, discounted at a market appropriate rate are generated (“expected value”) from the assets owned immediately before the acquisition (“pre-acquisition value”).
There are two sides to the acquisition, a theoretical side and a practical side. Acquisition Analysis, while being extrapolated from the theoretical side, is still more focused on the practical side of things. The theoretical side is what’s known as “economic value,” which represents the excess value of an investment over what was paid for it. For example, suppose that you purchase a business for $10,000 and you sell it for $20,000 (a 200% increase in value). The investment generated an economic value of $10,000 (the difference between the pre-acquisition value and the expected future value). The acquisition analysis methodology outlined in this article focuses on what’s called “economic value at risk” (EVAR). EVAR represents the potential (or risk) that you’ll lose more than 10% of your investment.
There are two ways to evaluate an investment: One way is to measure if the actual outcome is better than expected. The other way is to look at the potential risk that comes with a particular investment. It’s important to consider both sides because a positive outcome doesn’t necessarily mean that it’s a good investment; it may come out as an acceptable loss. However, that means you should have considered the potential risk involved in the investment.
The actual outcome of an investment is referred to as “value at sale” (VAS) and is measured by comparing the pre-acquisition value and expected future value. An excellent example of this occurs with a company named “Dairy Queen.” Suppose that you purchase DQ for $1 million, but two years later it’s worth $6 million (a 300% increase in value). The VAS is $6 million. However, there was a potential risk that the business would not be worth what you paid for it. Calculating the economic value at risk (EVAR) on the investment, which is calculated as the difference between pre-acquisition value and expected future value less 10% of pre-acquisition value and divided by two, results in a economic value at risk of $1.65 million. The EVAR represents the potential or risk you could lose over 10%. In this case, it’s very low because even though there was a high VAS, you made money on the deal.
The above example is what we call “a home run.” This occurs when there are no losses, only gains. By our definition, a home run involves an increase in VAS of greater than 10%. Unsurprisingly, there aren’t too many home runs. However, there are also “base hits,” which occur when the VAS is greater than 10%, but less than 50%. So a base hit would represent an increase in value, but not as much as a home run. Finally, there are “errors” and “strike outs.” Errors occur when the VAS is less than 10% of pre-acquisition value. Strike outs occur when the VAS is between 0% and 10% of pre-acquisition value. As mentioned above, going for a strike out would be an optimal strategy if you have strong reasons to believe that the investment won’t be worth what you paid for it (i.e. you’re confident that risks were analyzed properly and you have a very good read on the project). You should be aware, however, that when calculating an EVAR it is assumed that all cash flows in perpetuity (i.e. discounted at a market appropriate rate) are generated from the assets owned immediately before the acquisition (“pre-acquisition value”). In short, not every investment will end up being worth what was paid for it because there are risks involved.
What is an Acquisition Analysis report?
A report provides a snapshot of an investment during the time period between inception and sale. However, it also estimates a pre-acquisition value, an expected future value and economic value at risk. Using these figures and the tax code, the report provides an estimated return on investment. For instance, if an investment was made in 2006 and sold in 2010, there are taxes to pay (2010 taxes) based on a gain of $8 million:
Another important figure is the target’s cash flow. It includes three components: Interest payments for borrowed funds; Operating income or loss; and Owner’s or shareholder’s profit or loss.
The essence of analyzing an acquisition is to figure out what was paid for the target. It is based on three ratios:
1) Price/Interest Ratio;
2) Price/Operating Income; and
3) Price/Owner’s or Shareholder’s Profit.
The ratio gives you an idea of how much a buyer is willing to pay for the cash flows that come from an asset. Typically, if you do an acquisition, your goal is to pay less than market value.
How to calculate economic value at risk
You can’t just take a stock price and subtract book value because some assets may be overvalued or undervalued depending on their accounting method. So you need to survey the market and determine market values (i.e. based on the strategy of an acquisition). Then, you can calculate what is referred to as “the spread.” The spread represents the difference between book value and market value. If there is a positive spread, which means that market value is greater than book value, it tells you that you are paying above-market prices for an asset. If there is a negative spread, which means that book value is greater than market value, then it implies that a buyer is getting below-market asset pricing for an acquisition target.
We also need to make some assumptions for the three ratios. For example, we assume that there is no significant risk involved in the acquisition (although we should never rely on that assumption, it’s a good place to start). Also, we assume that there is no penalty for inflation. It doesn’t mean that you should ignore inflation because it may get much worse than what you’re predicting. When calculating the return on investment, however, it’s best to ignore inflation because its effect doesn’t last forever and it adds variables you don’t need to calculate returns on investments. So by ignoring inflation we can keep things simple and get an estimate of how much money an investor will make (the return) using the other ratios.
There are a variety of ways to calculate each of the three ratios and it’s best to calculate them for every project. So let’s do a quick example using DQ Inc. Again, take DQ as an acquisition target because it’s easy to understand and you’ll get an idea of what is involved in analyzing acquisitions.
In 2006, you paid $1 million for the shares of DQ Inc. You expect that the business will generate $10 million in cash flow over 10 years (which is equivalent to annual cash flows of 10 million). The pre-acquisition value is essentially nothing because the business was still valued at zero before you acquired it. Using the first ratio (price to interest rate), we can say that you paid $100,000 over market value ($1 million cash flow divided by 6% interest). When you calculate the second ratio (price to operating income), you find out that you paid $200,000 over market value ($10 million cash flow divided by 10% operating income). You didn’t pay too much for DQ Inc. However, you may have paid more than what the business was really worth. If you were smart, however, you would take precautions when paying for a company because companies tend to grow at a rate of around 10 percent a year. The third ratio (price to owner’s or shareholder’s profit) tells you that it would be more expensive to acquire the business than to simply keep cash. The spread is negative: $100,000 over market value ($1 million cash flow divided by 5% owner’s or shareholder’s profit).
Hoover’s method is probably one of the best-known ways to carry out an acquisition analysis. You’ll need to first use the financial statements from a company to collect data, then analyze this and decide whether it shows potential for further growth or problems for investors. Then you can compare your findings with those of previous analysts to see how accurate your prediction was!
The analysis of an acquisition is a complicated and detailed process. However, it can provide important insights on how much your investment is worth. Nevertheless, it does have its limitations and there are other resources for acquiring better information about companies for specific projects.