Online Tutorial #9: How Do You Analyze an M&A Deal?

In this online tutorial, we walk through the application of several M&A analytical tools:

Shareholder Value at Risk (SVAR). SVAR is a "bet your company" index. It shows you what percentage of the acquiring company's value is at risk if the combination doesn't product any post-acquisition synergy.

Premium at Risk. This measure helps selling shareholders assess the risk that they will lose a portion of the premium they have been pledged if no synergies materialize.

Anticipating the market's initial reaction. The value change from an M&A deal equals the present value of synergies minus the acquisition premium. You can use this formula to anticipate the market's initial reaction to an M&A deal. This tool offers far superior predictive power than the more commonly used M&A earnings accretion/dilution analysis.

Post-announcement analysis. This analysis updates the SVAR and Premium at Risk metrics after the deal is announced and the market has reacted. Such analysis enables you to judge the post-announcement attractiveness of the acquirer's and the seller's shares.

We will use the hypothetical deals in which Buyer, Inc. acquires Seller, Inc. for various amounts of cash or stock—developed in Chapter 10 of the book—as case studies for this online tutorial.

Readers who want to perform these calculations may wish to download the accompanying spreadsheet.

What Are Three Common Ways To Pay For an M&A Deal?

Before we continue, we must define three common ways to pay for an M&A deal:

1. Cash. If Buyer, Inc. uses cash in its bid, it will offer shareholders in Seller, Inc. a specific amount of cash for each share of Seller, Inc.

2. Fixed-Value Stock. Buyer, Inc. may offer "fixed-value stock"—with a guarantee fixing the value of the shares it will pay—for each Seller, Inc. share. Put simply, in a fixed-value stock deal, the value of Buyer, Inc. shares offered to Seller, Inc. shareholders is completely fixed, while the number of shares offered fluctuates depending on Buyer, Inc. share price at closing date. This means that Buyer, Inc. shareholders bear all the price risks and rewards during the preclosing period. Seller, Inc. shareholders face no price risk or reward, as they receive a fixed value of Buyer, Inc. shares.

3. Fixed-Shares Stock. Buyer, Inc. may offer "fixed-shares stock"—with a guarantee fixing the number of the shares it will pay—for each Seller, Inc. share. Put simply, in a fixed-share stock deal, the number of Buyer, Inc. shares offered to Seller, Inc. shareholders is completely fixed, while the value of shares offered fluctuates depending on Buyer, Inc. share price at closing date. This means that Buyer, Inc. and Seller, Inc. shareholders share the risk and rewards of changes in Buyer, Inc. stock price during the preclosing period. In a fixed-shares stock deal, Seller, Inc. shareholders can face significant risk that their newly issued shares in Buyer, Inc. will trade at a discount to the pre-deal price of Buyer, Inc shares.

Please note that a particular M&A deal may have more than one of the three components as part of its offer. For example, acquirers often make an offer using a combination of cash, and either fixed-value stock or fixed-shares stock. We have designed the downloadable spreadsheet accompanying this tutorial to analyze these more complicated transactions.

Inputting the Data For An M&A Analysis

Entering the data for these analyses is very simple. Here are the data points you need and where to enter them in the spreadsheet:

1. Company name. Enter the name of the Acquirer in cell C6 of the "Inputs" worksheet. Enter the name of the Seller in cell C12 of the "Inputs" worksheet.

2. Shares outstanding (in millions). Enter the number of Acquirer shares outstanding (in millions) in cell C7 of the "Inputs" worksheet. Enter the number of Target shares outstanding (in millions) in cell C13 of the "Inputs" worksheet. You can obtain these from a press release, news article, or recent SEC filing.

3. Stock price pre-announcement ($, per share). Enter the pre-announcement closing price of Acquirer's shares ($, per share) in cell C8 of the "Inputs" worksheet. Enter the pre-announcement closing price of Target's shares ($, per share) in cell C14 of the "Inputs" worksheet.

In the case studies we develop in Chapter 10, these data points are as follows:

Next, we need to enter the terms of the M&A transaction. In the book, we present three hypothetical deal examples:

1. All cash. In this case, Buyer, Inc. offers $100 per Seller, Inc. Share. Here, we would enter $100 ($, per share) in cell C18 of the "Inputs" worksheet. Cell C20 and Cell C22 should be empty:

2. All fixed-value stock. In this case, Buyer, Inc. offers $4 billion in fixed-value stock to acquire all outstanding Seller, Inc. shares. Here, we would enter $4,000.0 ($, in millions) in cell C20 of the "Inputs" worksheet. Cell C18 and Cell C22 should be empty:

3. All fixed-shares stock. In this case, Buyer, Inc. offers to exchange one Buyer, Inc. share for each Seller, Inc. share outstanding. Here, we would enter 1.000 in cell C20 of the "Inputs" worksheet. Cell C18 and Cell C20 should be empty:

Calculating Shareholder Value at Risk (SVAR) and Premium at Risk

Using the inputs described above, the accompanying spreadsheet will calculate the Buyer's Shareholder Value at Risk (SVAR) and the Seller's Premium at Risk for any given type of deal. The results for these calculations can be seen in the worksheet "SVAR and Premium at Risk" in the spreadsheet accompanying this tutorial.

We highlight seven interesting results:

Percent of postmerger company owned by Seller, Inc. shareholders assuming no synergies (%). This gives us the percent of the postmerger company owned by Seller, Inc. shareholders, assuming no synergies are reflected in Buyer, Inc.'s stock price at closing date. This metric is calculated in cell C48 of worksheet "SVAR and Premium at Risk."

Percent of postmerger company owned by Buyer, Inc. shareholders assuming no synergies (%). This gives us the percent of the postmerger company owned by Buyer, Inc. shareholders, assuming no synergies are reflected in Buyer, Inc.'s stock price at closing date. Note that Buyer, Inc.'s stock price affects ownership percentages after the closing only in fixed-value stock deals. This metric is calculated in cell C49 of worksheet "SVAR and Premium at Risk."

Post-deal return to Seller, Inc.'s shareholders assuming no synergies (%). This metric calculates the expected share price performance earned by Seller, Inc. shares assuming no synergies are reflected in Buyer, Inc.'s stock price at closing date. This metric is calculated in cell C60 of worksheet "SVAR and Premium at Risk."

Post-deal return to Buyer, Inc.'s shareholders assuming no synergies (%). This metric calculates the expected share price performance earned by Buyer, Inc. shares assuming no synergies are reflected in Buyer, Inc.'s stock price at closing date. This metric is calculated in cell C61 of worksheet "SVAR and Premium at Risk."

Seller, Inc.'s Premium at Risk (%). To entice Seller, Inc. shareholders to sell their shares, Buyer, Inc. must offer a premium over Seller's preannouncement share price. In a deal with a fixed-share stock component, Seller, Inc. shareholders face the risk that some of this premium will be lost in the event that Buyer, Inc.'s stock price at closing date does not reflect any synergies. Seller, Inc.'s Premium At Risk refers to the percent of Seller, Inc.'s premium that would be lost if there are no synergies. This metric is calculated in cell C63 of worksheet "SVAR and Premium at Risk."

Buyer, Inc.'s Hypothetical Shareholder Value at Risk (SVAR) assuming an all-cash deal (%). In a cash or fixed-value stock deal, Buyer, Inc. shareholders bear all the potential price risk and reward from announcement to closing date. This metric calculates the Buyer, Inc.'s SVAR in the hypothetical case that the deal is financed entirely by cash or fixed-value stock. It offers a useful way to measure the ceiling of the potential SVAR of a deal at a certain price. This metric is calculated in cell C65 of worksheet "SVAR and Premium at Risk."

Buyer, Inc.'s Actual Shareholder Value At Risk (SVAR, %). If a deal has a fixed-share component, the potential risk and reward will be shared among both Buyer, Inc. and Seller, Inc. shareholders. Thus, the Buyer, Inc.'s SVAR will be less than SVAR for a deal financed entirely with cash or fixed-value stock. This metric—Buyer, Inc's actual SVAR—is calculated in cell C67 of worksheet "SVAR and Premium at Risk."

These seven results will vary according to the structure of the M&A deal. Below, we present them for our three case studies: an all-cash deal, a deal in fixed-value stock, and a deal in fixed-share stock.

Calculations Anticipating the Market's Initial Reaction

We can estimate the market's initial reaction to a deal by using the inputs described above, along with two more data points:

Expected annual synergies from M&A deal ($, in millions). This is equal to the annual synergies—resulting from higher sales, lower costs, and lower investments—expected to occur from two companies coming together as one entity. For example, if we expected $50 million in annual synergies from the merger of Buyer, Inc. and Seller, Inc., we would enter $50.0 ($, in millions) in cell C24 of the "Inputs" worksheet.

Weighted Average Cost of Capital (WACC, %). This is equal to the weighted average cost of capital (%) for the postmerger company. For example, if we estimated WACC to be 10%, we would enter 10% in cell C25 of the "Inputs" worksheet.

The results for these calculations can be seen in the worksheet "Pre-Market Reaction Analysis" in the spreadsheet accompanying this tutorial.

Using these inputs, the accompanying spreadsheet calculates the expected "Post-deal return" for both Buyer, Inc. and Seller, Inc. shareholders. The spreadsheet calculates this by assuming that the value change from an M&A deal equals the present value of synergies minus the present value of the acquisition premium. Specifically, we make the following calculations:

Present value of synergies. We calculate this by assuming estimated annual synergies continue into the future, and thus equate to a perpetuity. This means the present value of synergies equals estimated annual synergies divided by the weighted average cost of capital. In the example of a $50 million in expected annual synergies and a 10% WACC, the present value of estimated synergies equals $50 million divided by 10%, or $500 million. Note: Valuing synergies as a perpetuity may be aggressive in some cases. Thus, we would suggest that this calculation serves as a first approximation of the value impact of a deal. This calculation can also help investors determine whether the synergies expected by management are consistent with the premium that they paid.

Premium offered. This is the difference between the value of cash and stock offered for all Seller, Inc. shares—equal to $4.0 billion in our case studies—and the pre-deal value of Seller, Inc.—equal to $2.8 billion. Thus, the premium offered equals $1.2 billion.

In addition to the two calculations above, we highlight four interesting results:

Percent of postmerger company owned by Seller, Inc. shareholders (%). This gives us the percent of the postmerger company owned by Seller, Inc. shareholders, assuming estimated synergies are reflected in Buyer, Inc.'s stock price at closing date. This metric is calculated in cell C45 of worksheet "Pre-Market Reaction Analysis."

Percent of postmerger company owned by Buyer, Inc. shareholders (%). This gives us the percent of the postmerger company owned by Buyer, Inc. shareholders, assuming estimated synergies are reflected in Buyer, Inc.'s stock price at closing date. This metric is calculated in cell C46 of worksheet "Pre-Market Reaction Analysis."

Post-deal return to Seller, Inc.'s shareholders (%). This metric calculates the expected share price performance earned by Seller, Inc. shares assuming estimated synergies are reflected in Buyer, Inc.'s stock price at closing date. This metric is calculated in cell C55 of worksheet "Pre-Market Reaction Analysis."

Post-deal return to Buyer, Inc.'s shareholders (%). This metric calculates the expected share price performance earned by Buyer, Inc. shares assuming estimated synergies are reflected in Buyer, Inc.'s stock price at closing date. This metric is calculated in cell C56 of worksheet "Pre-Market Reaction Analysis."

These four results will vary according to the structure of the M&A deal. Below, we present them for our three case studies—an all-cash deal, a deal in fixed-value stock, and a deal in fixed-share stock—assuming $50 million in annual synergies and a 10% cost of capital:

Calculations After the Market's Initial Reaction

The final part of the M&A assessment updates the analysis after the deal is announced and the market has reacted. Such analysis enables us to judge the postannouncement attractiveness of the acquirer's and the seller's stock for cash and stock transactions.

To perform this analysis, we need to use our initial inputs as well as one more data point:

Buyer, Inc.'s postannouncement share price ($, per share). This equals the value of Buyer, Inc.'s shares after the market has reacted to the deal. In the book, we set this number equal to $90. In the spreadsheet, we enter $90.00 into cell C30 of the "Inputs" worksheet.

The results can be seen in the worksheet "Post-Market Reaction Analysis" in the spreadsheet accompanying this tutorial.

The spreadsheet makes the following calculations:

• Buyer, Inc.'s preannouncement market capitalization ($, millions). This equals Buyer, Inc.'s preannouncement share price multiplied by the number of Buyer, Inc. shares outstanding, or $5.0 billion. You can see this calculation in cell C14 of worksheet "Post-Market Reaction Analysis."

• Buyer, Inc.'s postannouncement market capitalization ($, millions). This equals Buyer, Inc.'s postannouncement share price multiplied by the number of Buyer, Inc. shares outstanding, or $4.5 billion. You can see this calculation in cell C18 of worksheet "Post-Market Reaction Analysis."

• Postannouncement market value change ($, in millions). This equals the difference between the preannouncement market capitalization--here, equal to $5.0 billion—and the postannouncement market capitalization—here, equal to $4.5 billion. Thus, the postannouncement market value change equals $500 million. You can see this calculation in cell C20 of worksheet "Post-Market Reaction Analysis."

• Total premium offered for Seller, Inc. (in millions). As before, this is the difference between the value of cash and stock offered for Seller, Inc. shares—equal to $4.0 billion in our case study—and the pre-deal value of Seller, Inc.—equal to $2.8 billion. Thus, the premium equals $1.2 billion. You can see this calculation in cell C36 of worksheet "Post-Market Reaction Analysis."

• Synergy risk that remains for the continuing shareholders of Buyer, Inc. or other investors who purchase Buyer, Inc. shares at the current price ($, in millions). This equals the difference between the total premium offered for Seller, Inc.—here, equal to $1.2 billion—and the positive postannouncement value change—here, equal to $500 million. Thus, the remaining synergy risk for Buyer, Inc. shareholders equals $700 million. You can see this calculation in cell C40 of worksheet "Post-Market Reaction Analysis."

Using these numbers, this analysis generates five interesting results:

• Percent of postmerger company owned by Seller, Inc. shareholders (%). This gives us the percent of the postmerger company owned by Seller, Inc. shareholders, given Buyer, Inc's new share price. This metric is calculated in cell C49 of worksheet "Post-Market Reaction Analysis."

• Percent of postmerger company owned by Buyer, Inc. shareholders (%). This gives us the percent of the postmerger company owned by Buyer, Inc. shareholders, given Buyer, Inc's new share price. This metric is calculated in cell C50 of worksheet "Post-Market Reaction Analysis."

• Seller, Inc.'s Postannouncement Premium at Risk (%). After the market reacts to the deal, Seller, Inc.'s Premium At Risk--the percent of Seller, Inc.'s premium that would be lost if there are no synergies reflected in Buyer, Inc.'s stock price at closing date--will change. This metric is calculated in cell C59 of worksheet "Post-Market Reaction Analysis."

• Buyer, Inc.'s Hypothetical Postannouncement Shareholder Value at Risk (SVAR) assuming an all-cash deal (%). After the market reacts to the deal, the Buyer, Inc.'s hypothetical all-cash SVAR will change. This metric is calculated in cell C61 of worksheet "Post-Market Reaction Analysis."

• Buyer, Inc.'s Actual Postannouncement Shareholder Value At Risk (SVAR, %). After the market reacts to the deal, the Buyer, Inc.'s actual SVAR will change. This metric is calculated in cell C63 of worksheet "Post-Market Reaction Analysis."

These five results will vary according to the structure of the M&A deal. Below, we present them for our three case studies—an all-cash deal, a deal in fixed-value stock, and a deal in fixed-share stock—assuming no synergies and a fall in Buyer, Inc.'s share price from $100 to $90: