What are Synergies?
Synergies are where two companies, when combined, can create greater value than on a standalone basis. These include operational, financial, and tax synergies. In most transactions, cost savings are the most important and easily quantifiable synergies. An acquisition usually involves the buyer paying a premium above the target’s traded share price to achieve control. This is valuable because it gives an acquirer ability to set strategy of the target, make operational improvements, extract cost savings, and ultimately, create value. The value creation is driven by synergies.
The combined business will take time to realize synergies, often over several years. Analysts discount these future streams of cash flows to calculate the present value (PV) of synergies. The difference between the PV of synergies and the control premium paid represents the acquisition’s value created or destroyed in the deal.
Estimating the PV of Synergies
The synergies can be estimated using a multiple or it can be valued using a DCF approach.
The discounted cash flow methodology discounts post-tax synergies using a discount rate. The actual discount rate is a subject of debate, as the synergies are arguably riskier than the forecast cash flows. Most analysts will use the target’s WACC as the discount rate. Beyond the forecast period (in the steady state,) the perpetual growth of synergies should be very low, probably the long-term inflation rate. Some analysts might even use a 0% growth rate to be conservative. We can estimate the value using the perpetuity formula.
The multiple methodology applies a multiple of earnings such as EV/EBIT to pre-tax synergies. Finding a suitable multiple can be hard as you need a number which reflects the long-term growth rate of the synergies which is usually close to inflation.
Calculating the PV of Synergies Using DCF Methodology
Here is a simple illustration to calculate the PV of synergies using DCF with a growth rate of 0%.
|Forward Year 1 SG&A synergies (Pre-tax)||50 million|
|Marginal tax rate||30%|
|Post-tax synergies||35 million (50 x (1-30%)|
|Discount rate/Target WACC||8%|
|Present value of synergies||437.5 million (35.0/8%)|
We look at the key terms used in this calculation:
Post-M&A, the combined business may experience synergies due to higher sales from increased market share, lower operational expenses from rationalizing factories, lower taxes, or lower interest payments. In the above example, the source of synergies is a reduction in SG&A expenses.
MTR is the tax on the next dollar of earnings. The target company’s marginal tax (MTR) is applied to synergies earned. The assumption is that synergies will be realized in the target company. If the synergies are occurring on the acquirer’s side of the business, analysts can use their marginal tax rate.
Calculating the PV of Synergies Using Multiple Methodology
Calculate the present value of synergies based on the information below:
|Forward Year 1 SG&A Synergies (Pre-tax)||50 million|
|Target EV/FWY 1 EBIT||8.5x|
|Present value of synergies||425 million (50 x8.5x)|
EV/FWY 1 EBIT
This is the ratio of enterprise value to the combined company’s expected EBIT in year 1. The result indicates that SG&A savings of 50 million would increase the combined company’s enterprise value by 425 million.
Applying the Present Value of Synergies
Calculating the present value of synergies is useful to understand the value created or destroyed in an M&A deal.
|Acquisition equity value||1,500 million|
|Pre-offer market capitalization||1,200 million|
|Forward year 1 SG&A synergies||50 million|
|Growth rate in synergies||0%|
Using the above data, we can calculate the control premium paid in this acquisition. It is calculated as the acquisition equity value less the pre-offer market capitalization. The pre-offer market capitalization is calculated using the unaffected share price.
|Acquisition equity value||1,500|
|Pre-offer market capitalization||1,200|
|Control premium paid||300 (1,500 – 1,200)|
Next, we compare the control premium paid with the PV of synergies.
|Control premium paid||300 million|
|Present value of synergies||437.5 million|
|Value created/destroyed||137.5 million|
In this example, the present value of synergies is higher than the control premium paid. As a result, the value created is 137.5 million.