Free «Qualitative Evaluation of Mergers» Essay

Mergers have become quite popular in the market today. This basically involves two distinct companies agreeing to work together under a common brand. Essentially, the seller company will lose most of its identity in the process while the buyer will have to pay the seller for winding up its independent operations. It is important to mention that the two companies end up having one managerial unit, which in most cases, concerns the buyer company. In any given merger, investors have the belief that they stand to gain in terms of the size of the market as well as the volume of sales by acquiring other companies. However, investors must be certain that a proposed merger will work for them before they enter into it. For example, they must seek to know what the target company is worth in terms of market volume as well as its reputation. This is quite important, because a company risks collapsing due to the wrong choice of a strategic company for a merger. In addition, a company may lose its loyal customers by appearing to associate with another company that people lack confidence in. As a matter of fact, both sides of the deal will have varying opinions about the other even as they negotiate the deal. It should be noted that each seller will try to make his or her company look as good as possible to fetch a high price. On the other hand, the buyer will try to use various tricks to ensure he or she gets the lowest price possible. Therefore, this is natural in a free market system and should not cause any worry. The fundamental thing that each firm should do is to use legitimate ways to assess the value of each other. In most companies, taking a look at comparable companies within the same industry would be a very good idea. However, various other ways have become popular as well. These include comparative ratios, replacement cost and discounted cash flow.

1. Comparative Ratios

There are two comparative ratios that are popularly used by investors in order to assess the value of companies they target for merger. The most commonly used ratio is the price-earnings ratio, because it is more qualitative in nature. Generally, the price of stock can be improved due to an improvement in the overall earnings by the company. As a result, managers are able to use strong incentives in a bid to boost the amount of their earnings per share, and this may increase the growth rate of the firm in the long term. In practice, if a company wishes to take over another company that has a higher price-earnings ratio, it will be beneficial to pay the selling company in form of cash, rather than in stock. Since paying in stock will significantly harm the acquiring company as it will cause earnings dilution. Eventually, the merger will not have a lot of impact in terms of increased volume of earnings for the acquiring firm. Conversely, a firm that has a higher price-earnings ratio will definitely use its stock to pay for the acquisition. This is more strategic and investors often use this ratio to decide on which route to take. It should also be noted that companies that have relatively lower price-earnings ratio will most likely leverage their balance sheet quite openly. This will make it look more expensive after leverage, giving an impression that earnings growth rate significantly increased after that. This are basically attempts to drive the price of shares up so that the acquiring firm can pay slightly more. For that reason companies acquiring companies should understand these tricks and avoid falling into the traps. It should be noted that the actual performance of the selling firm is quite important to the success of the merger. The other ratio that is often used is the enterprise-value-to-sale ratio. Essentially, these ratios can help the acquiring firm to access the actual performance of the firm in order to ascertain that the merger deal will not backfire.

2. Replacement Cost

This refers to the cost of replacing an asset at the time of the merger, in accordance with its actual worth in the market. It is a common practice for the selling company in any merger to over-price its assets in a bid to fetch a higher price in the deal. This is purely natural in business given that every player seeks to maximize on its profits. In this regard, the acquiring firm should not sit pretty and expect that the selling firm will provide the right value of its assets. Instead, the company should set out in order to determine the actual value of each asset if they were to be replaced at the given time, also considering the value of taxation as well as other policy issues. This is purely to prevent the firm from paying too much for assets that will not serve an equal purpose after the merger. Actually, the acquiring firm will be struggling to make profits simply because it paid more cash than was worth the assets of the selling company. It is an area that is often taken for granted, but has the potential of bringing down the acquiring firm, especially considering that assets will stay with the company for a long period of time. Although, it may be equally expensive to hire professionals to provide the actual value of the assets, it is an important adventure given that the margin that the selling company may put is unknown to the acquiring firm. This makes it as a common practice in mergers, especially when investors are cautious about the possibility of making extreme losses after the integration. It should be noted that the main reason why the acquiring company opted into the merger was purely to boost its chances of success. Thus, it will make little sense if it allowed itself to lose by paying the selling company more than it is worth.

3. Discounted Cash Flow

This is basically a method of analyzing the actual value of a project with a view to determining its market value. This is common for assets where calculations take into consideration the fact that the assets have been used for a particular period of time and therefore, their value has depreciated significantly. The concept is also popularly referred to as time value of money considering that it appear to change with time. For example, an asset that has been used for four years will have a higher market value that another asset that has been in use for ten years. In calculation of a company’s worth, this is determined in order to assess the rate of cash flow as well as the discount that can be allowed on the present value. The principle of discounted cash flow is mostly used in real estate, corporate finance as well as in investment finance. This principle has been applied by buying companies to determine the value of the selling companies before they make payment. However, it has several shortcomings that hinder investors from applying it as often. For example, the discount rates that are used in the valuation rely on various market forces that keep changing in any dynamic market. It goes without saying that interest rates are bound to change, in fact dramatically, over time thereby rendering most calculations irrelevant. In addition, the concept is a mere mechanical tool that is undoubtedly subject to the idea of “garbage in and garbage out”. As such, slight alterations in the actual inputs can result in huge changes in the company’s worth. It is this reality that limits its use in the market to determine the value of companies. Therefore, this concept can only apply in an ideal market where factors are kept constant and important market forces are not at play. However, this can never be possible, leaving it with little use in determining the market value of real estate investments.

In conclusion, mergers have become quite popular in the market today. This involves two distinct companies agreeing to work together under a common brand. Essentially, the seller company will lose most of its identity in the process while the buyer will have to pay the seller for winding up its independent operations. There are two comparative ratios that are popularly used by investors to assess the value of companies they target for merger. The most commonly used ratio is the price-earnings ratio, because it is more qualitative in nature. Generally, the price of stock can be improved due an improvement in the overall earnings by the company. Replacement cost is also a common practice for the selling company in any merger to over-price its assets in a bid to fetch a higher price in the deal. This is also purely natural in business given that every player seeks to maximize on its profits. Lastly, in this regard, the acquiring firm should not sit pretty and expect that the selling firm will provide the right value of its assets.