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How to calculate synergies in M&A

Inna Jelies - December 8, 2014 - No comments

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M&A (mergers and acquisitions) should be proceeded in a way that increases the value of a company to the
shareholders.

A corporate merger is a combination of assets and liabilities of two firms which form a single business entity. When the
senior management decides to buy another company, it is mostly focused on increasing the value of a new company.

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The synergy effect is expected to be the core driver to improve sales, profit margins and the market positioning of the
company. Excluding any synergies resulting from the merger, the total post-merger value of the two firms is equal to
the pre-merger value.

Nevertheless, synergies do exist. Often the value creation is the motive for an acquisition. And it can result in several
ways from the transactions synergy. Value can be created, for example, through revenue enhancement, cost reductions,
increased operating cash flow, improved managerial decision making, or the sale of redundant assets. However, value
created from proposed synergies also may have an additional investment cost as well.

Acquisition targets total value comprises of the assets in place and the value of merging companies combined with real
options.In another words, a buying company, who views synergies as real options can profit from acquisitions even
though it paid a premium over the market price. Post-acquisition strategic real options are considered as the value
adding real options (which we defined broadly as synergies) that are unlikely fully priced in the market, because they
can be exclusively available only for a specific acquiring company.

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Synergy takes the form of revenue enhancement and cost savings. When two companies in the same industry merge,
such as two banks, combined revenues tend to decline to the extent that the businesses overlap in the same market and
some customers become alienated. For the merger to benefit shareholders, there should be cost-saving opportunities to
offset the revenue decline. In other terms, the synergies deriving from the merger must exceed the initial lost value.

As a rule of thumb, synergy is a business combination where 2+2 = 5. Or here is another way we can calculate synergies
in M&A:

Synergy = NPV (Net Present Value) + P (premium), where

NPV net present value of newly created company.

Synergy benefits can come from four potential sources:

1. Revenue increase. This can be done by selling more different goods and services using a broadened product
distribution. This will help the new company to compete for customers which originally were not the clients.
2. Expenses reduction. Because of a merger or acquisition, many companies optimize internal positions and
introduce more responsibilities to the existing roles.
3. Process optimization. It is done by introducing enhanced marketing tactics and strategies, branding, better
technologies, and more effective distribution.
4. Financial economy. United enterprise from the legal prospective can get better tax benefits, state support etc. But
the buyers should remember: financial economy alone cant optimize the strategic position of a company. So it
should not be the only value driver in the deal.
To calculate synergies in M&A, the evaluation should be focused on three parameters:

Benefit impact from synergy effect. This basically means that each forecast component should be critically
reviewed. However, consultants tend to make overly-optimistic cash flows and costs.
Probability of achieving. Here we can consider three scenarios: optimistic, pessimistic and the realistic for
achieving. The Monte-Carlo simulation methodhelps with finding the range of possible results.
Time of benefit generation. History of M&A deals have a lot of cases when speeding up with a purpose of
increasing acquisition attractiveness lead to overestimated synergy value. Doing this M&A team cheat on
themselves.
These parameters can have a huge impact on accuracy of the synergy evaluation.

M&A professionals often solely focus on the benefits of synergies during a pricing analysis for an acquisition. However,
acquirers often must make incremental investments before realizing the return on capital generated by synergies. Many

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analysts, however, do not consider these incremental investments or hidden costs when performing a pricing analysis
or valuation of a potential target. Failure to consider the hidden costs often causes the overvaluation of a potential
target, which may lead to destroyingvaluerather than creating it.

Synergy appeared due to acquisition should include higher results then it was originally expected.

Acquisition process should be well-planned. Mark Sirower, US leader of the Merger & Acquisition Strategy and
Commercial Diligence practice,named 4 components which should take place in order to achieve successful synergies:

Strategic vision
Operating strategy
Systems integration
Power and culture
The buyer should pay out the premium to shareholders of merged company. The higher the premium, the lower the
potential benefit for the buyer. Therefore, synergies should not be intangible. It should be carefully forecasted and
discounted net cash flows which are feasible within the chosen time frame.

Post-merger integration issues, as well as competitors reactions, can contribute to the hidden costs of an acquisition.
Besides the positive impact of revenue enhancements, cost reductions, and other efficiencies, valuation analysts need to
price them in, too.

Tags: calculate synergies, how to calculate synergies in M&A, how to evaluate synergies in M&A, inna jelies, m&a, net present
value, synergies, synergies effect, synergy, value creation
Categories: Finance

About the author

Inna Jelies is a financial analyst, specialist in business appraisal and financial expert at AlphaGamma. Has a
Master degree in Economics and Finance with a focus in "Property Valuation". Sphere of interests:
investments, M&A, financial analysis. Likes to create handmade items, travel, chess and to do sports.
View all posts by Inna Jelies

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