valuation of synergy

Synergy Valuation and Merger Analysis

Synergy in a merger refers to the additional value created by combining two businesses, exceeding the sum of their individual values. This extra value arises from cost reductions, increased revenue, or both. Synergy valuation is the process of estimating the present value of these potential synergistic benefits and adding it to the combined company's valuation.

Types of Synergies:

Synergies are broadly categorized into revenue, cost, and financial synergies:

1. Revenue Synergies:

These synergies arise from increased sales and market reach. Examples include:

• Access to New Markets: Merged companies can leverage each other's existing customer bases and distribution networks to expand into previously inaccessible markets.
• Cross-selling and Up-selling: A diversified product portfolio allows for cross-selling (selling related products) and up-selling (selling higher-value products) to existing customers, increasing market share.
• Enhanced Brand Recognition: Combining strong brands can create a more powerful and recognizable entity, attracting more customers.

Example: The Lafarge and Holcim merger in 2014 exemplifies revenue synergies. The combined entity gained access to a wider range of construction materials, broader geographic coverage, and improved opportunities for expansion and innovation.

2. Cost Synergies:

These synergies result from reductions in expenses and improved operational efficiency. They can be further divided into:

• Income Statement Synergies: These are reflected in the income statement and include:
  • Reduced Cost of Goods Sold (COGS): Streamlined operations and economies of scale can lower production costs.
  • Lower Marketing Expenses: Combining marketing efforts can reduce overall marketing spend.
  • Decreased General and Administrative Expenses: Consolidation of administrative functions can lead to cost savings.
  • Streamlined Operational Expenses: Improved efficiency and elimination of redundancies can lower operational costs.
• Balance Sheet Synergies: These impact the balance sheet and involve:
  • Operating Liquidity Efficiencies: Improved cash flow management and working capital optimization.
  • Capital Expenditure Efficiencies: Reduced capital expenditures due to shared resources and infrastructure.

3. Financial Synergies:

These synergies relate to optimizing the merged company's financial structure and reducing the cost of capital. Examples include:

• Tax Benefits: Utilizing tax losses or credits from one company to offset the profits of the other, or achieving a lower overall tax rate.
• Increased Debt Capacity: A larger, more diversified entity may have greater access to debt financing and at more favorable interest rates.
• Lower Cost of Capital: A stronger financial profile can lead to a lower cost of capital, making it cheaper for the company to raise funds for future investments.

In essence, financial synergies aim to minimize the cost of capital and enhance the financial flexibility of the combined entity.

Example Merger Analysis:

Let's analyze a hypothetical merger between Companies P and Q:

Company P:

• Market Value: 500
• Outstanding Shares: 25
• Profits: 40

Company Q:

• Market Value: 300
• Outstanding Shares: 15
• Profits: 20

Synergy Value: 50

(a) Post-Merger Overall Value:

• Total Value = Market Value of P + Market Value of Q + Synergy Value

• Total Value = 500 + 300 + 50 = 850

  (b) New Earnings Per Share (EPS):

• Combined Earnings = Earnings of P + Earnings of Q Combined Earnings = 40 + 20 = 60

• Total Shares Outstanding = Shares of P + Shares of Q Total Shares Outstanding = 25 + 15 = 40

• Combined EPS = Combined Earnings / Total Shares Outstanding

• Combined EPS = 60 / 40 = 1.50 (c) Premium Paid for Company Q:

  • Pre-Synergy Total Value = Market Value of P + Market Value of Q

• Pre-Synergy Total Value = 500 + 300 = 800

• Pre-Synergy Value per Share = Pre-Synergy Total Value / Total Shares Outstanding

• Pre-Synergy Value per Share = 800 / 40 = 20

• Purchase Price for Q = Pre-Synergy Value per Share * Shares of Q

• Purchase Price for Q = 20 * 15 = 300

• Premium Paid = Purchase Price for Q - Market Value of Q

• Premium Paid = 300 - 300 = 0

In this example, no premium was paid for Company Q because the purchase price based on pre-synergy value equaled its market value. However, the combined entity benefits from the synergy value, increasing the overall value and EPS.