FREE online courses on Mergers & Acquisitions - Chapter 5 - Financial Analysis

 

We start the valuation process with a complete analysis of historical performance. The valuation process must be rooted in factual evidence. This historical evidence includes at least the last five years (preferably the last ten years) of financial statements for the Target Company. By analyzing past performance, we can develop a synopsis or conclusion about the Target Company's future expected performance. It is also important to gain an understanding of how the Target Company generates and invests its cash flows.

 

One obvious place to start is to assess how the merger will affect earnings. P / E Ratios (price to earnings per share) can be used as a rough indicator for assessing the impact on earnings. The higher the P / E Ratio of the acquiring firm compared to the target company, the greater the increase in Earnings per Share (EPS) to the acquiring firm. Dilution of EPS occurs when the P / E Ratio Paid for the target exceeds the P / E Ratio of the acquiring company. The size of the target's earnings is also important; the larger the target's earnings are relative to the acquirer, the greater the increase to EPS for the combined company.

 

It is important to note that we do not want to get overly pre-occupied with earnings when it comes to financial analysis. Most of our attention should be directed at drivers of value, such as return on capital. For example, free cash flow and economic value added are much more important drivers of value than EPS and P / E Ratios. Therefore, our financial analysis should determine how does the target company create value - does it come from equity, what capital structure is used, etc.? In order to answer these questions, we need to:

 

1. Calculate value drivers, such as free cash flow.
2. Analyze the results, looking for trends and comparing the results to other companies.
3. Looking back historically in order to ascertain a "normal" level of performance.
4. Analyzing the details to uncover how the Target Company creates value and noting what changes have taken place.