how mergers and acquisitions are valued
both companies involved on either side of an m a deal will value the target company differently the seller will obviously value the company at the highest price possible while the buyer will attempt to buy it for the lowest price possible fortunately a company can be objectively valued by studying comparable companies in an industry and by relying on the following metrics with the use of a price to earnings ratio p e ratio an acquiring company makes an offer that is a multiple of the earnings of the target company examining the p e for all the stocks within the same industry group will give the acquiring company good guidance for what the target s p e multiple should be with an enterprise value to sales ratio ev sales the acquiring company makes an offer as a multiple of the revenues while being aware of the price to sales p s ratio of other companies in the industry a key valuation tool in m a a discounted cash flow dfc analysis determines a company s current value according to its estimated future cash flows forecasted free cash flows net income depreciation amortization capital expenditures change in working capital are discounted to a present value using the company s weighted average cost of capital wacc admittedly dcf is tricky to get right but few tools can rival this valuation method in a few cases acquisitions are based on the cost of replacing the target company for simplicity s sake suppose the value of a company is simply the sum of all its equipment and staffing costs the acquiring company can literally order the target to sell at that price or it will create a competitor for the same cost naturally it takes a long time to assemble good management acquire property and purchase the right equipment this method of establishing a price certainly wouldn t make much sense in a service industry wherein the key assets people and ideas are hard to value and develop impact on shareholdersgenerally speaking in the days leading up to a merger or acquisition shareholders of the acquiring firm will see a temporary drop in share value at the same time shares in the target firm typically experience a rise in value this is often because the acquiring firm will need to spend capital to acquire the target firm at a premium to the pre takeover share prices after a merger or acquisition officially takes effect the stock price usually exceeds the value of each underlying company during its pre takeover stage in the absence of unfavorable economic conditions shareholders of the merged company usually experience favorable long term performance and dividends the shareholders of both companies may experience a dilution of voting power due to the increased number of shares released during the merger process this phenomenon is prominent in stock for stock mergers when the new company offers its shares in exchange for shares in the target company at an agreed upon conversion rate shareholders of the acquiring company experience a marginal loss of voting power while shareholders of a smaller target company may see a significant erosion of their voting powers in the relatively larger pool of stakeholders 