Now that we have identified reasons for paying a premium; what is a premium? By definition, it is higher than the average price. But if the market will ultimately determine the price, where do you start?
You start with the notional value. A notional value determination is one in absence of an open market transaction, in other words, intrinsic or stand-alone value. The notional value of an enterprise does not include what a strategic acquirer can bring to the operations (i.e. with a distribution network or sales force, etc.) The notional value is determined through an extensive analysis of the company’s financial performance and market opportunities typically by applying a Discounted Cashflow Analysis (DCF) and/or a public company market trading and acquisition comparable analysis (I will provide more details regarding valuation analysis in a later post).
The notional enterprise value is driven by earnings and earnings potential and the risk associated with generating those earnings. Earnings may be generated by levered or unlevered assets. Enterprise value consists of term debt and equity (assuming a normal level of working capital), so if there is debt in the company, it must be subtracted from enterprise value to get to equity value, which is the net amount a seller can expect to receive.
A premium is the amount a buyer will pay, over and above the notional value, however, how the purchaser is being valued is a factor in this equation. Only in rare cases will a buyer pay a price that is dilutive to the acquiring company’s forecast earnings. An example is acquiring technology; whether it is a patent that doesn’t generate any direct revenues or whether it is a company that is losing money presently but is expected to be very profitable in the future. In cases like this it may make sense to accept short-term dilution to earnings (i.e. an investment in future earnings) from an acquisition.
The norm is that an acquisition is accretive to the purchaser’s earnings. An example of an accretive acquisition is best illustrated with an example of a publicly traded company (Company A). Say Company A trades at 12 times EBITDA of $10M (i.e. an enterprise value of $120M) and the target is purchased at 7 times EBITDA of $1M (a price of $7M). The go forward enterprise now generates $11 million (excluding synergies) and with a multiple of 12 (assuming the market likes the acquisition and views the pro-forma combined company as having similar prospects), the enterprise value is now $132M.
While the example is simplistic, the concept that I want to highlight is, what if the notional value is $5M?
Perhaps during a divestiture process there would have been several expressions of interest at $5M but the winning bidder had to pay more. Company A could have paid $10M (10 times EBITDA – as it trades at 12 times EBITDA) and it would still have been accretive. How much of a premium should Company A pay? This is the technical dance; the grey area between the intrinsic value and the value to a buyer.
So what will a strategic buyer pay? They will pay somewhere between the notional value and the value to the buyer. Creating a competitive bidding environment can persuade the winning buyer to pay more than the notional value and share some of the value to the buyer with the seller.