How Financial Modeling can be used in Mergers & Acquisitions?
Financial Modeling in Mergers & Acquisitions (M&A) is the analysis of the amalgamation of two companies coming together through the process of M&A. Wherein, a mutual agreement is formed for a consolidated entity, and one company offers cash or buys the shares of another company in order to buy it.
Let’s understand the same with the help of a scenario.
It is well past 9 pm on Friday night at the M&A team of a leading investment bank. Ronak was looking forward to the weekend break. After all this was his first week at the new job and he wanted to catch up with friends over the weekend. Just then the phone rang and after a quick conversation, his boss announced “The deal is on. We have 3 days to complete the analysis of the target company. Let’s get started”.
Ronak was completely confused and had no idea what was expected and what was his role. So he approached Vijay, his boss, a veteran investment banker for help. Vijay started explaining, “As you know Ronak, Priya Ceramics, our client wanted to acquire a smaller company in the ceramics space. They have zeroed in on Jewel ceramics as their likely candidate. Now, Priya Ceramics wants us to carry out the valuation of Jewel Ceramics to know the price at which they should bid for Jewel ceramics.
Ronak, still puzzled, enquired how that would be accomplished. Vijay explained “We will start by looking historical financial statements of Jewel Ceramics. By populating these numbers in our spread sheets, we will create a financial model “. Ronak quickly replied, “Yes, That would be the historical model. Based on our expert knowledge of the ceramics industry, we would be able to create a model for Jewel that will forecast future profits. This would help Priya Ceramics realize how Jewel’s business will contribute to its profit over the next few years”.
Vijay was happy to see that Ronak now understood the valuation process. “You are right Ronak. Not just the performance but Priya Ceramics would also need to know now much to pay for Jewel Ceramics. Based on the cash flows expected to be generated, we will carry out the valuation of Jewel Ceramics. To eliminate any possible errors in estimation, we will employ multiple methods like DCF, P/E Multiple, EV/EBITDA multiple etc. to value the company. Once we have our financial model in place, all these calculations can be carried out quickly. Also we can check the sensitivity of the valuation to changes in the key inputs”, remarked Vijay.
Ronak was quite excited now and he asked “I had read somewhere that when a merger or an acquisition takes place, there can be synergies for both the companies involved. How do we account for these?” Vijay replied “As you may be aware, synergy represents potential financial benefit achieved through the combination of companies. To model synergies, we also have to build the model of Priya Ceramics. After studying both companies, we would be in a position to comment on the different areas where synergies can exist. Using financial models for Priya Ceramics and Jewel Ceramics, the synergy benefits for revenues and costs can be crystallized. Based on our analysis, Priya Ceramics management will be able to take the final decision of purchasing Jewel Ceramics, including the purchase price”
Vijay looked at Ronak, after completing the explanation. Ronak remarked “At every step, we will have to work with the financial models that we create for both companies. And before you tell me, I know I have to start the work of creating the models”. Both laughed and got back to their work. They had a long night before them.