EVAluation Volume 3 • Issue 8 • November 2001

Stern Stewart Research

India

EVAluating Mergers and Acquisitions–

How to avoid overpaying

Executive Summary
Tejpavan Gandhok, Most acquirers tend to overpay because they overestimate the value they will add to the
Anurag Dwivedi target and execute poorly in delivering promised benefits
Jatin Lal
T: 91-22 654 1536 This article discusses how Boards of Directors, CEOs, CFOs and Corporate Strategists can
F: 91-22 654 1535 use EVA“ based valuation and performance management techniques to improve their
company’s chances of success in M&A and other major investments.

The empirical evidence overwhelmingly concludes that in most merger and acqui-
sition transactions, the value created typically goes to the shareowners of the tar-
get companies, i.e. acquirers typically overpay. There are two major reasons for
this. First acquirers overestimate the value of the target firm and/or the value of
the synergies that they will add. Second the rewards of most acquirers’ manage-
ment teams and their advisers are tied to doing the deal rather than to creating
wealth for their shareowners1 .

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1
The empirical evidence and a more thorough discussion of the reasons for these observed findings are presented in our
EVAluation Volume 3, Issue 4, April 2001; “M&A Why Most Winners Lose”, by Dennis Soter.

Stern Stewart & Co., Sunteck Centrako #8-03 MMTC HouseBandra-Kurla Comples, Bandra (E)Mumbai 40051, India
EVAluation is a series of periodic reports from Stern Stewart & Co., drawing on the depth of our experience
and internal research, to cover issues of valuation, organizational design, decision making, remuneration, and
corporate governance. We assist in understanding how actions affect value. We believe that all stakeholders
benefit from the creation of value through both innovation and efficiency.

The views expressed in this report are based on Stern Stewart & Co.’s general knowledge, analysis and understanding of value,
incentives and corporate governance issues. All estimates and opinions included in this report constitute our judgement as of the
date of the report and may be subject to change without notice. No warranties are given and no liability is accepted in contract,
tort (including negligence) or otherwise by Stern Stewart for any loss or damage that may arise from actions based on any infor-
mation, opinions, recommendations or conclusions contained in this report. This report is being submitted to selected recipients
only. It may not be reproduced (in whole or in part) to any person without the prior written permission of Stern Stewart & Co.

Stern Stewart & Co., 1345 Avenue of the Americas, New York, NY 10105
Current Operations Value™, COV™, Future Growth Value™ and FGV™ are trademarks of Stern Stewart & Co.
EVA® is a registered trademark of Stern Stewart & Co. Copyright 2001 All Rights Reserved for Stern Stewart & Co.
 Stern Stewart & Co.

We suggest two key applications of the EVA Framework to help companies improve their chances of success in M&A:
• Use more rigorous analytical tools to help address the over-valuation problem by improving the rigor of traditional
Discounted Cash Flow (FCF) based analysis; and obtaining greater insight into value creation and risk management.
Exhibit 1 summarizes our suggested valuation techniques and their benefits over conventional analyses.

• Encourage Superior Execution by using an integrated EVA linked Decision Making and Performance Management System–
Link performance targets and incentives to the expected EVA improvements to ensure greater accountability post
investment.

Exhibit 1: Summary of Best Practice Valuation Techniques

CONVENTIONAL PRACTICE SUGGESTED BEST PRACTICE TECHNIQUES BENEFITS

1. Usually look only at absolute Analyse the cumulative discounted EVA profile to bet- Greater insights into sources
value of NPV/IRR over the ter understand the pattern of value creation over the of value creation and how to
entire project life entire project manage risk

2. Deal Structure (mix of stock Better understand the impact of deal structure on pat- Enables the acquiring firm to
and cash) is mainly used as a tern of value creation. share risks – especially for
tactical negotiating tool and/or Understand the sensitivity of the overall valuation to acquisitions where value cre-
as an accounting earnings the terminal value assumption. ation is further out into the
manipulation device future

3. The Terminal Value (TV) is Reality check the implications for key financial value Insights into the project’s
often a large part of the NPV drivers such as growth rate, risk and reinvestment economics, risks. Acquirers
and is usually based on a requirement embedded in your TV assumption can more explicitly link their
“guesstimate” market multiple Address key questions such as: What is the duration strategic thinking about the
or cash flow growth rate. over which the business is expected to earn above cost competitive advantage
of capital returns? How will the excess returns fade dynamics of the business with
over time? its long-term financial impli-
cations.

4. Synergies are often estimated Understand the Expected EVA Improvement already More realistic estimate of
only from the perspective of built into the stand-alone value of the target. synergies. Helps the acquirer
the acquirer. avoid double counting the
possible improvements and
thus avoid overpaying.
Explicitly evaluate the synergies and value of the target Improves acquirer’s under-
to other potential acquirers. standing of its chances of
launching a winning bid and
reduces the likelihood of get-
ting carried away in a bidding
war.

5. Focus is either on a single Rather than focus only on a single number, think more Greater insight into the
point estimate of risk for valu- about the probability of realizing a range of NPVs by sources of value and risk
ing an investment opportunity conducting more dynamic and probabilistic tools such
or analysis paralysis. as Monte Carlo and Real Options analysis.

For the sake of brevity in this article we have not discussed technical details of how to perform advanced valuation analy-
sis such as Probability weighted NPV, Monte Carlo Analysis, Real Options, Adjusted Present Value (APV), etc which are
perfectly consistent with both FCF and EVA analyses. The analytical details of these techniques have been discussed in
great detail in the finance literature. We apply these techniques to help clients develop better valuation estimates in situ-
ations of high risk and uncertainty.

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Stern Stewart & Co.

…Use EVA profiles to better understand the pattern of value creation …

Conventional FCF analysis focuses only on the total NPV/IRR of the project, which helps one understand whether the
entire project is value creating or not. In contrast EVA is NPV by period and helps one better understand the pattern of
value creation throughout the project life. Exhibit 2 illustrates this by comparing the EVA and FCF profiles of an acqui-
sition. Although the total NPV of this investment is positive, this project generates positive EVAs only for the first 7 years,
after which the EVAs turn negative even though the project is generating sizeable positive cash flows. Understanding this
unusual pattern of value creation raises three very strategic questions for the senior management. “What are the key dri-
vers of value creation in the first seven years?” “What can we do to minimize value destruction during the later years?”
“Should we consider exiting this investment in the long-term?”

…Insights into the Pattern of Value Creation can influence your Strategic Choices…

If you better understand the value creation pattern you may end up choosing a different alternative than if you only had
information on the total NPV over the entire project life. For example a client in contemplating a new market entry strat-
egy was considering whether to “acquire” a major player at a higher initial investment or “build” a presence with small
investments initially and grow subsequently. Conventional FCF analysis gave decision makers information only on the
total project NPV/ IRR as shown in Exhibit 3 and they were inclined towards the “acquire” alternative as it offered a high-
er NPV. Even though its lower IRR suggested that it was a riskier alternative than “build”, the IRR was higher than the
required hurdle rate of 15%.

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 Stern Stewart & Co.

However analyzing the cumulative discounted EVA profile helped them better understand the value creation pattern of
the two alternatives. As Exhibit 4 shows, even though the “build” alternative has a lower overall NPV it has a more attrac-
tive value creation pattern because it destroys less value in the initial five years, reaches positive NPV faster and creates
more value over the forecast ten year horizon. The higher NPV of the “acquire” alternative is all due to the Terminal
Value assumption – not an uncommon result with many acquisitions! This insight combined with real options analysis
led them to change their mind and opt to “build” note that this choice also preserved the flexibility value of the option
to make an acquisition in this segment at a later stage.

…Dynamic tools such as Monte Carlo help understand the sensitivity of NPV to key assump-
tions / scenarios and better identify sources of risk…

Conventional analysis focuses on an absolute value of NPV based on a single point estimate of risk. Single point
analysis fails to take into account the downside risk and upside benefits. When the downside risk / upside bene-
fits are high a single point estimate can be either dangerously optimistic or overly conservative. You should pro-
ject the sensitivity of project NPV to systematic risks by varying cash flows for various scenarios and changes in
key assumptions. Sensitivity analysis will help identify key value drivers, which will call for extra caution in mak-
ing forecast assumption and will frequently provide more insights on the scenarios / drivers for you to manage.
For high-risk large projects, Monte Carlo simulation can help understand the risk profile as well as the expected
NPV in great detail. Exhibit 5 shows probability distribution of NPV for two projects. While “expected” NPV
of the two projects is the same, project A has a higher probability of positive NPV outcomes compared to project
B and is therefore more desirable.

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Stern Stewart & Co.

EVA BASED CAPITAL BUDGETING

The Present Value of future EVAs is identical to the Net Present Value of future cash flows…
The EVA based valuation approach is totally consistent with accepted corporate finance theory and traditional
discounted free cash flow (FCF) analysis. The main difference between EVA and FCF analysis is the treatment
of investments. FCF analysis treats a capital investment just like any other cash flow and subtracts the entire cost
of the investments in the periods during which they are incurred. EVA spreads the cost of investments over the
useful economic life of the assets that have been acquired. The present value of the total depreciation and capi-
tal charge levied in EVA analysis is equal to the present value of investments made under FCF. This makes the
EVA based approach mathematically consistent with the FCF analysis as shown in Exhibit A. Although both EVA
and FCF techniques provide the same overall valuation, we suggest companies should do both sets of analysis.
The conventional Free Cash Flow analysis should be done to better understand the project’s funding require-
ments and cash generation pattern. EVA based analysis on the other hand can often provide additional insights
into the value creation pattern and thus improve the quality of the investment decision.

Exhibit “A” PV(EVA) is identical to NPV(FCF)… .

…because the PV of Depreciation and Capital Charge is equal to initial investment

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 Stern Stewart & Co.

… the acquirer’s choice of deal structure can improve the pattern of value creation and help better
manage risk…

Where value creation is well out into the future (especially when it is largely driven by the terminal value assumptions) it
implies greater risks for acquiring shareowners. One effective way of managing such risks is to share it with the target
firm’s shareowners by working out alternative deal structures. While it is not uncommon for acquirers to use a mix of cash
and stock in acquisitions, the percentage of stock and cash is more commonly used as a tactical negotiating tool and/or as
an accounting earnings manipulation device. However, the stock – cash split can also be used as a strategic risk manage-
ment mechanism. Exhibit 6 compares the cumulative discounted EVA profile to the shareowners of the acquirer when (a)
the deal involves paying 100% of the value of the target firm in cash; (b) the deal involves paying 70% of the value in stock
and 30% in cash. The total NPV to the shareowners of the acquirer is identical in both cases. Which is what you would
expect if the combined firm were fairly valued, because then the discounted cash flow value of the operating profits for-
feited is identical to the reduction in the upfront cash payout.

However the value creation pattern can be very different. As Exhibit 6 shows the stock plus cash deal lowers the risks for
the acquirer’s shareowners, relative to the all cash deal, by bringing forward the NPV breakeven point from 8 years to
only 3 years. The reason is that by partly paying for the acquisition through the sharing of stock in the combined firm the
acquiring company’s shareowners reduce their need to invest greater capital upfront. In return they agree to give away a
larger share of the future operating profits of the combined firm. Thus while the total value accruing to the acquiring
firms shareowners is the same, the timing of realizing the value and hence the risks can be influenced considerably by the
choice of deal structure2.

Better Understand the Fundamental Value Creation Implications Of Terminal Value Assumptions

A major problem acquirers face while estimating how much to pay for an acquisition lies in assessing the reasonableness
of the terminal value assumption. For acquisitions particularly in high growth sectors the terminal value accounts for a
significant proportion of the total value. Yet very often simplistic assumptions are made and the terminal value is calcu-
lated either as a simple multiple/ growth rate of the last forecast year’s cash flows and/or as a relative valuation multiple
(e.g. Value as a multiple of EBITDA, Revenue, Capacity etc) of socalled “comparable” transactions. While these conven-
tional approaches to estimate terminal value appear simple they implicitly have embedded, assumptions about the funda-
mental drivers of future value creation such as the risk and the rate of future cash flow growth.

2
Of course the final choice of deal structure will also be influenced by other considerations such as tax treatments, preferences of both acquirer and target firms’ shareown-
ers, signaling impacts and other complex interactions.

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Stern Stewart & Co.

Thinking of terminal value in terms of its value drivers offers greater flexibility and insight into the project. Further dis-
aggregating the FCF growth rate assumption into its constituent drivers: growth in operating after tax profits (NOPAT),
rate of reinvestment and the return on incremental investment (ROIC). (see Exhibit 7)
The Value Drivers approach allows acquirers to more explicitly link their strategic thinking about the competitive advantage dynam-
ics of the business with its long-term financial implications and address key questions such as: What is the duration over which the
business is expected to earn above cost of capital returns? How will the excess returns fade over time?

Therefore acquirers should not only test out the sensitivity of the valuation to different assumptions regarding terminal
value, but also reality-check the implications of their terminal value assumption for key financial value drivers. Very small
changes can dramatically affect the project economics because the relationship between the multiples and the fundamen-
tal value creation assumption are not linear. Exhibit 8 shows a matrix that contains the ROIC assumptions implicit in
using an EBITDA multiple for estimating the value of a firm given different expectations of future NOPAT growth3. For
a given growth rate in NOPAT (5%), even a small change in EBITDA multiple (from 3 to 4) would result in a huge change
in the required ROIC (from 17% to 88%).

3
This table is calculated using the formula shown below, for a weighted average cost of capital of 18%. This formula assumes that existing capital earns a constant
rate of return, a fixed portion of NOPAT will be reinvested in business, the new investment will earn a constant return on incremental capital ‘ROIC’, and conse-
quently the NOPAT will grow at a constant rate ‘g’. TV refers to Terminal Value. Terminal Capital refers to book capital at the end of forecast period. Note this
formula does not hold for perpetual growth rates ‘g’ greater than WACC.
Terminal Value = [NOPAT*(1+g)*(1-(g/ROIC))] / (WACC – g) – Terminal Capital

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 Stern Stewart & Co.

Understand Expectations of improvement already built into the stand alone value of the target to avoid
over-paying…

Acquirers assessing the attractiveness of potential acquisition target often spend considerable effort estimating the value
of synergies that would accrue to the combined firm. The synergies define how much more the combined firm is worth
in comparison to the standalone value of the two firms put together and thereby help decide the maximum price that the
acquirer can afford to pay for the target.

The stand-alone valuation of the target will usually already build in certain expectations of future performance improve-
ment. It is important for the acquirer to understand the extent of the expected performance improvement in the base-line
valuation, to more realistically estimate the synergies that they hope to add on top of this to justify the premium for con-
trol. By comparing the expected improvements with the perceived synergies the acquirer can determine the maximum
premium and avoid double-paying (see Exhibit 9).
The COV“ - FGV“ framework helps better understand the future expected improvements in EVA terms by disaggregat-
ing the target’s stand-alone valuation into its Current Operating Value (the Economic Book Capital plus the Current EVA
capitalized as a perpetuity) and the remainder Future Growth Value4.

…Understand the real options embedded in the project and how to maximise their value…

The valuation of the project based on the NPV of projected future cash flows does not capture all benefits accruing from
the project. Taking up the project might open a set of options that would otherwise not be available to the acquiring firm
such as the ability to invest in new projects, enter new markets / geographic areas, adopt new technologies, expand if
things work out well, abandon/scale-down the project if things turn out to be unfavorable, etc. These “Real” options
embedded in the investment opportunity are analogous to the commonly traded “Financial” options that give the option
holder a right to buy or sell an underlying asset at a specified price at or before a specified date. Since these options are
rights and not an obligation the holder can choose not to exercise this right and allow it to expire. The value of “Real”
options can be estimated by adapting the techniques used for valuing “Financial” options5. This can be a useful comple-
ment to the project’s value estimated by NPV/EVA capital budgeting because it helps value flexibility and thus melds
strategic intuition with analytical rigor and financial market discipline.
®
Current Operations Value, COV, Future Growth Value and FGV are registered trademarks of Stern Stewart & Co.
4
The COV-FGV framework and its applications for Value Based Strategy are discussed in further detail in EVAluation, April 2000; “EVA & Strategy”, by Justin Pettit.
5
The details analytics involved in arriving at the financial value of real options can be found in “The Promise of Real Options” by Aswath Damodaran, Journal of Applied
Corporate Finance – Summer 2000, Vol 13 number 2.

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Stern Stewart & Co.

However, instead of focusing on estimating the absolute value of the real options we suggest that, it is more important
that senior management of the acquiring firm understand what types of real options exist in the investment that they are
evaluating. Senior management should think about how they can create these options and maximise their value. This
understanding of what options are embedded in the acquisition opportunity and what drives their value not only helps
managers better evaluate the go – no go decision on the projec,t but also enables them to better sequence their actions to
maximise flexibility and shareowner value.

Explicitly evaluate the target’s value to other potential acquirers

Before deciding on how much to bid for a target, the acquirer should also explicitly assess the value of the target to other
potential acquirers. Thinking about other potential acquirers that may be interested in the target and comparing the syn-
ergies that are likely to accrue to them relative to you can be very useful. This can improve the acquirer’s understanding
of its chances of launching a winning bid in a competitive situation and therefore its negotiation tactics. It also helps
reduce the likelihood of getting carried away in a bidding war.

Encourage superior execution by using an integrated EVA linked decision making and performance
management system to improve managerial alignment and increase accountability

Whatever the merits of the investment decision, most acquirers agree in retrospect that the actual results fail to live up to
their expectations. Unforeseen events and under-estimation of “cultural issues” are the most often cited causes. However,
most organisations’ performance management systems fail to foster and reward the superior execution and sense of
urgency needed to achieve post-acquisition integration and deliver the promised synergies. A key reason for this is inad-
equate accountability - the NPV/ FCF projections made at the time of the investment decision are rarely revisited once
the investment has been made and there is a disconnect between the metrics used for investment decision making (usual-
ly NPV/ IRR) and subsequent performance measurement (usually accounting earnings relative to budget). Not only does
this lack of a closed-loop monitoring system lead to poor post – acquisition implementation, it also indirectly encourages
overly optimistic projections at the time of acquisition.

The use of an integrated EVA linked decision making, performance measurement and reward system helps instill greater
accountability for delivering targeted shareowner returns by measuring performance and linking the incentives of the
management team to the actual post acquisition EVA improvements relative to shareowners’ expectations.

For Stern Stewart’s Mumbai office contact details and other research publications www.eva.com

8
 EVAluation
Past Issues
Why So Many Dotcoms Failed

M&A: Why Most Winners Lose

The Equity Risk Measurement Handbook

EVA & Strategy II: Value-Based Strategic Portfolio Management

Herman Miller: Growth in the New Economy

Best of Times, Worst of Times

The New Math 4>8

IT Outsourcing & Shareholder Value

EVA & Production Strategy: Jonah is Back!

Compensation Strategy for the New Economy Age

EVA & Strategy

Internet Valuation

Applications in Real Options & Value Based Strategy

ABC, the Balanced Scorecard & EVA

The Value of R&D

The Capitalist Manifesto

Lessons from Gorbachev

U.K. Remuneration Practices

For copies please visit the Stern Stewart website at www.eva.com.

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