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2. How to Build Merger Models
Merger models are very different to basic valuation models, as they contain 3 separate models in 1. In this lesson, I'll show you how a merger model is constructed and the metrics used to evaluate the attractiveness of a transaction
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Lesson Goal (00:04)
The goal of this lesson is to learn how to build and evaluate an M&A financial model.
Building an M&A Model (00:10)
In previous financial models, we have built financial projections for the company of interest. In an M&A model, we build projections for the acquirer company and the target company, and also build projections of the synergies that can be earned. We then use these projections to build a merger model containing transactions assumptions, a combined Income Statement, and additional analysis of cash generation and debt exposure for the combined company.
Evaluating the Model (00:43)
It’s possible to build discounted cashflow models for both companies in the transaction, but this can be a difficult process. Instead, it’s more common to evaluate M&A models by analyzing the impact of the transaction on earnings per share for the acquirer company.
Earnings per share, or EPS, is simply net income divided by the number of shares. It’s a metric that’s commonly used to evaluate a company’s performance. A successful M&A should boost earnings per share in the years after the transaction.
Earnings per share helps us understand profitability changes, and accounts for any dilution that occurs as part of the transaction. However, it doesn’t consider the cash position of the business or its debt exposure. As a result, we need to perform additional analysis of these aspects of the business.
Now that we understand why mergers and acquisitions happen, let's explore how these models are built. We begin by projecting the operating performance of the acquirer and the target for the next five years and we also project the impact of synergies and these projections will focus largely on the income statement. Once these three steps are complete, we feed this information into our merger model which will contain transaction assumptions, a combined income statement for both companies, and some additional proforma analysis related to cash generation and debt exposure of the combined entity. While it's possible to build out two big large discount cash flow models for both the standalone acquirer and the combined entity, a much more common and easier approach is to compare the earnings per share of the acquirer pre-transaction and then post-transaction. Since this is our first merger model and due to the fact we haven't used earnings per share before, I'm going to rely on it in this course. For public companies, earnings per share is a very popular method for evaluating performance especially among research analysts. Earnings per share is simply net income divided by the number of shares. In a merger involving a publicly listed acquirer, the management team will be judged on the ability of the target to markedly improve earnings within a two to three-year timeframe, if not before.
Earnings per share helps us understand the increase in profitability and it also allows for any dilution that may occur when acquiring a business. However, it doesn't consider the cash position of the business or any increased debt exposure especially when debt forms part of the transaction. As a consequence, we will need to perform some additional analysis in this course to gauge the debt exposure and cash position of the combined entity. In addition, we'll create some sensitivity tables that will help us make a final recommendation to our clients on whether Shared Shop should go ahead with the deal.