Considering an acquisition? What's the right price?

March 11, 2013 11:49 by Terry Christenberry in M&A  //  Tags:   //   Comments (0)

There are many qualitative and quantitative factors to consider in determining the right price for an acquisition.  Many of these factors, especially factors like impact on employees, corporate image, markets served etc. involve long term considerations and are difficult to quantify.  Short term financial factors such as synergistic savings and cost of funds are easier to estimate, but may still involve a significant margin of error.  As investment bankers, we are skilled at utilizing a number of valuation techniques such as peer group valuations, recent similar transactions, and discounted cash flows to calculate an estimated valuation for a target company.  While we are skilled at estimating value, these values have to be weighed against the price at which a client can achieve their financial objectives with the acquisition.

Achieving a Company’s financial return objectives with an acquisition is simply price versus future cash flows.  Reaching agreement on a set of assumptions required to estimate future cash flows, desired (or required) rate of return, and a Company’s cost of capital may involve much analysis and discussion.  However once agreement is reached on those assumptions, calculating the expected rate of return is straight forward.  In practice we expect to use the specific projected cash flows associated with a transaction to calculate an expected return.  However, for simply gauging interest in pursuing an acquisition, it is sometimes helpful to consider a range of potential prices and returns with a matrix similar to the one shown below.

Using an EBITDA multiple as a proxy for price and using EBITDA as a proxy for future cash flow, the following table, created (and easily duplicated) in Excel, shows the range of IRR’s associated with a particular price (EBITDA multiple on the left), and a particular cash flow (EBITDA) growth rate.  In the table we have assumed one growth rate for the first five years, with a perpetual growth rate thereafter, and a holding period of ten years for illustration purposes.

For example, let’s assume the acquiring Company’s cost of capital is 20%, they expect the target to have an EBITDA growth rate of 5% for the first five years and 3% thereafter and their IRR required hurdle rate is 25%, they can pay no more than 5X EBITDA.  Considering the acquisition from a different perspective, if the acquirer believes the acquisition will require bidding a 7.0X EBITDA multiple, they should be prepared for achieving only an 18.4% IRR.


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