Understanding Mergers & Acquisitions (M&A): Types and Valuations

What Are Mergers and Acquisitions (M&A)?

Mergers and acquisitions (M&A) are the process of consolidating companies or major assets of companies through financial transactions. A company may:

• Purchase and absorb another company outright
• Merge with it to create a new company
• Acquire some or all of its major assets
• Make a tender offer for its stock
• Stage a hostile takeover

All of these ways of combining or consolidating assets are M&A activities. The term M&A is also used for the divisions of financial institutions that facilitate or manage such activities.

Understanding Mergers vs. Acquisitions

The terms mergers and acquisitions are often used interchangeably, but they have slightly different meanings.

When one company absorbs another and establishes itself as the new owner, the purchase is called an acquisition. Unfriendly or hostile takeover deals are always regarded as acquisitions. However, an acquisition can be done with the willing participation of both companies.

In a merger, two companies join forces to reinvent themselves as a single new entity. In general, the two firms are of approximately the same size, and this action is known as a merger of equals.

For example, when Daimler-Benz and Chrysler merged, those companies ceased to exist. A new company, DaimlerChrysler, was created. Both companies' stocks were surrendered, and new company stock was issued in its place.

DaimlerChrysler underwent another name and ticker change to the Mercedes-Benz Group AG (MBG) in February 2022.

A deal can be classified as a merger or an acquisition based on whether the acquisition is friendly or hostile and how it is announced. The difference lies in how the deal is communicated to the target company's board of directors, employees, and shareholders.

Exploring Different Types of Mergers and Acquisitions

The following are some common transactions that fall under the M&A umbrella.

Types of Mergers

In a merger, the boards of directors of two companies approve the combination and seek shareholders' approval.

This type of M&A activity is designed to benefit both brands, allowing each to bring their existing strengths to a new company and enjoy a bigger piece of the industry pie.

For example, in 2024, the holding company HBC announced that it was acquiring the Neiman Marcus Group and merging it with another brand that it owned, Saks Fifth Avenue.

Both NMG (which owns Neiman Marcus and Bergdorf Goodman) and Saks are luxury retailers, but their share of retail sales has declined with the rise of online shopping and the reduction of brick-and-mortar retail. The merger consolidates three existing brands (Saks, Neiman Marcus, and Bergdorf Goodman) into a single luxury retail brand known as Saks Global. This consolidation is intended to make it easier to compete with the online retail giants.

Types of Acquisitions

In a straightforward acquisition, the acquiring company obtains the majority stake in the acquired firm, which does not change its name or alter its organizational structure.

In some cases, the target company may require the buyers to promise that the target business remains solvent for a period after acquisition through the use of a whitewash resolution. An acquisition often allows the acquiring company to move into a new or related industry, expanding its offerings by tapping into the acquired company's existing customer base and services.

An example of this type of transaction was Amazon's acquisition of Whole Foods in 2017. The acquisition allowed Amazon to expand into grocery delivery services and tap into the market for health-conscious customers.

Whole Foods, which had been losing market share to lower-priced grocery chains, benefitted from Amazon's broad customer base and ease of connecting with consumers.

Consolidations

In a corporate consolidation, two or more companies combine to increase their market share and eliminate competition.

For example, Facebook has consolidated its dominance of social media by acquiring other companies that had promising business models and could have become competitive with Facebook.

An example is Facebook's acquisition of Instagram in 2012 for $1 billion. Instagram continued to operate as a separate company under the parent Facebook company (now Meta Platforms).

Other instances of consolidation under Facebook resulted in acquired social media companies being integrated into the Facebook platform. For example, the messaging service Beluga was acquired by Facebook and rebranded as Facebook Messenger.

Tender Offers

In a tender offer, one company offers to purchase the outstanding stock of the other company at a specific price rather than the market price. The acquiring company communicates the offer directly to the other company's shareholders, bypassing the management and board of directors.

For example, in 2008, Johnson & Johnson made a tender offer to acquire Omrix Biopharmaceuticals for $438 million. The company agreed to the tender offer and the deal was settled by the end of December 2008.

Acquisition of Assets

In an acquisition of assets, one company directly acquires the assets of another company. The company whose assets are being acquired must obtain approval from its shareholders.

The purchase of assets is typical during bankruptcy proceedings. Companies bid for various assets of the bankrupt company, which is liquidated upon the final transfer of assets to their new owners.

Management Acquisitions

In a management acquisition, also known as a management-led buyout (MBO), a company's executives purchase a controlling stake in another company, taking it private. These former executives often partner with a financier or former corporate officers to help fund the transaction.

This type of M&A transaction is typically financed disproportionately with debt, and the majority of shareholders must approve it.

For example, in 2022, Tesla Motors CEO Elon Musk purchased Twitter, Inc. for $44 billion, taking the company private. The deal included $25.5 billion of margin loan and debt financing.

How Mergers Are Structured

Mergers can be structured in various ways depending on the relationship between the two companies involved in the deal:

• Horizontal merger: Two companies that are in direct competition and share the same product lines and markets merge
• Vertical merger: A company merges with a supplier, such as an ice cream maker buying its cone supplier
• Congeneric mergers: Two businesses that serve the same consumer base in different ways, such as a TV manufacturer and a cable company, combine
• Market-extension merger: Two companies that sell the same products in different markets combine
• Product-extension merger: Two companies selling different but related products in the same market merge
• Conglomeration: Two companies that have no common business areas combine

Mergers may also be distinguished by following one of two financing methods, each with its own ramifications for investors.

Purchase Mergers

As the name suggests, this kind of merger occurs when one company purchases another company. The purchase is made in cash or through the issue of a bond or other debt instrument.

The sale is taxable, which attracts the acquiring companies, who enjoy the tax benefits. Acquired assets can be written up to the actual purchase price, and the difference between the book value and the purchase price of the assets can depreciate annually, reducing taxes payable by the acquiring company.

Consolidation Mergers

A new company is formed, and both companies are bought and combined under the new entity. The tax terms are the same as those of a purchase merger.

Vertical vs. Horizontal Acquisitions

Horizontal integration and vertical integration are strategies that companies use to consolidate their position among competitors.

Horizontal integration is the acquisition of a related business. A company that opts for horizontal integration will take over another company that operates at the same level of the value chain in an industry—for instance when Marriott International, Inc. acquired Starwood Hotels & Resorts Worldwide, Inc.

Vertical integration is the process of acquiring business operations within the same production vertical. In this type of acquisition, a company is taking control over one or more key stages in the production or distribution of its products. Apple, for example, acquired AuthenTec, which makes the touch-ID fingerprint sensor technology that goes into its iPhones.

Financing Techniques for Mergers and Acquisitions

A company can buy another company with cash, stock, assumption of debt, or a combination of all three. At times, the investment bank involved in the sale of one company might offer financing to the buying company. This is known as staple financing and is done to produce larger and timely bids.

In smaller deals, it is common for one company to acquire all of another company's assets. Company X buys all of Company Y's assets for cash, which means that Company Y will have only cash (and debt, if any). Company Y will eventually liquidate or enter other areas of business.

Another acquisition deal known as a reverse merger enables a private company to become publicly listed in a relatively short time. Reverse mergers occur when a private company that has strong prospects and is eager to acquire financing buys a publicly listed shell company with no legitimate business operations and limited assets. The private company reverse merges into the public company, and together they become a new public corporation with tradable shares.

How Mergers and Acquisitions Are Valued

Both companies involved on either side of an M&A deal will value the target company differently. The seller will obviously value the company at the highest price possible, while the buyer will attempt to buy it for the lowest price possible.

Fortunately, a company can be objectively valued by studying comparable companies in an industry, and by relying on the following metrics.

Price-to-Earnings Ratio (P/E Ratio)

With the use of a price-to-earnings ratio (P/E), an acquiring company makes an offer that is a multiple of the earnings of the target company. Examining the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be.

Enterprise-Value-to-Sales Ratio (EV/Sales)

With an enterprise-value-to-sales ratio (EV/sales), the acquiring company makes an offer as a multiple of the revenues while being aware of the price-to-sales ratio (P/S) of other companies in the industry.

Discounted Cash Flow (DCF)

A key valuation tool in M&A, a discounted cash flow (DFC) analysis determines a company's current value, according to its estimated future cash flows. Forecasted free cash flows (net income + depreciation/amortization (capital expenditures) change in working capital) are discounted to a present value using the company's weighted average cost of capital (WACC).

DCF is tricky to get right, but few tools can rival this valuation method.

Replacement Cost

In a few cases, acquisitions are based on the cost of replacing the target company.

For simplicity's sake, suppose the value of a company is simply the sum of all its equipment and staffing costs. The acquiring company could order the target to sell at that price or it will create a competitor for the same cost.

Naturally, it takes a long time to assemble good management, acquire property, and purchase the right equipment. This method of establishing a price certainly wouldn't make much sense in a service industry wherein the key assets (people and ideas) are hard to value and develop.

Impact on Shareholders

Generally speaking, in the days leading up to a merger or acquisition, shareholders of the acquiring firm will see a temporary drop in share value. At the same time, shares in the target firm typically rise in value. This is often because the acquiring firm will need to spend capital to acquire the target firm at a premium to the pre-takeover share prices.

After a merger or acquisition officially takes effect, the stock price usually exceeds the value of each underlying company during its pre-takeover stage. In the absence of unfavorable economic conditions, shareholders of the merged company usually experience favorable long-term performance and dividends.

The shareholders of both companies may experience a dilution of voting power due to the increased number of shares released during the merger process. This phenomenon is prominent in stock-for-stock mergers, when the new company offers its shares in exchange for shares in the target company, at an agreed-upon conversion rate.

Shareholders of the acquiring company experience a marginal loss of voting power, while shareholders of a smaller target company may see a significant erosion of their voting powers in the relatively larger pool of stakeholders.

The Bottom Line

There are many ways that a business or some of its assets can be bought, consolidated, or combined with another business. The acquiring company may be motivated by a desire to increase its share of a market, a need to operate more efficiently, or a desire to eliminate a business rival. Often, it is a combination of these factors.