FREE online courses on Mergers & Acquisitions - Chapter 5 - Value Drivers

 

Three core financial drivers of value are:

 

1. Return on Invested Capital (NOPAT / Invested Capital)

2. Free Cash Flows

3. Economic Value Added (NOPAT - Cost of Capital)

 

NOPAT: Net Operating Profits After Taxes

 

A value driver can represent any variable that affects the value of the company, ranging from great customer service to innovative products. Once we have identified these value drivers, we gain a solid understanding about how the company functions. The key is to have these value drivers fit between the Target Company and the Acquiring Company. When we have a good fit or alignment, management will have the ability to influence these drivers and generate higher values.

 

In the book Valuation: Measuring and Managing the Value of Companies, the authors break down value drivers into three categories:

 

Type of Value Driver                     Management's Ability to Influence

Level 1 - Generic                          Low

Level 2 - Business Units                 Moderate

Level 3 - Operating                       High

 

For example, sales revenue is a generic value driver (level 1), customer mix would be a business unit value driver (level 2), and customers retained would be an operating value driver (level 3). Since value drivers are inter-related and since management will have more influence over level 3 drivers, the key is to ascertain if the merger will give management more or less influence over the operating value driver. If yes, then a merger and acquisition could lead to revenue or expense synergies. Be advised that you should not work in reverse order; i.e. from level 1 down to level 3. For example, an increase in sales pricing will add more value to level 1, but in the long-run you will hurt customers retained (level 3) and thus, you may end-up destroying value.

 

Once we have identified value drivers, we can develop a strategic view of the Target Company. This strategic view along with drivers of value must be considered in making a performance forecast of the Target Company. We want to know how will the Target Company perform in the future. In order to answer this question, we must have a clear understanding of the advantages that the Target Company has in relation to the competition. These competitive advantages can include things like customer mix, brand names, market share, business processes, barriers to competition, etc. An understanding of competitive advantages will give us insights into future expected growth for the Target Company.