How Finance Operates: The Three Valuation Errors

A valuation procedure is necessary whether you’re investing in school, purchasing shares, purchasing a business, or purchasing a home. Is the suggested investment appropriate? What is the appropriate amount to pay?

However, it is not uncommon for the acquirer’s stock to decline following an acquisition, suggesting that it most likely overpaid and transferred value from itself to the target. That raises the question: Why do businesses consistently overpay? The explanation is that they had to be making a mistake in their valuation:

Disregarding rewards

The first and most common error is ignoring the incentives of those involved in an acquisition, which is simple to do. Of course, asset sellers want their buyers to overpay. Additionally, sellers have access to key information sources, such as historical financial data. In preparing for a sale, what actions do you believe the seller has taken? It might accelerate sales, postpone expenses, and underinvest to make itself appear especially good. Due diligence is therefore an essential component of every acquisition process.

The seller is only one side of the issue. Investment bankers often only get paid after a deal is completed, so they want you to close the deal. Perverse motivations exist even for those within your organization who have examined the transaction. They might very well be expecting a promotion to oversee the recently acquired new division. Everybody engaged in the transaction wants it to go through, and they might gently adjust estimates or assumptions to help make that possibility come to pass. This deluge of inaccurate information so causes overspending and overconfidence.

Inflating synergies and disregarding integration expenses

The concept of synergy states that when two businesses combine, their combined value will exceed the sum of the worth of the two separate businesses. The concept of synergy seems fair at first glance. Cost savings should occur, for instance, if you combine and rationalize two sales forces. Combining two businesses will provide you greater pricing power and industry control over capacity.

What if Amazon and eBay decided to merge? It could be advantageous for the combined company to be able to use both sets of vendor lists or customer lists. On the other hand, merging the two businesses can result in a number of back-office and computer costs being lowered. These two situations demonstrate synergy. The business may reach consumers it wouldn’t otherwise be able to reach or reduce expenses in a way it couldn’t do it on its own.

People sometimes overestimate the speed at which synergies will occur and the extent to which they will have an impact, which is an issue when it comes to synergies. They disregard the complexity of mergers and the length of time it takes to transform workforces and cultures. The second related issue is that, even in cases when synergies are valid, buyers will frequently factor in all of those benefits when determining how much to pay for a company. This may also result in an overpayment if the benefits of the synergy’s value creation are passed to the shareholders of the acquired firm rather than contributing to the value creation that the merger creates for the acquiring company.

Undervaluing the intensity of capital

Finally, underestimating the capital intensity of the company is a mistake made by both sellers and enthusiastic bidders. Continuous expansion in free cash flows or EBIT usually necessitates capital expenditures to expand the asset base. However, such capital expenses diminish free cash flows dollar for dollar—and those eager to close agreements simply overlook them. For instance, terminal values are based on the assumption of constant growth rates; yet, in the final year of the modeling, when capital expenditures are equal to depreciation, there is no indication of asset growth. Values are inflated when capital intensity is understated.