Purchase accounting follows every M&A transaction. It typically requires a valuation analysis that covers acquired intangible assets, earn-outs, and other elements of the transaction. While relegated to the post-transaction activities, these valuations offer substantial amount of information that can assist management in making important strategic decisions. Below are 5 reasons to take a closer look at your hot-off-the-press valuation report (“PPA valuation”).
1. Fair Value of the Target
A substantial part of the PPA valuation deals with the fair value of the target. In fact, the report must demonstrate that the acquirer paid fair value, or it faces potential day-one P&L gains/losses. Internal Rate of Return (“IRR”) links purchase price to the financial forecast. It is a discount rate that reconciles purchase price and the financial forecast within the traditional DCF valuation framework.
Economic theory requires the acquirer to pay no more, and the target to accept no less, than the present value of future cash flows the target can generate. While most forecasts are wild guesses, management should be able to develop a sense of what’s reasonable. If the forecast is too low to produce an adequate IRR, the acquirer has overpaid.
To justify the purchase price, IRR has to be in line with reasonable cost of capital. Your next acquisition may benefit from enhancing forecasting efforts during the due diligence phase and applying an IRR framework. This approach may help you negotiate a lower price or reject an overpriced deal.
2. Goodwill Impairment Implications
Goodwill impairment is tested at the reporting unit level, not at the target level. A strong reporting unit can withstand bad acquisitions without triggering impairment studies. However, a large enough target can become a significant factor in future goodwill impairment.
PPA valuations provide important benchmarks for assessing impairment triggers and for the detailed quantitative or qualitative analysis to follow. The financial performance of the target is compared against the forecast developed in the PPA valuation. That report includes a long list of assumptions to which any future goodwill or intangible asset impairment analysis would have to reconcile. PPA valuation can also help justify an easy qualitative Step Zero goodwill impairment review or force extensive Step One / Step Two valuations.
3. Developing A Discount Rate for Your Next Acquisition
Between IRR and market-based cost of capital (“WACC”), PPA valuation provides a thorough discount-rate analysis. As discussed in our prior post, the discount rate can help you price your next acquisition or benchmark the financial performance of completed acquisitions.
Of course, PPA valuations attempt to find the most comparable publicly traded comparable companies and to summarize their financial performance, which can be helpful in benchmarking the financial results of both the acquirer and the target.
4. Intangible Asset Amortization Amount
While many analysts are quick to dismiss amortization amounts and focus on EBITDA, the numbers can be revealing when assessing the attractiveness of a target. Suppose PPA valuation estimates software value at $5 million, amortized over 5 years. The target has to be able to generate enough cash to recoup the value of the intangible asset before it becomes obsolete. Hence the financial forecast must demonstrate sufficient future profits at EBIT levels.
Goodwill is not to be overlooked in this analysis either. In a scenario where the target is relatively small, management may want to amortize goodwill to determine whether the transaction was accretive or dilutive, even if GAAP does not require such amortization.
5. Preliminary Purchase Price Allocations and Pricing Studies
Pre-deal purchase price allocations are common for larger transactions, but can also benefit many smaller ones. They may help to scrutinize deal pricing and the forecast, assess the economic cost of amortization, and get access to the substantial market data included in a typical PPA valuation. If the acquisition price is being justified as sum of parts, PPA valuation will help determine what those parts are and how valuable they can be. Cost-based analysis of acquired technology or attrition-based valuation of customer relationships can also be very revealing.
Finally, PPA valuation is a pricing study in disguise. It does not say what the value of the target should be, but IRR does signal if the price is too high or too low, potentially helping the acquirer obtain better deal terms and hence an increased return on investment.