How can you account for synergy risks in company valuation?

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When two companies merge or acquire each other, they often expect to create value by combining their resources, capabilities, and markets. This value is called synergy, and it can be a key driver of company valuation. However, synergy is not guaranteed, and it can also pose significant risks for both the acquirer and the target. How can you account for synergy risks in company valuation? Here are some tips to help you assess and adjust your valuation models for potential synergy effects.

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Marina Vizdoaga, MSF

VP of Investments | Strategic Acquisitions | Board Member

1 Define synergy sources

The first step is to identify and quantify the sources of synergy that the deal is expected to generate. Synergy can come from different areas, such as revenue enhancement, cost reduction, tax benefits, or capital structure optimization. For each source, you need to estimate the incremental cash flows, the timing, and the probability of realization. You also need to consider the costs and challenges involved in achieving the synergy, such as integration expenses, cultural clashes, or regulatory hurdles.

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Marina Vizdoaga, MSF

VP of Investments | Strategic Acquisitions | Board Member
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When examining synergy sources for a valuation, I consider not only the clear-cut categories of revenue and cost synergies but also the less tangible elements like brand value enhancement and cross-functional team efficiencies. It’s crucial to be methodical in dissecting these sources—going beyond mere estimations to employ a qualitative lens. For instance, while quantifying cost reduction, I leverage industry benchmarks and historical data from similar integrations that I’ve observed. Additionally, the 'soft' synergies like cultural alignment have a long-term impact on productivity and innovation, aspects that are often underestimated in their contribution to cash flow.

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2 Use scenario analysis

The next step is to use scenario analysis to incorporate the uncertainty and variability of the synergy sources into your valuation models. Scenario analysis involves creating different sets of assumptions and outcomes for the synergy effects, such as best case, base case, and worst case scenarios. You can then apply these scenarios to your valuation methods, such as discounted cash flow (DCF), multiples, or transaction comparables. This will help you to capture the range and distribution of possible synergy values and risks.

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Marina Vizdoaga, MSF

VP of Investments | Strategic Acquisitions | Board Member
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In my approach to scenario analysis, I incorporate a holistic view that encompasses market dynamics and competitive behavior post-transaction. The scenarios crafted are not mere variations of financial inputs but are narrative-driven, exploring how strategic moves may play out in the ecosystem of customers, competitors, markets, regulators etc. For instance, in a revenue synergy analysis, I don’t just look at product cross-selling opportunities but also how the combined entity will reposition itself in the market and how competitors might react. These narrative-rich scenarios allow for a more informed and dynamic valuation model that adapts to the strategic context rather than just the numerical one.

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3 Adjust discount rates

Another way to account for synergy risks in company valuation is to adjust the discount rates that you use to calculate the present value of the future cash flows. Discount rates reflect the required rate of return or the cost of capital for an investment. The higher the discount rate, the lower the present value. You can adjust the discount rate by adding or subtracting a premium or a discount based on the level of risk or uncertainty associated with the synergy sources. For example, if the synergy is highly speculative or difficult to achieve, you can increase the discount rate to reflect the higher risk.

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Marina Vizdoaga, MSF

VP of Investments | Strategic Acquisitions | Board Member
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Adjusting discount rates is as much an art as it is a science, especially when it involves synergies. Instead of applying generic risk premiums, I delve into the specifics of the investment climate, industry volatility, and the idiosyncrasies of the businesses at hand. I often find that traditional risk assessment models do not capture the unique risk profile of synergy; hence, I refine these models with inputs from operating models and post-merger integration plans.

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4 Use sensitivity analysis

The final step is to use sensitivity analysis to test how your valuation results change with different inputs or assumptions about the synergy sources. Sensitivity analysis involves changing one or more variables at a time and observing the impact on the valuation output. You can use sensitivity analysis to identify the key drivers and the critical assumptions of your valuation model, and to evaluate how robust or fragile your valuation is to changes in the synergy sources.

Synergy risks are an important factor to consider when valuing companies involved in mergers and acquisitions. By following these tips, you can improve your valuation accuracy and reliability, and avoid overpaying or underestimating the potential value of a deal.

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Marina Vizdoaga, MSF

VP of Investments | Strategic Acquisitions | Board Member
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Sensitivity analysis in my practice is not just a tool to test assumptions—it's a strategy to identify value creation levers. By manipulating variables such as integration cost timelines and the pace of achieving revenue synergies, I’m able to pinpoint which factors have the most profound effect on value. For example, I consider how an increase in customer churn rate post-merger could outweigh cost synergies, a nuance often overlooked in standard analyses. I also look to scenario-specific triggers which could dramatically shift the sensitivity of the valuation.

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5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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How can you account for synergy risks in company valuation?

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1 Define synergy sources

2 Use scenario analysis

3 Adjust discount rates

4 Use sensitivity analysis

5 Here’s what else to consider

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