8 key definitions to understand finance
The world of mergers and acquisitions (M&A) is fascinating but highly demanding. This is why interviews for internships or full-time positions in investment banks are both feared and challenging. If you are a finance student or studying at a business or engineering school, and seeking an internship or a full-time job, mastering certain key concepts is essential to excel in interviews. Here are 10 crucial notions you must know to succeed in your M&A interviews.
Valuation: the art of valuing a company
Valuation lies at the core of every M&A transaction. It involves estimating the value of a company or an asset. The three main methods are:
DCF (Discounted Cash Flow): This method is based on discounting future cash flows to determine their present value. It is ideal for stable companies with reliable financial projections.
Comparable Companies Analysis (Trading Comps): This method compares the target company to similar publicly traded companies, using ratios such as EV/EBITDA.
Precedent Transactions Analysis (Transaction Comps): It relies on analyzing past comparable transactions to estimate the value of the company.
Valuation helps the parties define a fair price and negotiate based on solid data.
Read also : Innovis insights - Mastering the Term Sheet
Synergies: the driver of transactions
Synergies are the economic benefits expected from a merger or acquisition. They are divided into two categories:
Cost Synergies: Cost reduction by eliminating redundancies (e.g., staff, infrastructure).
Revenue Synergies: Increased sales through strategic complementarities, such as access to new markets or products.
⚠️ Note: There is no such thing as financial synergies!
Synergies are often difficult to fully realize, which explains why some transactions fail to meet their initial objectives.
Enterprise Value (EV) vs. Equity Value (EQV): understanding the difference
These two concepts are essential for valuation:
Enterprise Value (EV): The total value of a company, including net debt (debt minus cash). EV is used for comparisons independent of the company’s capital structure.
Equity Value (EQV): The value of the company’s shares. It is calculated by subtracting net debt from EV.
These concepts allow a company to be evaluated from different angles, depending on stakeholders’ interests. The relationship between EV and EQV is captured in the Bridge formula:
EV = EQV + Net Debt
Due Diligence: risk assessment
Due diligence is a critical step in the acquisition process. It involves an in-depth examination of the financial, legal, operational, managerial, environmental, and strategic aspects of a company before finalizing the transaction. Financial analysis might reveal hidden liabilities or discrepancies in accounting. Legal review could identify ongoing litigations.
This step ensures that the buyer makes an informed decision and minimizes post-transaction risks.
Operating Assets: the core of valuation
Operating assets represent the total amount committed by a company, whether linked to its operating cycle or its investment cycle. Operating assets are financed by two main types of financial resources: equity and debt.
Operating Assets = Working Capital Requirement (WCR) + Fixed Assets = Equity + Net Debt
Accretion/Dilution: measuring impact on EPS
In M&A transactions, it is crucial to evaluate the impact of the deal on the acquirer’s Earnings Per Share (EPS):
A transaction is accretive if it increases EPS.
A transaction is dilutive if it decreases EPS.
This analysis is particularly important for publicly traded companies, as it directly affects investor perception and stock price.
Valuation Multiples: a quick comparison tool
Valuation multiples are financial ratios used to quickly compare companies. Common multiples include:
EV/EBITDA: Measures operational performance and cash flow generation, independent of financial structure.
EV/Sales: Used for loss-making companies (e.g., startups).
NI/Equity (ROE): Measures the return on equity.
P/E (Price-to-Earnings Ratio): Compares stock price to EPS. It depends on the company’s financial structure and includes its debt.
These multiples are particularly useful for analyzing comparables and evaluating whether a company is undervalued or overvalued.
Net Working Capital (NWC)
NWC represents the short-term funding needed to manage daily operations. It is calculated as:
WCR = Current Assets - Current Liabilities
Positive NWC: Indicates a funding need due to higher current assets than liabilities.
Negative NWC: Indicates a cash surplus, though the term “WCR” is still used.
NWC is critical for understanding the cash required to handle operational timing differences.
This comprehensive understanding of key M&A concepts will not only prepare you for your interviews but also give you the confidence to tackle complex scenarios. Good luck!
