Synergies in a DCF
November 3, 2020
What is a Discounted Cash Flow (DCF)?
A DCF analysis can be done on a standalone basis or include the expected cost-saving effects of a potential acquisition (synergies). Synergies are often expected to arise when two businesses are integrated (which may involve some up-front costs). The most common are cost synergies as the two sets of resources provide efficiencies when operated as one rather than two standalone businesses.
How are Synergies Valued?
Typically, synergies will be valued separately, and the resulting amount will be added to the DCF value without synergies.
The process of valuing synergies is similar to the standard DCF valuation process:
- Estimate the expected annual synergies. Synergies are assumed to be cash.
- Apply the marginal tax rate (the MTR) of the company to find after-tax synergies.
- Establish the discount rate to be applied. Usually, this discount rate will be the target WACC plus a risk premium. In other words, synergies are deemed riskier than standard cash flows.
- Estimate the terminal value (TV) of synergies using a perpetuity formula. This can be done with or without an expected perpetual growth rate.
- Discount the annual post-tax synergies and the terminal value of synergies back to today and add them together.
The resulting value of synergies is an unlevered number and adds to the estimated Enterprise Value of the valued company.
| Year 1 | Year 2 | Year 3 | ||
| Pre-tax synergies | 100.0 | 200.0 | 300.0 | |
| Post tax synergies @ 30% | 70.0 | 140.0 | 210.0 | |
| Discount rate | 10.0% | |||
| TV (no growth) | 2,100.0 | |||
| Discount factors | 90.9% | 82.6% | 75.1% | |
| PV of synergies | 63.6 | 115.7 | 157.8 | |
| Sum of PV of synergies | 337.1 | |||
| PV of TV | 1,577.8 | |||
| Value of Synergies | 1,914.9 |
You should use the target’s marginal tax rate for post tax synergies.
The discount rate is equal to target’s WACC + risk premium.
You could assume a perpetuity growth for the terminal value calculation.