Damodaran on Valuation

15.1. WHAT IS SYNERGY?

Synergy is the additional value that is generated by combining two firms, creating opportunities that would not have been available to these firms operating independently. It is the most widely used and misused rationale in mergers and acquisitions. In this section, we consider the potential sources of synergy and categorize them into two groups. Operating synergies affect the operations of the combined firm and include economies of scale, increased pricing power, and higher growth potential. They generally show up as higher expected cash flows. Financial synergies, in contrast, are more focused and include tax benefits, diversification, a higher debt capacity, and uses for excess cash. They sometimes show up as higher cash flows and sometimes take the form of lower discount rates.

15.1.1. Operating Synergy

Operating synergies are those synergies that allow firms to increase their operating income from existing assets, increase growth, or both. We would categorize operating synergies into four types.

1. Economies of scale that may arise from the merger, allowing the combined firm to become more cost-efficient and profitable. In general, we would expect to see economies of scale in mergers of firms in the same business (horizontal mergers)—two banks coming together to create a larger bank or two steel companies combining to create a bigger steel company.

2. Greater pricing power from reduced competition and higher market share, which should result in higher margins ...