Valuing M&A Synergies as Real Options: A Case Study

Abstract

This thesis examines whether real option valuation (ROV) may serve as a viable supplement to traditional valuation methods in valuing synergies related to M&A transactions. The deal chosen for this purpose is Geely’s acquisition of Volvo Cars as of 2010, and the specific ROV method used to value the synergies arising from this transaction is the simulation-based Datar-Mathews method. Whilst traditional valuation methods may be appropriate when valuing investments characterized by a low degree of uncertainty and non-volatile cash flows, they may not represent the optimal choice when dealing with riskier and more unpredictable investments such as M&A. Synergies, despite their actual realization in many cases being highly uncertain, remain the main reason for companies to engage in M&A activity in the first place. Therefore, when valuing M&A synergies, there is a strong case for adopting a valuation method that is able to capture the value effects of the traits associated with synergies, namely uncertainty, managerial discretion and irreversibility. Real options share these very same traits, for which reason ROV is viewed as the optimal method when valuing synergies as opposed to more static and less flexible methods such as classical DCF analysis. By dividing synergies identified in the Geely-Volvo case into revenue-enhancing and cost-reducing synergies, the Datar-Mathews method, which involves the use of Monte Carlo simulation, ultimately yields a real option value equal to approximately USD 2,485bn. This is the value that the real option to realize the synergies embedded in Volvo Cars is worth from Geely’s perspective. Adding Volvo Cars’ stand-alone value, as estimated through the method of comparables, to the real option value yields the total price that Geely should be willing to pay for Volvo as of 2010. This price amounts to USD 6.86bn and represents the main finding of the analysis in this thesis. In conclusion, ROV and, more specifically, the Datar-Mathews method is found to be a useful supplement to traditional valuation methods, given its ability to more appropriately estimate the value of managerial flexibility and the effect of uncertainty on value. As such, it holds the potential to lead to more accurate synergies estimates being generated and hence more informed decisions being made by management in relation to M&A activity.