Academic journal article Academy of Accounting and Financial Studies Journal

The Link between Valuations and Due Diligence

Academic journal article Academy of Accounting and Financial Studies Journal

The Link between Valuations and Due Diligence

Article excerpt


This paper deals with the link between valuations and due diligence in merger and acquisitions. It analyses due diligence in terms of the net asset, the discounting of future cash flows and earnings valuation methods and the residual income method. It attempts to highlight the motives for mergers and acquisitions and converts these into the concepts of valuations, while considering shareholder value. While many authors implicitly understand this, the issue has often been sidelined leading to an overemphasis on less vital matters. The paper examines faults in current due diligence approaches and provides possible solutions to these problems by emphasising the link between due diligence and valuations. The topicality of shareholder value analysis and hence the due diligence valuation link is underpinned by recent empirical findings, its prominence in recent literature and the fact that shareholder value analysis is not being used sufficiently in practice.


A number of sources have stated that mergers and acquisitions often fail. These authors attribute such failures partly to inadequate due diligence procedures (Harvey, Price & Lusch, 1998; "An overview", 1997). Mergers and acquisitions are increasing in the United States of America, (Kroener & Kroener, 1991) however, there is data showing that such reorganisations have succeeded in only half of the instances (Kroener & Kroener, 1991). A failure rate that could be worsened because merger and acquisition activities are becoming more involved (Kroener & Kroener, 1991). There is, therefore, a necessity to develop strategies that increase the likelihood of success in company take-overs. It seems that a likely method of increasing success of merger and acquisitions is improving the "due diligence review" (p. 33), which is by definition a complex fact finding device to form the structure for the acquisition appraisal (Kroener & Kroener, 1991).

The due diligence process should challenge the reasons why mergers and acquisitions fail and devise strategies and procedures to reduce or minimise the risk of failure.


An analysis of merger and acquisition motives will aid in establishing why mergers and acquisitions fail. Motives attempt to justify mergers and acquisitions. If there is a weakness in the motives, the merger or acquisition is almost certainly doomed to fail. It is, therefore, essential that we analyse motives in the due diligence process.

Akason and Keppler (1993) postulate that the acquirer's objectives or motivations can be divided into two broad categories. Firstly, financial motivations: factors such as tax implications, the spreading of risks, purchase of assets at a discounted price, or profiting from fragmenting assets might be considered. Secondly, strategic motivations: factors to be considered include synergy and efficiency of the integration process. Harvey, Price and Lusch (1998) list a number of theories to justify mergers and acquisitions. Among these, they include the "efficiency", the "market power", the "empire building", the "process", the "raider" and "disturbance theory" (p. 18).

There is a common thread amongst all these theories: the acquirer must be in a better position after the acquisition. Rappaport (1998) states clearly that the objective of acquisitions and mergers is to "add value" (p. 33). Dess, Picken and Janney (1998) emphasise that mergers and acquisitions must be considered in light of the following sentiment: that it is often less expensive for an individual on the stock exchange to diversify than it is for a company by means of a takeover. This is because of the high premiums often paid in order to obtain control (Dess, Picken & Janney 1998). A study by Sirower indicates that in order to break even on a premium of fifty percent, the acquirer would have to increase a target's return on equity by twelve percentage points in the second year and maintain this return for the following nine years (Dess, Picken & Janney, 1998). …

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