What is synergy?

Mergers and acquisitions are arguably the most popular and influential form of discretionary business investment. Synergy is a word often found in the press release of the reasons given by the acquirer when they bought over another company. Like a major R&D project or plant expansion, acquisitions are a capital budgeting decision. Stripped to the essentials, an acquisition is a purchase of assets and technologies. But usually, the acquirer often pay a premium over the stand alone market value of these assets and technologies. They pay for something called synergy.

The common definition of synergy is 2 + 2 = 5. However, the accurate definition should be increases in competitiveness and resulting cashflow beyond what the 2 companies are expected to accomplish independently. It can simply be modeled as:
NPV = synergy - premium

From the above formula, one can understand why the share price of the acquirer usually drops after the announcement. If a high premium was paid, the net present value of the assets and technologies gained will be negative if the expected synergy did not occur. According to a McKinsey study, more than 60% of the the acquisition programs were failures because the acquisition strategies did not earn a sufficient return on the funds invested. Companies that do not understand this fundamental fact risk falling into the synergy trap.


Quote of the day
The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do. A too high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favourable business developments.
------- Warren Buffett (1982 annual report)