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Chapter 5 of 5 · 10 min

Contribution analysis

In a stock deal, does each side's share of the combined company match what it brings to the table?

By the end of this chapter you can
  • Calculate each side's contribution to combined revenue, EBITDA and net income
  • Calculate the target's pro forma ownership in a stock deal
  • Work out the offer that would match ownership to contribution
  • Explain why the metrics give different answers
1

The intuition

Two friends merge their food trucks into one business and split the shares. One truck makes three times the profit of the other. A fair-sounding split gives its owner three quarters of the shares. If the smaller truck's owner insists on 40%, they are being paid for more than they bring.

Stock mergers work the same way. After the deal both sets of shareholders own the combined company. Contribution analysis puts side by side what each side contributes and what share of the company each side ends up owning.

The key idea

Compare the target's share of combined revenue, EBITDA and net income with its shareholders' share of the combined company. Ownership above contribution means the acquirer is paying a premium to contribution.

2

Why it works

  • Contribution on a metric = target ÷ (acquirer + target).
  • Ownership in a stock deal = offer value ÷ (acquirer equity value + offer value), assuming both sides are valued at those figures.
  • The contribution-implied offer is the offer that makes ownership equal contribution: acquirer equity value × target metric ÷ acquirer metric. It values the target at the acquirer's own multiple of that metric.
  • The premium to contribution = actual offer ÷ implied offer − 1.
  • The metrics disagree because margins, leverage and tax differ. A high-margin target contributes more EBITDA than revenue; a less-indebted one contributes more net income than EBITDA. The spread is the point: bankers show several metrics as a range.
Acquirer: equity value $3,000, revenue $2,000, EBITDA $300, net income $150. Target: revenue $500, EBITDA $100, net income $40
Revenue contribution: 500 ÷ 2,50020.0%
EBITDA contribution: 100 ÷ 40025.0%
Net income contribution: 40 ÷ 19021.1%
EBITDA-implied offer: 3,000 × 100 ÷ 3001,000 (25.0% ownership)
Actual offer 1,200: ownership 1,200 ÷ 4,20028.6%
Premium to EBITDA contribution: 1,200 ÷ 1,000 − 120%
Premium to net income contribution: 1,200 ÷ 800 − 150%
3

The formulas

Target contribution (metric) = target ÷ (acquirer + target)

Its share of what the combined company produces.

Target ownership = offer ÷ (acquirer equity value + offer)

Its share of the combined company's shares.

Contribution-implied offer = acquirer equity value × target metric ÷ acquirer metric

The offer at which ownership equals contribution.

Premium to contribution = actual offer ÷ implied offer − 1

How much more than contribution the target's holders are getting.

4

Worked example

Three metrics, three contributions. Target over the total, line by line.

Drawing the numbers…
5

See it move

Same companies. Change the size of the offer, the target's margin and how much of its EBITDA reaches net income.

Drawing the numbers…
Try this
  • Raise the offer. The target's ownership and both premiums to contribution rise.
  • Set the offer to 1.0x. Ownership lands exactly on the EBITDA contribution, and the premium to EBITDA contribution is zero.
  • Raise the target's EBITDA margin. Its EBITDA and net income contributions rise and its revenue contribution stays put. Because the offer here is pegged to EBITDA, the offer and ownership rise too.
  • Change how much of the target's EBITDA reaches net income. Only the net income contribution and the premium to it move.
6

Run it backwards

Same companies, reversed: what offer would give the target's shareholders exactly their EBITDA contribution?

Drawing the numbers…

Ownership equals contribution when the offer is to the acquirer's equity value as the target's EBITDA is to the acquirer's EBITDA. So multiply the acquirer's equity value by that EBITDA ratio.

That offer values the target at the acquirer's own equity-value-to-EBITDA multiple. It is a reference point, not a price: a faster-growing target deserves more, a weaker one less.

7

Traps

Comparing contribution with the offer premium over the target's share price.
Compare it with ownership of the combined company. That is what the target's holders actually receive.
Reading one metric as the answer.
Revenue, EBITDA and net income give different contributions because margins and leverage differ. Show the range.
Using contribution analysis for a cash deal.
In a cash deal the target's holders own nothing afterwards. The analysis is for stock deals and mergers.
Treating the contribution-implied offer as fair value.
It assumes the target deserves the acquirer's multiple. Growth, margins and risk can justify more or less.
Ignoring debt when comparing EBITDA with net income contribution.
A target with less debt keeps more of its EBITDA as net income, so it contributes more on net income than on EBITDA.
8

Say it in the interview

The interviewer asks

“What is contribution analysis, and when would you use it?”

Say yours out loud first, then compare.
9

Check yourself

4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.

Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.

0 of 4
Drawing your questions…
Remember
  • Contribution = target ÷ combined, for each metric.
  • Ownership = offer ÷ (acquirer equity value + offer).
  • Implied offer = acquirer equity value × target metric ÷ acquirer metric.
  • Metrics disagree because of margins and leverage: show the range.