M&A Deal Evaluation
Emphasis is often placed on
evaluation metrics that look as if they tell the story, but they can be
misleading in the world of M&A.
Key questions to be answered as part of a due diligence process in determining whether or not to proceed with an acquisition include the following:
Is the target company a good fit?
How does the synergies stack up
against the risks?
Does the target company's sector show potential for
growth?
Can accretive earnings trump the negatives if the finding are less than encouraging? Does the fact that a deal is accretive necessarily mean that it's a
good move? Conversely, are deals that dilute earnings per share (EPS)
necessarily bad moves? Should EPS as a measure by which to
evaluate an M&A transaction even be used?
Recently A.T. Kearney discussed the
findings from their research into the metrics and analyses most frequently
used to evaluate proposed mergers and acquisitions. The research
introduced a surprising insight: The impact on EPS is by far the most
emphasized metric used to evaluate proposed M&A transactions between
public companies.
They looked at two common and
related myths surrounding EPS and demonstrated why these are at best
unhelpful and at worst potentially misleading. They also examined what
business leaders and market analysts should focus on instead.
How Do They Get It So Wrong?
"It is widely recognized that a significant percentage of M&A
transactions fail to deliver value to shareholders. What goes wrong? How
is it that acquisitions on average seem to create negligible returns?
It can be tempting to blame poor merger integration for the meager
returns, and certainly the execution of an integration can have a major
impact on whether or not a transaction is regarded as successful.
However, it may also be useful to consider if the deal was worth doing
in the first place. Maybe some transactions should never have happened.
With this in mind A.T. Kearney joined forces with the UK's Investor
Relations Society (IR Society) to understand exactly which metrics and
analyses get the most emphasis in evaluating proposed M&A
transactions. Maybe the solution to the question of "what goes wrong"
lies in the tools used to filter (and one would hope eliminate)
value-destroying transactions from those that create value.
Investor Relations professionals were surveyed to gauge the views of key
stakeholders—company executives, sell-side analysts, and investors—on
10 frequently used metrics and analyses .
We found that EPS analysis is used most, and by a wide margin: 75
percent of respondents ranked it in the "strong emphasis" category,
fully 26 points ahead of enterprise value/EBITDA, the number two rated
metric (see figure 1).
What Exactly Is EPS Accretion and EPS Dilution?
Before we go any further, let's define what we mean by EPS accretion
and EPS dilution. A company's EPS—again, earnings per share—is simply
the total profit allocated to each outstanding share.
EPS growth
can be achieved either organically or inorganically through M&A
activity, and few would argue that organic EPS growth is anything other
than a positive indicator. EPS growth delivered through M&A
activity, that is, EPS accretion, is fundamentally different. Yet there
are some commonly held beliefs—or, more accurately, myths—to suggest
this distinction is not fully understood by many experienced investment
professionals, including some company executives.
Two myths are widely believed:
EPS accretive transactions create value.
EPS dilutive transactions destroy value.
As we will see, neither of these preconceptions stands up to scrutiny.
Why then do so many executives and others persist in using EPS analysis
to evaluate M&A transactions?
The answer comes down to views
about valuation. A company's stock is frequently valued on the basis of
its EPS by applying a price-to-earnings (P/E) ratio. Based on the
assumption that an acquiring company's P/E ratio will stay the same
after an acquisition, if earnings per share increase, then the company's
overall value will increase, ostensibly as a result of the deal.
What's the Catch?
But, there's a catch. To understand it you need to consider the
fundamentals of why one company has a higher P/E ratio than another in
the first place. It is because the market believes the earnings of the
company with the higher P/E ratio—call it Company A—will rise faster
than those of the company with a lower P/E ratio (Company B).2
Now suppose Company A buys Company B, using its stock as the
acquisition currency. As a result of the purchase the EPS of the
combined company will be higher than that of Company A had it not made
the acquisition—thus the transaction is EPS accretive for Company A.
But being EPS accretive comes with a downside—and that's the catch. The
newly combined company will also have a lower earnings growth rate than
Company A would have had as a standalone company. So while the EPS of
the post-acquisition company will be higher than that of the
pre-acquisition Company A, its P/E ratio will be lower due to its
acquisition of the lower-P/E rated Company B.
In fact, the
reduction in the P/E ratio, all other things being equal, will exactly
counterbalance the impact of the higher EPS. The result is that the
valuation of the newly combined company will reflect the blended higher
EPS and lower P/E ratio of the two original companies. In other words,
no value is created.
A key reason for doing an M&A deal is,
of course, the synergies that can result. By increasing the new entity's
combined earnings, synergies can add enough value to make the combined
company worth more than the two individual companies were before the
merger. It is important to note that the increased value results from
the synergies created, not from the deal being EPS accretive or
dilutive. It is quite possible that highly dilutive deals offer the
greatest opportunities for delivering synergies.
An argument
sometimes put forward to support the myth that EPS accretion equates to
value creation is that "people believe it does." This becomes reality as
the misperception is priced into the stock.
Richard A. Brealey and Stewart C. Myers write about this idea in their seminal textbook, Principles of Corporate Finance.
They call it the “bootstrap game.” If companies can fool investors by
buying a company with lower P/E rated stocks, then why not continue to
do so? The flaw in the bootstrap game is the need to keep the market
fooled, hoping it doesn’t notice that the acquiring company’s earnings
growth potential is becoming progressively more diluted.
The
inevitable result of pursuing such a strategy to its logical conclusion
by continuing to acquire lower P/E rated companies is clear: In the same
way a Ponzi scheme must eventually fail due to the lack of underlying
value creation, the P/E multiple of the acquiring company must fall as
it becomes increasingly evident to the market that no value is created.
What's the Alternative for Evaluating Proposed Mergers?
Our advice for evaluating a proposed merger is characteristically
pragmatic: Stick to the fundamentals. M&A can deliver significant
competitive advantage and value to shareholders, but the criteria by
which to assess just how much must answer fundamental business
questions:
Is the proposed merger strategically logical?
Will it deliver cost, revenue, or other financial synergies?
Will it build management or other capabilities?
Is the combined company capable of delivering the synergies?
A thorough, fact-based due diligence is the best way to answer these questions (see figure 2).
Of course, there is also a role for using many of the M&A metrics
and analyses described in figure 1 as part of an overall assessment.
These can play a complementary role in developing a full perspective on a
transaction. Used in isolation, however, and without a clear
understanding of their limitations, they have a tendency to give a very
limited view of the real potential for value creation.
Ultimately, any value an M&A transaction creates must translate into
future cash flow, resulting from synergies in three value-creation
areas: topline growth, operations productivity, and asset and capital
investment rationalizations (see figure 3).3
And then there's the crucial question of how much to pay for a deal and
who will realize the value it creates. If the net present value (NPV)
of future synergies is paid to the selling shareholders in an
acquisition price premium, even the most synergistic of mergers can
result in value destruction for the acquirer's shareholders.5 Always consider who will be the winners in an M&A transaction—the final outcome is rarely the same for all parties.
EPS Myths Revisited
The moral of the story is this: Too often, too much emphasis is placed
on whether a deal is EPS accretive or dilutive. These are time-honored
metrics that appear sensible but in reality do not answer the most
important question: Should we do the deal? Let's review the two commonly
held myths and why they don't work as M&A evaluation measures.
EPS-accretive transactions create value. Not necessarily. Accretion is a relative measure that simply shows the company being acquired has a lower P/E rated stock.
EPS-dilutive transactions are value destroying.
Again, not necessarily. In fact, EPS-dilutive transactions can increase
value when the target company has good growth potential and the
strategic logic for the deal is strong.
The fact is that EPS
analysis is not a useful tool for evaluating the merits of proposed
M&A transactions. Accretion or dilution is a fact of doing deals but
is not a measure of potential value creation. For that, you need to
examine the deal's business fundamentals.
Our research reveals
one more insight: how the emphasis given to the different metrics and
analyses has changed over the past decade. Two measures, core capabilities and cultural fit,
the most qualitative among the 10 examined, are among the top measures
that have "become more important" in the past decade (see figure 4).
This suggests stakeholders are becoming increasingly aware of the
conditions necessary for merged organizations to deliver sustained value
after the deal has closed and the merger integration process begins.
Quick and Easy Shortcuts Can Be Misleading
This is not to say a proposed transaction's impact on EPS isn't
important. It is something that needs to be understood and communicated
to investors. The fact remains, however, that doing an EPS-accretive
deal is easy—simply buy a company with a lower P/E rated stock than your
own. So the next time someone says or implies that an M&A deal is a
good one because it is EPS accretive, ask why the market gave the
target company's stock a lower rating in the first place. To truly
understand whether a proposed acquisition will create value requires
evaluating the strategic rationale for making the deal, and if it will
deliver enough synergies to create value. As with many things in life,
quick and easy answers can be misleading."
Has your emphasis given to the different metrics and analyses changed over the past decade?
