The most overlooked number in corporate M&A
Corporate M&A often fails to deliver the value identified during the evaluation phase. Experience may suggest that good deals are those where the acquired company is left operating almost entirely as a stand-alone entity, relying on a pre-existing good business. When the success of the initiative is based on the premise of turning around companies or completely integrating them, the result is often disappointing. The bottom line seems to be that successful M&A involves companies already well performing before the deal and left operating independently after the transfer of the ownership. Maybe a subtle distinction should be made for vertical integrations but, whether that is true is not entirely clear.
M&A seems to be more of a capital allocation activity and less of a business strategy initiative.
During the evaluation phase of possible deals, business opportunities on sales and profitability are often used to highlight the deal’s underlying value, however, those numbers rarely capture the core essence and dynamic of the M&A initiative. Even a complex financial valuation fully justifying an acquisition through the discounting of future cash-flows is, in general, unreliable for numbers happening beyond 5-10 years from now. Discounting usually accounts pretty well for the cost of capital but, often fails to account for the uncertainty of human forecasting. Therefore, if the value of a company is based on cash-flows happening far away in the future, the result may be disappointing.
Approaching M&A with the principles discussed above – good businesses left operating independently even after the acquisition – could be analyzed also as a capital allocation activity rather than only as a business initiative. A possible complementary analysis to usual cash-flow discounting is an analysis of the return on capital of the entities, ROC – it may result in a series of cash-flows to discount as well but, built with a very different approach. Return on capital in this post has a little looser meaning than academia, for it could be considered also as return on assets or equity (ROA, ROE). However, ROC may be the most intuitive concept to the general reader and that is the main reason of that choice; the source of capital will then determine which indicator is the exact one to look at. The idea to think about is the capacity of the company to generate earnings with respect to the required investment, it is basically the capacity of generating $x of additional earnings for each $1 invested or re-invested in it. That is not directly related to the money used to purchase the business, it is the money invested to purchase real additional assets of the business or conduct real business initiatives – it is capital allocated.
Most of the times, what an acquisition can initially put on the table before any other contribution, is the availability of capital. Therefore, the return on that capital has to be considered in the evaluation. Going forward the post will use the term “reinvesting” in order to highlight the compounding effect of reinvesting internally-generated earnings (or cash, for sake of the argument). Money reinvested across different entities of the consolidated group will then compound through the capacity of each entity to generate extra earnings from those investments. The earnings’ growth of the combined company or group will be:
Combined group earnings’ growth [%] = Percentage of group's earnings reinvested [%] x Weighted average of the single ROC [%]
In the weighted average above, the weights are the allocation percentages of the reinvested earnings across the single entities.
When it comes to M&A, the usual focus on business-strategy may be a good starting point, however, the initiative has to be evaluated also as a capital-allocation activity because that is its nature. Obviously, part of those strategic opportunities initially identified will help extract value from the allocated capital but, the measure and rate of that process have to be quantified through the return on capital of the entities.
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