The acquisition seems to be the preferred strategy for most companies to grow. Empirical analysis shows that acquisition often doesn't create value for acquirers. Less successful deals occur when acquirers have the wrong strategic concepts - pursuing international scale, filling portfolio gaps, or building a third leg of the portfolio.
Marc Goedhart, Tim Koller and David Wessels in their article called "The six types of successful acquisitions" outlined six strategic concepts to consider if an acquisition will be beneficial.
1. Improve the target company’s performance
Improving the performance of the target company is one of the most common value-creating acquisition strategies. Put simply, you buy a company and radically reduce costs to improve margins and cash flows. In some cases, the acquirer may also take steps to accelerate revenue growth.
Keep in mind that it is easier to improve the performance of a company with low margins and low returns on invested capital (ROIC) than that of a high-margin, high-ROIC company. Consider a target company with a 6 percent operating-profit margin. Reducing costs by three percentage points, to 91 percent of revenues, from 94 percent, increases the margin to 9 percent and could lead to a 50 percent increase in the company’s value. In contrast, if the operating-profit margin of a company is 30 percent, increasing its value by 50 percent requires increasing the margin to 45 percent. Costs would need to decline from 70 percent of revenues to 55 percent, a 21 percent reduction in the cost base. That might not be reasonable to expect.
2. Consolidate to remove excess capacity from industry
While there is substantial value to be created from removing excess capacity, as in most M&A activity the bulk of the value often accrues to the seller’s shareholders, not the buyer’s. In addition, all the other competitors in the industry may benefit from the capacity reduction without having to take any action of their own (the free-rider problem).
3. Accelerate market access for the target’s (or buyer’s) products
Often, relatively small companies with innovative products have difficulty reaching the entire potential market for their products. Small pharmaceutical companies, for example, typically lack the large sales forces required to cultivate relationships with the many doctors they need to promote their products. Bigger pharmaceutical companies sometimes purchase these smaller companies and use their own large-scale sales forces to accelerate the sales of the smaller companies’ products.
4. Get skills or technologies faster or at lower cost than they can be built
Many technology-based companies buy other companies that have the technologies they need to enhance their own products. They do this because they can acquire the technology more quickly than developing it themselves, avoid royalty payments on patented technologies, and keep the technology away from competitors.
5. Exploit a business’s industry-specific scalability
Economies of scale can be important sources of value in acquisitions when the unit of incremental capacity is large or when a larger company buys a subscale company. For example, the cost to develop a new car platform is enormous, so auto companies try to minimize the number of platforms they need. The combination of Volkswagen, Audi, and Porsche allows all three companies to share some platforms. For example, the VW Toureg, Audi Q7, and Porsche Cayenne are all based on the same underlying platform.
While economies of scale can be a significant source of acquisition value creation, rarely are generic economies of scale, like back-office savings, significant enough to justify an acquisition. Economies of scale must be unique to be large enough to justify an acquisition.
6. Pick winners early and help them develop their businesses
The final winning strategy involves making acquisitions early in the life cycle of a new industry or product line, long before most others recognize that it will grow significantly. Johnson & Johnson pursued this strategy in its early acquisitions of medical-device businesses. J&J purchased orthopedic-device manufacturer DePuy in 1998 when DePuy had $900 million of revenues. By 2010, DePuy’s revenues had grown to $5.6 billion, an annual growth rate of about 17 percent. (In 2011, J&J purchased Synthes, another orthopedic-device manufacturer, so more recent revenue numbers are not comparable.) This acquisition strategy requires a disciplined approach by management in three dimensions. First, you must be willing to make investments early, long before your competitors and the market see the industry’s or company’s potential. Second, you need to make multiple bets and to expect that some will fail. Third, you need the skills and patience to nurture the acquired businesses.
Furthermore, even if an acquisition is based on ones of the archetypes above, it won't create value if you overpay - in other words, if you pay more than the company’s intrinsic value. To gain control of a target, acquirers must pay its shareholders a premium over the current market value. Although premiums can vary widely, the average ones for corporate control have been fairly stable: almost 30 percent of the preannouncement price of the target’s equity. For targets pursued by multiple acquirers, the premium rises dramatically, creating the so-called winner’s curse. If several companies evaluate a given target and all identify roughly the same potential synergies, the pursuer that overestimates them most will offer the highest price. Since it is based on an overestimation of the value to be created, the winner pays too much—and is ultimately a loser. The possibility that a company might pay too much when the market is inflated deserves serious consideration because M&A activity seems to rise following periods of strong market performance. If (and when) prices are artificially high, large improvements are necessary to justify an acquisition, even when the target can be purchased at no premium to market value.
Its pleasing simplicity and ease of application make the price to earnings (P/E) ratio one of the most commonly used valuation metrics in the world. Almost every financial website, from Bloomberg to Google Finance, puts the P/E near the top of the page, right near the stock price and market cap. Investors constantly reference the P/E ratio when making a bullish or bearish case for a stock.
However, the vast majority of evidence suggests that P/E ratios are an unreliable way to measure the true value of stocks. There are several reasons for this misconception, including the following:
Accounting Rules Are a Moving Target
The earnings denominator of the P/E ratio is subject to accounting rules that are constantly being reshaped. Former Financial Accounting Standards Board (FASB) chairman Bob Herz expressed this sentiment when we spoke to him last year, saying: “I’m not a big fan of earnings multiples, of P/E multiples and things like that. We have made over time dramatic changes in the accounting that affect the denominator of the P/E ratio, but it’s not clear whether and how that flows through the valuations.”
The changing treatment of employee stock options is an example of how accounting rule changes affect reported earnings and make P/E’s between different stocks incomparable. One of the biggest in recent history was the 2006 FASB decision to require companies to report the cost of stock options on their income statements. This change officially went into effect in 2006. Unofficially, many companies reported stock option expense years in advance of the ruling. For instance, Microsoft (MSFT) began expensing stock-based compensation in 2004. This expense lowered MSFT’s reported earnings decline by $1.8 billion in 2004 and made MSFT’s P/E incomparable to all other stocks that were not reporting their stock option expense.
Because companies have different fiscal year ends, the date they are required to follow new accounting rules is different too. So, at any given time, the EPS of some companies reflect the rule change while many others do not.
Accounting Earnings Are Often Misleading
Accounting earnings are based on rules designed for debt investors, not equity investors. They contain numerous loopholes that allow companies to inflate earnings. It takes diligent research in the financial footnotes in order to convert reported earnings to economic earnings. AT&T (T) is one example of a stock with a P/E that is based on artificially inflated accounting earnings. T earned nearly $8 billion in non-operating income from its pension plan assets in 2013. This non-operating income allowed T to more than double its reported earnings in 2013. T’s artificially high earnings gave it a low P/E of 10.
In reality, T’s NOPAT actually declined by 5%. While the stock isn't hugely expensive, it does have roughly 30% profit growth priced into its valuation. Investors who just look at the P/E get a misleading view of the stock’s valuation.
P/E Overlooks Key Liabilities and Assets
A stock’s worth is based on the present value of future cash flows attributable to the shareholder. Accounting earnings do a poor job of measuring cash flows, as we’ve already established. However, the other big flaw with P/E ratios is that they don’t account for many of the more senior claims on cash flows. T exemplifies this issue as well as it has nearly $35 billion in deferred tax liabilities.
Olin Corporation (OLN) also exemplifies this issue. OLN looks cheap with a P/E of 13. However, it has off balance sheet debt, pension, and other liabilities that add up to ~$500 million (25% of market cap). With a discounted cash flow model, we can see that its current valuation of ~$27/share implies that OLN will grow NOPAT by 5.5% compounded annually for 35 years. Only with a real grasp on the true cash flows of the business can one get an accurate measure of the future cash flow growth implied by the stock’s valuation.
Before entering into the subject of this article, there is a remark that is worth mentioning about the term "value investing" that I find inappropriate. Indeed, the term "investing" already means the act of seeking value.
Putting this aside, value investing refers to investing in stocks worth more than its market price. Such stocks having attributes as a low ratio of price to book value or a low price earnings ratio. However, such characteristics are not determinative to get a value from the investment; the market may well evaluate such stocks. In contrast, growth investing refers to investing in stocks having a high potential to grow. Such stocks have a high ratio of price to book value or a high price earnings ratio and are expensive. Most of the growth investors end by selling their stock below the buying price.
These strategies appear as separate and distinct for the most professional investors, nonetheless in my opinion they are joined at the hip. Growth is a potential avenue for creating value. It can have a positive impact on value or destroy value. Growth benefits investors only when it is disciplined when each dollar used to finance the growth creates value over the market long-term value. Any growth opportunity must help to create more value. Otherwise, there is no question to finance an undisciplined growth.
You may have answered this question by saying probably that it’s an investor with high IQ or SAT scores. But there’s a proof that high IQ and higher education are not enough to make an investor intelligent. In 1998, Long Term Capital Management L.P., a hedge fund run by mathematicians, computer scientists and two Nobel Prize winning economists, lost more than $2 billion in a matter of weeks on a huge bet that the bond market would return to normal. But the bond market kept right on becoming more and more abnormal and LTCM had borrowed so much money that its collapse nearly capsized the global financial system. And back in 1720, Sir Isaac Newton owned shares in the South Sea Company, the hottest stock in England. Sensing that the market was getting out of hand, the great physicist muttered that he “could calculate the motions of the heavenly bodies, but not the madness of the people”. Newton dumped his South Sea shares pocketing a 100% profit totalling £7000. But just months later, swept up in the wild enthusiasm of the market, Newton jumped back in at a high price and lost £20000. Sir Isaac Newton was one of the most intelligent people who ever lived, as most of us would define intelligence. Additionally, in 2000, all these so-called experts proclaimed that internet-related companies “are the only ones that are going higher consistently”. But year-end 2002, most of these companies had already gone bankrupt. In short, be an intelligent investor is more a matter of character than a brain. And if you've failed at investing, it’s not because you are stupid, it’s because you don’t have the characters that successful investing requires.
When asking people what they think about putting their money in the stock market, most consider it "not safe" or it's a "gamble" and some are "not familiar" with it. But it is a place where enormous value can be created. Investment and speculation are the two approaches by which you can put cash in the market. An investment operation is one which upon through analysis, promises safety of capital and an adequate return. Operations not meeting these requirements are speculative. Nowadays, anybody and everybody in the market considers himself as an investor no matter what they are buying, for which purposes, on margin or on cash. But there are very few investors.
Speculation is always fascinating and it can be very fun while you are ahead of the game. Its success is a matter of luck like flipping a coin, and the only thing you can expect when speculating is the loss of your principal.
What about investing? You are willing whether to follow the market or to achieve a better overall result. Most of professional investors on the market are passive and the world with a lot of passive investors is one where there are very few entrepreneurial investors prepared to make proposals in management, cost structure, strategies and capital structure. An entrepreneurial investor considers himself as a business owner while a passive investor considers himself as a stock owner.
The problem with being passive is the fact that you undergo the market's turbulence more than an entrepreneurial investor. How an enterprising investor can obtain a better overall return than his passive companion whose expert go through the same earning report? John Templeton said: "it's impossible to produce superior performance unless you do something different". To achieve a better overall result, you must follow policies which are inherently personal, promising and not popular. Investing successfully doesn't mean having a high IQ; it depends on the talent of the investor to identify "good business" where the market sees wrong. There is no check-list to go through to successfully invest; it's a matter of good judgement. For example I won't invest in a business that is relying on one customer for most of its revenue. Compared to a passive investor's portfolio, an entrepreneurial investor don't need a lot of stock in his portfolio and don't need to diversify. There is a popular saying in Wall Street: "don't put all your eggs in one basket", but when it comes to successfully invest you should put them in the same basket. Successfully investing takes time; Warren Buffet said: "you can't produce a baby in one month by getting nine women pregnant. It takes time, discipline and patience no matter how great the talent or effort, some things just take time".
For centuries, Wall Street have ran after immediate gratification thereby creating a gambling culture that spread beyond Wall Street.
There are many reasons why short-term mentality has taken hold in Wall Street. Greed and media that lead to a lost sight of long-term goal. Our so call "investors", who are not willing to own a business for long-term, who are renters on wall Street and are trading stock to make a quick gain are mainly responsible of the spread of this culture.
The consequence of that is the constant pressure on companies to produce quarterly results. And it is difficult for companies to focus on long-term strategies. Even if most CEOs would like to make long-term investment for the growth of their company, they are obliged to follow this trend.
So how can we fight again that? In my opinion nothing can be done to remove this culture from the market. It's for the companies to develop a culture of resistance to market habits. I mean, company leaders should "forget" the market and do their job rather than protect their jobs by satisfying speculators. Thereby our financial market will more reflect what is going on in the real economy and preserve our world from frequent financial crises.
A naïve acquaintance had ventured to ask a great man what the market was going to do. "It will fluctuate", replied the great man dryly. THE STOCK MARKET would not be what it is if it did not have its ups and down. From Tulip crash in 1637, Wall Street crash of 1929, October crash of 1987, bankruptcy of LTCM in 1998, Internet bubble in 2000 and 2008 financial crisis with bankruptcy of Lehman Brothers; one thing appears clearly: there is no "formula investing". What is needed to be on the market is "wisdom". The history behind LTCM bankruptcy is a "great lesson":
In such challenging area, where most people are running after a magic formula, there are some people who don't have a great background, don't necessary graduate from Harvard, don't hold a PhD degree and don't need a magic formula but understand what the market is and do better than most.
