COMMENT: Are you paying too much for that acquisition?

 

Written by Robert G. Eccles, CFA, Kersten L. Lanes, and Thomas C. Wilson

Summarized by George S. Mellman, CFA

Edited by Constantinos Papanastasiou, CFA

President, CFA Society of Cyprus

 

Corporate mergers and acquisitions have always been a part of the U.S. economy. But even in the 1990s, too many of these corporate acquisitions have failed at their primary objective: to increase shareholder value. To address this problem, the authors suggest practical financial techniques for evaluating mergers and acquisitions. Just as important, they also recommend that corporate executives acquire the discipline to quickly walk away from excessively priced deals.

Many corporate mergers in the 1990s failed to add shareholder value, which is not much different from merger results from earlier decades. Moreover, this failure to add value is not simply a matter of excessive share price premiums paid to the acquired company, because acquisitions with low premiums fail at about the same rate as those with high premiums. Thus, the art of negotiating corporate mergers and acquisitions deserves more-rigorous financial discipline and analysis. Using in-depth interviews with 75 experienced acquisition-oriented senior executives, the authors describe proven approaches to merger making that can be systematically applied to all types of industries and organizations. As they explain, success requires a combination of analytical rigor and strict process discipline.

The authors’ primary conclusion is that acquiring companies need to understand more rigorously the full economic value of any potential purchase, and they need to be steadfastly unwilling to pay more. It is this economic value that determines the appropriate upper limits of the offer. This economic value of a deal can be determined by systematically analyzing its two component parts: the intrinsic and synergy values.

For the intrinsic value, the current valuation of the target company must be computed. This valuation can be found by discounting the target company’s estimated future cash flows and applying an appropriate valuation model.

Next, a synergistic valuation of potential post-acquisition improvements must be made. These beneficial improvements should be above and beyond reasonable current market expectations for the future of each company as stand-alone entities. Synergy can come from several sources, but the most common are cost savings (which can result from reducing overhead and combining purchasing power) and revenue enhancements (which can come from combining product lines and distribution channels to increase overall sales opportunities).

For any potential acquisition, the combined intrinsic and synergy valuations need to be rigorously identified and quantified, and this amount represents the upper price limit for a potential acquisition offer. As the authors also point out, a necessary part of successful deal making is having the discipline to reject potential acquisitions that, although they may have some unique appeal, fail to offer the potential for clearly identifiable and measurable added value.

This ability to turn down a potential acquisition when the price gets too high may be a company’s greatest challenge. The author’s interviews reveal that growth, seemingly at almost any cost, appears to be an embedded part of many corporations’ organizational culture.

 

— The CFA Society of Cyprus is a member society of CFA Institute, an international, nonprofit member organization of more than 88,000 investment practitioners and educators in 129 countries. CFA Institute awards the Chartered Financial Analyst (CFA) professional qualification, the designation of professional excellence within the global investment community. For more information on the CFA designation, please visit CFA Institute web page on www.cfainstitute.org or CFA Society of Cyprus web page on www.cfacyprus.com , e-mail: [email protected] .