In my past three blogs, I have discussed the Value of Certainty, The Value of Stability and the concept of Value Preservation Before Value Creation. In this issue, I want to close the series by acknowledging that the best deals are those where the deal team is truly focused on Value…….Value by the numbers and not the cosmetics in this new economy.
The New Game
CEOs and their boards have always had a primary responsibility to compete for shareholder investment in the market. In order to do so, they must focus on driving up the intrinsic value (discounted cash flows) of the company to create demand for the stock. In simple terms, Intrinsic value is created from both ROIC (returns on invested capital) and Revenue Growth. Empirical evidence from both the stock market and cash flow analysis show that ROIC combined with Revenue Growth drive the intrinsic value and in turn the stock price. Stock prices, like all prices, are driven by demand. The highest valued companies are those who drive the spread between ROIC and the weighted average cost of capital while concurrently maintaining revenue growth above 10% year on year. Revenue growth is necessary in that it allows companies to reinvest earnings in the spread between ROIC and WACC at rates greater than those available to investors…….thus creating more demand for the stock. Neither growth nor profits by themselves will any longer attract smart shareholders. They are both required.
The Old Rules
The point is that revenue growth is and will continue to be a requirement of corporate value and a good CEO must find a way to grow the business by greater than 10% every year. If a weak global economy has marginalized the demand for products and services there will be a need to cut operating costs to optimize ROIC. Given that revenue growth is a major component of intrinsic value and that in this economy organic growth is nearly impossible and that many companies are flush with cash, isn’t M&A the best option? Isn’t it the only option?
The Game Plan
M&A in this economy will be a company’s best option for growth, only if a future transaction will maintain or increase ROIC. Period. Capturing a weak competitor to increase market share or buying undervalued assets may be good strategic decisions, but the entire deal team (CEO to Corporate Development to Integration Leaders) should forecast in advance the future impact on intrinsic value. It’s no longer an acceptable practice to qualify a target acquisition by assessing only the current strategic and financial fit. Acquisitions most often fail to meet expectations due to incomplete knowledge of the entity being acquired and what to do with it when the deal is inked. Companies blessed with deep pockets and a need to deploy capital to maintain revenue growth should require additional levels of due diligence:
- Strategic Fit - It is the responsibility of executives to make investment and resource allocation decisions to improve ROIC
- Financial Fit - Capital allocation is the process of deciding how to distribute or reinvest cash flows
- Culture Fit, Business Model and Capabilities Fit – Differences in these key areas are often the primary barriers to successful M&A
- Integration Strategy – Executives need to quit tossing acquisitions to their managers after an acquisition commitment has been made. The lack of a clear integration strategy along with pre-deal training and planning can overcome missteps from all of the above points
Since most M&As have failed to meet expectations and actually destroy value, management needs to do a far better job of target company analysis to decompose the drivers of value knowing that incorporating another entity can either increase or decrease ROIC.
In SUMMARY, to eliminate M&A as a primary strategy for shareholder value would be like throwing the baby out with the bath water. Just because most companies tend to focus on the deal and not the deal dynamics and subsequent consequences, doesn’t mean that incorporating one entity into another can’t be done successfully. M&A done right can be beneficial to the stakeholders on both sides. Value is best created when the Focus is Value……before the deal and after.
Photo: myfinlife.com
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About the Author: Jim Jeffries is the founder and Chief Executive at M&A Partners. He has held C-Level positions in multiple consulting companies and industry. Mr. Jeffries’ background includes P&L responsibility at various size organizations during multiple stages of growth. He is also a CEO coach and advisor in global leadership development. His particular strength is in creating organizational vision to stimulate revenue growth while optimizing returns on invested capital. He has been quoted extensively in USA Today and in recent releases of The Art of M&A book series published by McGraw Hill.