Aswath Damodaran has a blunt message for corporations contemplating an acquisition: “Don’t do it.”
“I firmly imagine that acquisitions are an dependancy, that after corporations begin to develop by means of acquisitions, they can not cease,” he advised the viewers on the CFA Institute Equity Research and Valuation Conference 2018. “Every part in regards to the M&A course of has all of the hallmarks of an dependancy.”
That’s why he titled his presentation, “Acquirers Nameless.”
And like each dependancy, the acquisitions behavior exacts a heavy toll from its abusers and those that depend on them.
“For those who have a look at the collective proof throughout acquisitions,” Damodaran mentioned, “that is probably the most worth damaging motion an organization can take.”
Methods to Create Worth
The dilemma comes right down to how corporations generate development. And it turns on the market are actually solely a handful of methods that may accomplish that, Damodaran mentioned, referencing information from a McKinsey examine.
“The easiest method of making development traditionally has been to provide you with a brand new product,” he mentioned. “Have a look at Apple. Between 2001 and 2010, the corporate went from being a $5 billion firm to a $600 billion firm, they usually constructed it on the iPhone, the iPad. Principally new product, new product.”
However creating new merchandise is like enjoying the lottery. While you win, the payoff is large, however wins are uncommon and losses widespread. “Consider the distinction with Microsoft’s new merchandise in 2001 and 2010,” Damodaran mentioned. “You possibly can’t bear in mind any of them, proper?”
The second finest technique for development is growth, both into a brand new market or by discovering new customers inside your market. Coca-Cola and Levi’s went international within the Eighties, Damodaran defined. As for locating new customers, he pointed to over-the-counter painkillers: “You know the way a lot greater the aspirin market obtained as soon as individuals found it was doubtlessly one thing you possibly can take to not have a coronary heart assault?”
The third only method, McKinsey discovered, was to develop or preserve market share in an increasing market. “Consider Apple and Samsung between 2011 and 2015 within the smartphone market,” Damodaran mentioned. “Apple’s market share truly decreased between 2011 and 2015, however their worth elevated. Why? Just because the smartphone market itself was rising. While you’re in a rising market, it offers you this buffer to have your market share drop off and nonetheless develop.”
Firms also can attempt to improve market share in a secure market, however that’s even much less efficient at attaining development and is usually worth damaging. As a result of to accumulate that market share, you need to reduce costs. “You’ll get a better market share however your margins collapse,” he mentioned. “Your worth, in actual fact, turns into way more unpredictable.”
“The Very Backside of the Barrel”
After which McKinsey will get to the dregs, what Damodaran calls “the very backside of the barrel.”
What’s the very worst strategy to develop?
“Go do acquisitions,” he mentioned.
The evidence isn’t in dispute: It’s piling up and pretty well disseminated. But the business has but to succeed in all-time low. “That is one thing we’ve identified for 40 years,” Damodaran mentioned. “And as you have a look at M&A examine after M&A examine, collectively, this isn’t a course of that creates worth, and I’m afraid the illness is spreading.”
After all, in case you’re the focused firm, being acquired is a good factor. Your inventory worth goes up. “Targets win,” Damodaran mentioned. “You get up the subsequent morning and thank God for capitalism . . . . You’ll by no means need this course of to cease. This can be a gravy practice that’s going to maintain giving.”
Why is that? As a result of buying corporations are likely to overpay. By rather a lot.
“I’ve seen corporations destroy 20 years of onerous work in someday with one acquisition,” he mentioned. “I bear in mind when Eastman Kodak was an awesome firm. It was one of many Nifty Fifty, thought-about a rare well-managed firm. Till the day they purchased Sterling Medicine, a development firm within the pharmaceutical enterprise.”
How pharma and cameras and movie match collectively was not particularly intuitive. “They claimed synergy,” Damodaran mentioned, “overpaid by $2.2 billion and that was the start of the tip for the corporate as a result of, after that, no person trusted them.”
Examples like this abound. And the phrase synergy tends to pop up fairly a bit.
Certainly, in response to a KPMG examine of about 9,000 mergers, synergy was probably the most usually cited rationale.
“Synergy sounds magical,” Damodaran mentioned. “However let’s put our worth hats on. If there’s actually synergy, what’s it? The place will it present up? How will I worth it? How a lot ought to I pay for it, proper?”
Step one is to worth each the buying and goal corporations as stand-alones. Then add these two values collectively. The third step is to take the mixed firm and add in no matter kind synergy will take. That may imply a lift in income development, decrease value of capital, elevated market share, and many others.
“Worth the mix firm with these adjustments put in, and what it’s best to get in step three needs to be larger than the sum of values you bought in step two,” Damodaran mentioned. “The distinction is the worth of synergy. That’s it.”
So what proportion of mergers even have synergy?
In round half of the mergers KPMG studied, there wasn’t any proof of synergy, in response to Damodaran. And in about one third of the mergers, there was proof of reverse synergy. “ what that’s, proper?” he requested.
McKinsey has made related inquiries for the final a number of a long time. One of many questions they ask is, Does the merger create a return on capital?
“Once more, in two thirds of all mergers, what they discover is the mergers fail that quite simple capital budgeting query with synergy included within the returns,” Damodaran mentioned. “And right here’s probably the most closing and most damning proof that mergers don’t work: Have you learnt half of all mergers are reversed inside 10 years of the merger? The corporate that did the acquisition part lastly exhibits up and says, ‘Didn’t work.’”
Given this mountain of collective proof that corporations pay an excessive amount of for acquisitions and that they destroy extra worth than they create, why are they nonetheless so well-liked? Why is the second of readability nonetheless so elusive?
Damodaran believes that the rationale for this lies not within the offers however fairly within the M&A course of itself. “The ecosystem is full of people that feed your dependancy,” he mentioned. “Beginning with who? Beginning with consultants who are available and say, ‘Your development appears to be leveling off. We have now simply the appropriate answer for you.’”
Then the everyday deal entails 4 gamers: the buying agency, the goal agency, and their funding bankers — All of whom seemingly are incentivized to finish the deal.
“There’s not pushback on this course of, proper?” he mentioned. “Are you going to be the skunk on the celebration saying, ‘ what, guys? That income development may not present up.’”
So what implications does this have for Damodaran as an investor?
“I’ve 53 shares in my portfolio, and I’ve one set off that can lead me to promote the shares immediately,” he mentioned. “You do a giant acquisition, I’m out of your inventory. I don’t care what justification you give me. As a result of I do know my historical past. For those who do a giant acquisition, the chances are loaded up towards you.”
In different phrases, simply say no.
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All posts are the opinion of the writer. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially replicate the views of CFA Institute or the writer’s employer.
Picture courtesy of Paul McCaffrey