How does merger & acquisition activity affect company valuation?
The answer to this question varies tremendously. If you’ve seen one merger or acquisition, you’ve seen one merger or acquisition. In general, I recommend looking at M&A situations with a healthy level of skepticism. Seventy to ninety percent of M&A activity fail, according to The Harvard Business Review.
Some mergers and acquisitions genuinely do outperform, though. Google’s acquisition of YouTube and Facebook’s acquisition of Instagram come to mind. Adding complementary businesses through a refined, systematized acquisitions process where the organization can bring in revenue without corresponding overhead or debt can yield splendid results. Some specific funds and organizations also excel at M&A. Danaher and Berkshire Hathaway, for example, have the culture and processes in place to select, execute, and govern successful acquisitions.
However, the average corporation is very unsophisticated from an M&A perspective.
All too often companies add other companies for no clear reason, and then they fail in the most obvious way: by overpaying. If you take market price for a business and add 30-40%, it becomes much harder to make a deal that will yield the outcome you want. If the organization is giving up $50 billion in enterprise value (through debt and equity), make sure you're getting $50 billion in return.
Making a merger or acquisition work can also be tougher than it appears at first glance. For example, what if the business gives the appearance of sticky revenue, but under the hood their financial success is relationship-based? If those employees move on (or are let go), the revenue may go with them, and that’s not something that may be obvious without some very in-depth analysis.
Sometimes CEOs do these deals because they’re under enormous pressure to grow the company.
Almost any deal can be justified in some way; there are armies of financiers out there whose entire function is to develop models that will justify what their client/employer wants to do.
Further, growth and overpaying can even be compatible, at least in the short term. It will impact invested capital, but a pressed CEO can grow their company just by bringing in other companies. They can push earnings 50% higher through an acquisition, at the cost of leaving the balance sheet 200% higher. In fact, this can be an especially attractive proposition for renter (short-term) CEOs because they can achieve easy, quick growth and then later, when it goes wrong, someone else will be left holding the bag.
For what it’s worth, M&A activity is another reason for doing due diligence on companies.
Some CEOs instinctively know how to create value over a long period of time and do it in a way that is shareholder friendly, by getting up every morning and growing organically at 3-6%. Others make bad deals. As investors, we want to be able to discern between the two, and that requires in-depth research into the companies (and their leaders) in which we invest.
As an aside on the note of private equity: most private PE firms will take on enormous debt (because they favor leverage over equity), hemorrhage the company of cash and resources, pay themselves a big fat dividend, and then try to flip it to the public market years later with a debt-ridden balance sheet. That’s a form of M&A activity in which I have no interest in participating.