As noted yesterday, increased M&A activity is good, initially, for the stock market as it 1) reduces the supply of existing stocks and 2) one deal leads to another so the process feeds on itself. But how does a company decide 1) which other company to buy and 2) for how much?
The first one is easy--look real hard at who might buy you. If you are in the food business your potential targets are Campbell Soup, General Mills, Kelloggs, ConAgra and any other company with a presence in the grocery store. Same goes for tires--Bridgestone, Goodyear, Cooper and some of these might already belong to one of the above. I know a guy that manages a discount tire store and I trotted down to get some Goodyears and he sold me Kellys because Goodyear owns Kelly and they are basically the same tire but for about 60% of the price of Goodyears. Same goes for cars with Ford buying Volvo and Jaguar and GM owning part of Mazda, or is that Ford again? And Mercedes buying Chrysler and so on and so forth.
Who does the work? If you work for a large company just look in the company directory for a group called Business Development as these are the guys doing the analysis. They are usually pretty close mouthed but you can get to know them, just don't be tempted to do any insider trading as you will lose your job and may end up in jail. It just ain't worth it.
And what do they do? They do analysis. Not business analysis like product analysis or demographics or new products but financial analysis. How much do we have to pay to get this target company?
And here is how they do it. As mentioned yesterday, if you have ever taken any finance course you were introduced to discounted cash flow analysis which translates into something like projecting a companys cash flows and then discounting them back using the corporations cost of capital to determine the value. Huh?
It is actually pretty simple. Company A will generate cash flow of $100 in year one, $120 in year two, $135 in year three and so on for ten years. Then you calculate the company's cost of capital. Actually, you don't. Somebody in treasury or planning does and gives you the number. The cost of capital is the weighted average of the after tax cost of debt ( the easy part) and the cost of equity (the hard part.) We won't go into all that because the number usually comes out to be around 10% because the cost of equity (the return needed to have somebody buy your stock as opposed to buying some other stock) is pretty high.
So you discount the cash flows using the cost of capital and you get a number, say, like $500. That's the highest price you can bid for the target company. I said this was simple.
Actually, the analysis is simple but humans make it complex because there are a bunch of smart MBA's in the target company doing the same analysis and they want a lot more money or they just might turn the tables and buy you.
So what is a poor analyst to do? You want to keep your job but the CEO is hot and wants to do the deal and the target company and their shareholders want more than your measly $500. What to do, what to do?
There are three things you can do. First, juice the numbers. Your analysis is based on what the operations guys tell you they can do with the company. They will ballpark low because they want to look good when they take over and do better than plan. So you juice the numbers, spread the margins, increase sales by 20% a year and get the present value up to, say, $650. Still not good enough.
Step two. Extend the life of the analysis. Good companies last more than ten years so why only project cash flows out ten years? Let's go 20 or 30. Now you are up to a present value of $900. Still not good enough.
Step three, the neutron bomb of financial analsyis known as the RESIDUAL VALUE. Residual value used to have another name, salvage value, or what you could sell a broken down asset or broken down company for in a fire sale. Then somebody got smart and said you are not going to sell a perfectly well running company for salvage value and they juiced residual value. If you think your company will have a value greater than the GNP of South Korea in 20 years, plug it in at the end of the analysis and see your value soar. And nobody will catch it.
So trot into the CEO's office and give him/her the answer they want. And you won't be around in ten, twenty years so don't sweat it.
This sounds pretty cynical. It is not because in a well run company cooler heads will prevail. Plus, financial analysis is not a crystal ball, it is only an estimate based on known facts. A successful acquisition is usually the result of some unknown or unseen variable popping up and taking everybody by surprise. Gatorade is a great example--nobody saw a market going south (colas) and a market going north (water) with that product sandwiched right in between ready to take off.