Shareholder equity appreciation and value management has increasingly become the dominant focus of corporate managers and company investors. Mergers and acquisitions (M&A) can be used by managers to drive value. When successful, there are five main ways in which M&A drives shareholder wealth. In this article, we'll show you how merging or acquiring a firm can have huge impacts on a companies' market worth.
Valuation of M&A Companies
The value of an entity stems from expectations of its future performance. The amount of cash owners expect to realize from their investment helps to determine the price they are willing to pay in order to secure that investment. Shareholders deserve and expect sufficient returns for their risked capital. Managers employ cost of capital considerations when making investment decisions - that is, they employ their owners' capital in such a way that it will yield sufficient returns. An operating company is a portfolio of investments, and its operating potential as a source of cash flow for the owner is a summation of both the investment opportunities and risks.
Mergers and acquisitions (M&A) is an effective tool used by managers to drive value, most commonly expressed in terms of stock valuation. A merger and/or acquisition combines two organizations, and there are factors that drive shareholder wealth creation through M&As. (To learn more about M&As, read The Basics Of Mergers And Acquisitions and The Merger - What To Do When Companies Converge.)
Companies pursuing symbiotic strategies and operations can pursue acquisitions to realize value. This is especially true in a fragmented industry where a large strategic company or an equity fund decides to "swallow up" smaller competing firms, thereby consolidating the industry. Take, for example, a business sector like semiconductors, which have relatively high research and development (R & D) expenses.
Semiconductor companies often expend a lot of cash in R & D in the hope of developing a next-generation computing chip. These companies may find it prudent to combine their operations and, with the combined (and larger) entity, higher sales volume can support higher budgets (in absolute dollars) for developing a next-gen chip. This would lower research costs as a percentage of net revenue. The more resources a company devotes to creating a competitive advantage, the more likely it is to win business in its industry. Value is created for shareholders because expect to reap more cash from this new business, which in turn drives up the stock price.
Managers may also pursue acquisitions as a means to further increase their company's market presence in a given industry. A common approach is to engineer a more effective sales and marketing organization by combining companies. Executives can institute benchmarks, promote the best salespeople and task the most talented marketing managers to spread their approaches to the rest of the sales organization. Conversely, they can cut back on ineffective salespeople or products. This approach typically increases overall revenue as the new training and sales processes lead to better effectiveness with customers. (To keep reading on this subject, see Why Fund Managers Risk Too Much.)
Such benchmarking is not limited to the sales and marketing department; it can be applied to all areas of the newly combined business. Management repeats this benchmarking approach and seeks similar champions in human resources, information technology, operations, finance, strategy and legal. By promoting the best and applying the optimal processes, various departments are enhanced, which leads to a stronger organization. Unsurprisingly, effective companies trade at higher valuation multiples in the marketplace.
Mergers and acquisitions are also often used to engineer a larger market presence for the acquirer. Higher market shares often result in greater purchasing power over suppliers. Increased orders result in lower purchase prices for materials and services, allowing the company to be more price competitive. While suppliers sacrifice lower margins per unit, they are often willing to enter into bulk discount arrangements as a means to realize faster turnover for their products and services. It is possible for a supplier to generate more cash with lower profit margins for its products if it increases the rate at which the goods are sold. Wal-Mart, for instance, the largest company in the world in terms of revenue, leverages its gargantuan purchasing power over its suppliers. Such an approach leads to lower prices for its customers. Wal-Mart's competitors, in turn, are forced to compete in avenues other than those that rely strictly on pricing.
Companies also acquire complementary organizations in order to diversify their product and service offerings. Managers can generate more revenue by offering their existing customers increased choices on goods and services. Car dealerships, for instance, not only sell cars but provide a wide array of maintenance-related, aftermarket services that provide convenience for car owners. Often, aftermarket repair services are more lucrative and generate higher margins than the product offerings.
Acquisitions can also be used to improve operations of the combined entity, especially for manufacturing companies. Business customers often assess their suppliers' capability to deliver goods as scheduled. By adding more facilities, a company increases its manufacturing capacities - and its credibility - when attempting to win business. Additionally, companies that merge present opportunities to reduce or eliminate duplications and overlap in job functions. For instance, legal, finance and human resource departments can be combined, resulting in cost savings.
In short, larger companies naturally command higher valuation. A small company with $10 million in revenue and a 10% net profit margin has a lower valuation than a $100 million company with the same 10% net profit margin. Larger companies are regarded by investors as less risky enterprises since the larger cash flow from operations allows managers to secure more credit from its financiers. As mentioned earlier, company valuation depends on the future cash flow that investors expect from their investment. Therefore, managers seek to maintain and/or increase shareholders' return by acquiring companies in order to pursue a variety of methods that increase future cash.