A Key Question For Any Acquisition – Does It Create Shareholder Value? M&A Basics Series – Article 3
A key question for any company to answer before it completes an acquisition is whether the acquisition will create shareholder value. But how do we determine if shareholder value is created? Many use an accretion/dilution model but a better approach would be to calculate the anticipated return on capital.
How is Shareholder Value Created?
For a company, value is created when a business earns a return on its capital that is greater than the cost of the capital used to generate that return. For example, if a company borrows money with an interest rate of 10% and achieves returns of 20% with that money, it has created value; however, if it achieves returns of 5% with that money, it has destroyed value. A company that consistently achieves returns greater than its cost of capital will become more valuable while a company that consistently achieves returns less than its cost of capital will become less valuable. Of course, the next question then becomes what uses of capital will generate the greatest returns.
The same rationale applies to acquisitions. If the company will achieve a return on its capital spent to make an acquisition that is greater than the cost of that capital, then the acquisition will have created value; if not, then the acquisition will have destroyed value. All factors being equal, if an acquisition creates value, the next question becomes one of our opportunity cost – is there another use of that same capital that would create a greater return or will the acquisition itself create the greatest return on the available capital.
For a shareholder, an acquisition personally creates value if it increases the value of his or her shares, whether in the short-term of in the long-term. Theoretically, transactions that create value for the company should create shareholder value as well.
Generally speaking, an acquisition creates value, and therefore shareholder value, when the fundamental value of the acquired business is lower than the purchase price paid for it. If the acquisition is strategic and synergies can be achieved (i.e. either: (i) cost synergies from the elimination of redundant personnel, R&D efforts, manufacturing plants and so on; or (ii) revenue synergies such as increased revenues from cross-selling opportunities; or (iii) both), the acquisition creates shareholder value as long as the fundamental value of the acquired business plus the present value of the synergies achieved is greater than the purchase price paid for the acquisition. If so, shareholder value has been created with the acquisition; if not, shareholder value has been destroyed by the acquisition.
As indicated above, fundamental value is generally derived from expected operating cash flows, returns on capital and the cost of capital. However, the cost of capital is difficult to define and difficult to calculate. As such, when assessing whether shareholder value is created by an acquisition, investment bankers often use an accretion/dilution calculation – this assesses an acquisition’s projected impact on the buyer’s earnings per share (EPS) as a proxy for determining whether shareholder value will be created or destroyed with the acquisition.
- An acquisition is accretive when the buyer’s EPS will be higher after the acquisition than it was before the acquisition.
- An acquisition is dilutive when the buyer’s EPS will be lower after the acquisition than it was before the acquisition.
The basic reasoning is that given a fixed price to earnings ratio, if EPS is expected to decline as a result of the deal, share price (value) should decline as well.
However, there are significant limitations in using an accretion/dilution calculation in determining whether shareholder value is created. First, there are relatively short term in nature, generally only looking out 1-2 years. Second, it takes no account of the capital deployed and the returns achieved on that capital. It is entirely possible for a company to increase earnings per share while at the same time using increasing amounts of capital generating falling or inadequate returns.
When analyzing whether an acquisition will create shareholder value, first look to calculate the anticipated return on capital from the acquisition. But also recognize that the investment community will be looking to see if the acquisition is accretive to EPS, either immediately or in the short term. If the acquisition is not accretive, be prepared to explain how the acquisition will in fact create shareholder value.
Invitation for Discussion:
At Nerland Lindsey LLP, we have a wealth of experience as legal advisors on M&A transactions, both large and small, and understand the process from beginning to end. If you are contemplating buying or selling a business, please do not hesitate to contact one of the lawyers in our business law group. We would be happy to assist you on this exciting journey.
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.