How to Correctly Analyze Corporate Acquisitions

Hi, this is David Trainer, and I'm following up a podcast I did earlier today with this webinar because I want to explain to you exactly what is meant by the whole, the whole high-low fallacy and how Wall Street bankers, all bankers for that matter, all mergers and acquisition bankers effectively manipulate a big loophole in accounting rules to make acquisitions look good. And to quickly evaluate acquisitions, and it's very, very misleading. And the key point I point out, I make in my podcast today, is that is that the accretiveness of an acquisition is is completely irrelevant. Whether or not it is accretive to earnings per share or not is irrelevant to the actual true underlying economics of the business or the economics of the acquisition. And you'll see that I'm not the first person to talk about this. This is a A blog post I did back in August of 2012. I'm referring to an article written by Michael Mauboussin, Let's Make a Deal, an awesome, a really, really good article in general about mergers and acquisitions and how to evaluate the economics and something that we've, you know, an approach we definitely take to heart. One of the great things about Michael Mauboussin, he's always really focused on the economics of businesses, as are we. And we believe that we are effectively the ideal implementation of these concepts that focus on the underlying economics. And Mobison got it from our good friend Bennett Stewart from the firm Stern Stewart, which focuses on executive compensation for large corporations and aligning that with what they call EVA. And EVA, economic value added, is just their proprietary Or unique term for economic earnings. Economic earnings and the concept have been around for decades, even centuries. It's implementation of this concept. So let's get to the point. The takeaway here is to point out that no matter what the underlying economics of the deal are, if a company with a high PE buys a low PE company, then the earnings per share are higher. If you want to get your PE up or your price-to-earnings ratio up. Then the low PE buys the high PE company and the PE gets higher than it was before. So here the high PE company buys the low PE, earnings per share go from $1 to $1.20. And keep in mind, everything is exactly the same for these companies except for the stock price. This is a really good example. One has a higher PE because the stock price is higher. So when the high PE company buys the low PE, earnings per share go up. When the low PE company buys The high PE company, the PE goes up and earnings per share go down. Now this is a nice little example. What I'm gonna give you guys, my people watching this today, is actually access to the file that I used to prove this, an Excel file. You can see that I've got the links here for you to access on your own if you wanna go get access to this file. I'm sharing it with everybody because I want you to have access to this. I mean, this is the kind of work we do all the time, putting together models like this. Is something that honestly is very straightforward for us, but we realize for folks who aren't familiar with these kinds of things, it could be quite a bit of work to try to do this on your own. So I'm giving it to you, and it's also another sign of all the work that we do. So here's the example, right? And I've made mine a little bit different, but we can make— we can change anything we want in these blue cells here. And that's why I want to give you guys access so you can go in and you can change whatever you want, see how this works, and and look at the formulas. But you can see these are just inputs. Earnings per share is simply the formula that focuses on dividing the earnings by the number of shares outstanding, right? Very straightforward. P/E is very simply price divided by earnings, right? And the market value, we're gonna assume that these are, that these are Totally, there's no debt in these companies, so the market value is the enterprise value, right? And that's just simply the number of shares outstanding times the price, right? And I'm also gonna provide on here just for reference, we're not gonna talk about this at first, but what the, what the, what the NOPAT and invested capital are. Now you can go to my blog and you can get definitions for NOPAT and invested capital very easily. We provide definitions for everything. So, very straightforward situation. All right. Now, when high buys low, effectively, the value of the purchase here for high to buy low, the high PE company, the high price-to-earnings multiple company buying the low price-to-earnings multiple company, well, it's an $80,000 transaction. That's because that's the value of the enterprise. And the number of shares required to do that, well, that's just the $80,000, right, divided by the current stock price of the high PE company. That's how many shares they got to sell in the marketplace to raise $80,000. That's $1,600. Okay, so when we're looking at the combined entity, right, the price, you know, and we're going to assume that this is a good acquisition, they paid exactly the right price, and nothing happens, there's no impact on the price of the high P/E company due to this acquisition. All right, that's a big assumption, but for the purposes of this hypothetical situation, it makes a lot of sense, right? The earnings, very simply, just the combined earnings of the 2 companies together. The earnings per share Right? Now, that's the new complete shares outstanding, right? Divided by the number— plus the— which is based on the existing number of shares outstanding plus the number of shares required to purchase the low P/E company, right? That's 3,000 plus 1,600, 4,600. Okay? So then my earnings per share is now the new combined earnings divided by— Shares outstanding. The new total number of shares outstanding, right? And my PE very simply is the price divided by earnings per share. All right, we see now the PE has gone down from 25 to 23.6, but our earnings per share, they're higher. Okay, and then if low buys high, well, you've got the same thing going on. The difference here is that in order to— they gotta, they gotta sell a lot more shares or create a lot more new shares to accommodate or to affect the purchase of the high P/E company because its value is higher, right? Got $150,000, that means they got to have 3,750 more shares, which more than doubles, almost triples their share base. It goes from 2,000 to 5,750, right? Okay, so what we're seeing here— and we can change these numbers around, we could say, oh well, this is, uh, $2,000 in earnings. Right? Earnings per share's lower in the beginning, 0.67, but it goes up to 1.25, right? We can change the share price to 60, right? We still got the same situation. The PE of the combined entity is the same no matter what, but earnings per share goes up for the high PE company, earnings per share goes down for the low PE company. Now, this is all sort of doesn't really matter actually at the end of the day. You're like, well, you know, what's the big deal? The point is, is that it does not reflect the impact The cash impact of the cash economics of the business. Let's focus now on the cash flows, right? Net operating profit after tax—it's your it's your real after-tax cash flow. Invested capital—that's all capital invested in the business over its life without regard to accounting name or financing form. That's how much money has gone in the business in order to get it to where it is today. And so I put these two stats in for both of these companies, right? The high P/E company. has a higher return on invested capital than the low P/E company, which makes sense, right? You should have more value for a company that's getting more cash flow out of its capital per dollar, right? If you're going to be able— you know, if you can get $1.50 out of a $10 investment, then you're better than the guy who's only getting $1.20. You deserve to have a higher valuation. So I think all this is straightforward and makes sense. So now let's look and see what the impact on return on invested capital And really what the cash flow situation impact is here. So in this situation, you're seeing that the combined NOPAT is $11,750. That's the same in both situations, right? The invested capital, right, is now the original invested capital plus whatever they had to pay for it, right? Right? So the return on invested capital of the combined entity now drops from 28% to 11%. Pretty bad, right? Same situation for low PE. If he buys high PE, his return on capital drops even more because he's paying so much. The key thing to focus on here is that when measuring the quality of an acquisition, it's not how many shares you issued, it's how much capital you had to spend to get it. This is the denominator in understanding the quality of the acquisition. So let's focus on the ROIC on the purchase/acquisition, okay? That means we look at the incremental NOPAT. So high PE gets that $4,750 of NOPAT from the low PE. So that's the incremental cash flow they're getting. That's what they paid for, right? And how much did they pay? They paid $80,000 for it. That's a return on invested capital of 6%. Not very good, especially compared to 28%, right? That drives the overall return on invested capital for the business down to 11%. Things don't fare much better for the low P/E company versus the high P/E company either. Its return on invested capital drops from 24% to 6%. That's because the incremental return on capital for the acquisition— they're getting $7 million in NOPAT, but they paid $180,000— sorry, $7,000 in NOPAT, they paid $180,000 for it. That's a 4% return on capital, right? And what you're going to be able to do is when you access this model, you can go in and you can look and see the formulas, and we're going to make sure that you can edit it as well. Here are the links for access, and you can change all these numbers around. Let's, let's, let's pretend like this is a much lower number, $3,500, right? The ROIC for the acquisition for low PE, it's even worse. Right? Even though the earnings per share goes up for the combined entity, which most people would think is a good thing, right? The ROIC still goes way down, right? Let's change this to a higher number. They're actually buying a high— even though they've got a A higher PE, they're able to get a good deal here. They're able to buy a low PE company, right? 'Cause they're getting— they're gonna buy a company with higher return on invested capital. Is it a good deal? No. Return on invested capital starts at 14%. After the deal, it's at 9%. The incremental return on capital, you're getting $6 million in OPAT, you're still paying $80,000. I'm sorry, $6,000 in OPAT, still paying $80,000. It doesn't matter. The point is, do not focus on earnings per share. Focus on return on invested capital before and after, and understand the return on invested capital related to the acquisition. How much incremental NOPAT am I getting compared to how much I'm spending? That's how you're supposed to evaluate acquisitions. That's the key. We want to give you this tool so you can see and analyze this ourselves, yourself, and really get a direct sense of, well, this is actually how the math works, and this is what we need to focus on. And we love this kind of transparency because it shows you not just how we do our work, but it gives you the ability to take advantage of the same insights we put into every one of the 10,000 securities we cover for you. This is the kind of work we do. We want to be more transparent about it because we don't believe smart analytical techniques should be hidden and kept available only to a few precious few insiders. We think everybody should have access to information, and we're not worried about people being able to cannibalize our business because we know that we do more work than everybody else wants to do. Trust me, going through annual reports cover to cover to get high-quality data, to get the high-quality NOPAT and invested capital. It's a lot of work. Thanks for your time, and if you have any questions, please feel free to comment on our blog or on the video and let us know what you think.