Problems in M&A: Are you bidding too low?


Today’s slow growth, low interest rate environment is ripe for increased M&A activity.  Even companies like Dell and P&G who historically pursued organic growth strategies have come to the realization that achieving historical returns requires a smart M&A strategy.   Yet, this is easier said than done.  One of the biggest challenges from the acquirer’s perspective is what to bid for the target company or part of its assets without over or under bidding.

A recent edition of Knowledge@Wharton a Wharton School of Business publication, discusses an important yet often ignored deal killer, namely that of the “false negative” valuation.  These are deals that get away but shouldn’t as a result of the target being under-valued due to out dated methodologies. According to the authors, the true value of a target company can be determined only if the buyer looks beyond current core operations to include future growth potential.  A better valuation approach should embolden reticent buyers without ratcheting up incentives to over-optimistic acquirers.

Most acquirer’s experience False Negatives due to a systematic bias in their valuation methodology.  This bias is in the form of organizational and shareholder pressure to accelerate deal pay back and to discount value creation (i.e. cash flows) that is tied to future time horizons. This inclination towards conservative, short-term based valuations is understandable.  However, it often results in companies systematically missing out on strategic opportunities to competitors who are more capable of managing the uncertainty associated with future.

To overcome this bias, the authors have developed a new method to M&A value determination that avoids both false positives (over paying) and false negatives. This approach combines McKinsey’s Three Horizons strategic planning model with a new process for analyzing value, called Opportunity Engineering.  At the core of the methodology is how companies determine the target’s value and cash flows over 3 time horizons:

Horizon 1 includes the existing core operations of a firm that produce the cash flow needed to sustain the business, to meet investor expectations and to invest in future growth.  Horizon 2 represents operations that are generating small, albeit fast-growing revenue streams that could become high-revenue core operations in the next 2-3 years.  Horizon 3 opportunities embody new products, services, and capabilities that extend beyond the core business.  H3 opportunities show compelling, long term potential but carry a high degree of uncertainty and risk.

The methodology to determine the full value of a potential acquisition is straightforward.  First, the acquirer should analyze the target firm’s cash flows and assets and assign them to the relevant horizons of their strategic plan.  Secondly, the acquirer will drill deep to understand how these assets add value today and in the future. Simply put, the more horizons that a target hits, the more valuable it becomes, since it not only increases current value but also carries the potential for future organic growth.

Finally, the acquirer would supplement their traditional net present value (NPV) analysis with a new valuation methodology called Opportunity Value (OV).  OV attempts to calculate the potential returns of an acquisition by estimating the positive cash flows of hidden or uncertain assets in future horizons. In essence, OV is providing a positive view of uncertainty.  As such, OV is complementary with NPV, which treats uncertainty negatively.  When used together, these tools provide an all-encompassing but not inflated valuation.

In my experience, the majority of deal makers rarely consider anything beyond the H1 value of a target when arriving at a bid price, although some managers will intuitively take future potential into account.

Not surprisingly, the greatest potential growth is found in the areas with the highest levels of uncertainty. Acquirers would be prudent to use tools that systematically identifies elusive but potentially rich medium to long term returns found in the target firm and then factor them into their bid prices.

For more information on our services and work, please visit the Quanta Consulting Inc. web site.

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