In both our professional and academic experience we have come across certain mistakes rather frequently. We list some of them below in the hope that we’ll get rid of them once and for all!
1. Believing that growth in earnings per share (EPS) is the same as creating value
As it is difficult to measure the value created by an acquisition, share buyback, merger, capital increase, etc., the EPS impact is often used as a measure of value creation. However, there is a link between EPS accretion and value creation, or between EPS dilution and value destruction, only under three conditions.
Before discussing these three conditions, let’s take a fictional example. Let’s imagine that the software company SAP (2006e P/E ratio of 27) has decided to merge with Barclays bank (P/E of 10) on the basis of current share prices. As SAP’s P/E is higher than Barclays, its EPS will increase automatically after this transaction, by 88%. Does this mean that the merger has created value, based on this yardstick? Of course not! If there is value creation, it will be due to synergies, and in this case, we don’t see much in the way of synergies … Incidentally, looking at things from the other side, i.e. Barclays’ EPS, the impact would be completely different: -28%.
So when is an improvement in EPS an indicator of value creation? (1)
a) when earnings growth of the merged entity is more or less the same as previously. Clearly, in our hypothetical SAP-Barclays merger, this is not the case: SAP projects 19% earnings growth as a stand-alone entity, vs. 10% for Barclays. The new group’s growth rate would be between the two (given the absence of synergies) and, in this case, 12%. This is not the same as 19%! Please note that the higher SAP expected growth rate in EPS explains its higher P/E ratio.
b) when the risk of operating assets after the merger is more or less the same as before the merger. In our example, this is doubtful. Generally speaking, however, this can be true when two companies in the same sector and with the same positioning merge, Autostrade and Abertis, for example. This is much less true for Mittal (basic steel) and Arcelor (high value steel);
c) and when the new group’s financial structure is more or less the same after the transaction as before, as this helps ensure that financial risk is the same after the transaction as before. Moreover, it is well known that debt leverage raises EPS but does not create value; otherwise, all companies would have leveraged up long ago and we’d all be rich!
2. Believing that merger synergies can be valued on the basis of the average of the two companies’ P/E.
There are two reasons why investors do not value announced synergies using the average P/E of the new group:
• Synergies announced at the moment of the merger are only an estimate, and the people who have announced them have every interest in giving rather high figures to get shareholders to approve the deal. Moreover, the technical execution of a merger or any other link-up carries its own complications, such as making employees of formerly competing firms work together, creating a new culture, trying to keep from losing clients who wish to maintain diversity in suppliers, etc. Experience shows that more than one merger out of two fails from this point of view and that synergies actually generated are weaker than announced, and take longer to show up.
• Sooner or later, the merged group will have to pass on some of the synergies to its customers, staff and suppliers. For the company will not be the only one undertaking a merger. M&A tends to come in waves, and competitors will be encouraged to follow suit, in order to generate synergies that allow them to remain competitive. Ultimately, all companies will be able to lower their prices, or refrain from raising them, and it is the end customer who will benefit (2).
3. Believing that the debt/equity ratio is the best measure of debt-repayment capacity.
Financial leverage (i.e. the ratio of net debt to book value of shareholders’ equity) is often used to assess a company’s debt level and its ability to meet its debt obligations. However, this approach has become completely archaic! A company does not pay off its debts with its equity but with its cash flow. Even in the event of liquidation, equity provides a cushion of security only if the company is able to sell its assets at their book value, which, in practice, is almost never the case.
Ask a banker today the highest debt possible for a target company and he is sure to answer in terms of net debt/EBITDA (earnings before interest, tax, depreciation and amortisation) or net debt/cash flow, as these ratios are good indicators of a company’s ability to generate enough cash flow to pay off its debt.
Unilever, for example, has leverage of more than 130%, which may look huge, but when looking a little closer, we see that its net debt is equivalent to just 1.5 year of EBITDA!
At the other extreme, Rémy Cointreau has leverage of 0.6, but its debt is equivalent to 3.6 times its EBITDA (3) .
4. Confusing apparent and real cost of a source of financing and comparing the costs of financing while forgetting differences in risk.
Investment bankers are geniuses at selling their services to companies. When they “sell” a convertible bond issue, for example, they play up the “insignificant” (or even “non-existent”!) cost of this source of financing. And it is true that companies pay a very low rate of interest on a convertible bond (4) , and its (apparent!) cost of financing is below the risk-free rate.
Obviously, this is an illusion, as the apparently low cost is cancelled out by the ultimate risk of dilution. And CFOs are not usually duped, but it is hard sometimes to resist the temptation of low annual cash costs, especially when the materialisation of the risk (i.e. the issue of shares at a price below the current share price, thus leading to shareholder dilution) does not occur until years later.
So a distinction should be made between the apparent cost of a source of financing, i.e. the annual cash cost, and its real cost, which includes the entire ultimate cost, including deferred coupons, redemption premium, expected increase in share price, etc.
Moreover, cost of the product must reflect the risk incurred. Obviously, issuing shares has a higher real cost than issuing convertible bonds (the difference can range from 4% to 10%). In buying new shares, the investor hopes for a good return, but the company is under no obligation to pay a dividend or to reimburse him. Such flexibility comes at a cost – in issuing bonds, the company must pay out a coupon and guarantee repayment of the debt.
However, we are not suggesting here that all sources of financing are equivalent and that it doesn’t really matter which type of is chosen. A convertible bond, for example, can be the best choice for a company whose cash flow is currently small but which is expected to grow strongly in the future (5).
5. Forgetting the risk to profitability (6)
This will be obvious to our readers (at least, we hope), but in light of recent events, it is always point out. After all, finance is nothing more than risk, return and value. The value of a product can only be determined when risk and required return are known.
When financial markets are doing well, as in 1999 and 2000, investors have an unfortunate tendency to overlook risk. The big losses suffered by equity investors in 2001 and 2002 were merely the materialisation of risk. The more a portfolio was invested in TMT stocks, the greater the risk was. The losses suffered were not an injustice, but simply a reminder of common sense.
What is true for investors is also true for companies. Some company treasurers thought they were doing well by investing some of their company’s cash in Parmalat commercial paper, which offered much more attractive returns than other Italian industrial companies… and for good reason!
(1) For more, see chapiter 32 of the Vernimmen.
(2) For more, see chapter 42 of the Vernimmen.
(3) For more, see chapter 12 of the Vernimmen.
(3) For more, see chapter 12 of the Vernimmen.
(4) For example, GBL’s seven-year convertible bonds, issued 3 months ago, pay out a coupon of just 1.7%.
(5) For more, see chapter 30 of the Vernimmen.
(6) Readers who’ve seen the film Time out may remember that the hero, as part of the scam, played up the extraordinary performances of the Russian market until a potential investor pointed out that this was also the market that suffered the steepest declines!