Prime Numbers

When executives are evaluating a potential acquisition target, they know they should use a range of metrics: net present value, ROIC, ROE, and so on. Often, however, they lean on the one or two metrics they know rather than the metrics that may better reflect a target company’s context. Using ROIC or ROE as primary indicators of performance, for instance, may make sense when assessing a mature target but not so much when evaluating a high-growth, early-stage company. The latter is likely ...

Executives can get caught up in decisions about how to finance large M&A deals to create the most value: should the company pay in cash or in shares? Such decisions come down to risk and reward—specifically, how much of each does the acquirer want to share with the target company’s shareholders. Consider the situation for an acquirer with a $1 billion market capitalization and a target company with a $500 million market capitalization. The acquirer pays $650 million for the ...

When boards, investors, and executives consider potential acquisitions, talk often turns to whether earnings per share (EPS) will rise or fall because of the deal and, in turn, how the stock market may react. This obsession with EPS has to stop; there is no correlation between whether a deal is accretive or dilutive and the market’s perceptions of it. Regardless of whether EPS is expected to be greater, smaller, or the same two years after the deal, the market’s reaction is ...

Using multiples to determine whether your merger or acquisition will create value over time can complicate, rather than clarify, your analyses. If you don’t believe us, do the math yourself: Scenario 1. A target company priced at $500 million is acquired for $600 million, resulting in an acquisition premium of $100 million. In this case, let’s assume that the deal helps the acquirer realize $200 million in synergies, so this merger ends up with a net present value of $100 million. ...

When a company announces a merger or acquisition, executives hold their breath and hope for a favorable reaction from the market. In general, the market tends to be pessimistic about such deals. So a positive reaction must mean that the deal team struck the right terms, told the right story to investors, and has the right strategies in place to appease regulators and create value from the deal long term—right? Maybe not. Our research shows that the market’s immediate reaction to ...

When inflation is high and expected to stay there a while, metrics like EBITA and ROIC can be less reliable as indicators of performance. To understand why, look at the relationship among EBITA, ROIC, and a company’s cash flow. Long-term inflation can erode cash flows, which can affect the value of a company. To preserve that value, a company’s free cash flow must keep pace with inflation for a no-growth company. But what happens to EBITA and ROIC at the same time? Depending on the ...

High inflation and rising (though historically low) interest rates are making it more difficult for executives to estimate the cost of equity as part of their financial planning. In part, that’s because many are heavily weighting the arguments from some academics and bankers that rising interest rates have increased the cost of equity and have been a factor in lower equity valuations since the beginning of 2022. The academics and bankers have likely come to these conclusions because they ...

Investors have learned to ride out the highs—and more recently, the lows—of the US stock market. They expect fluctuations, and they react to short-term performance. Many might be surprised to learn, however, that since about 1800, stocks have consistently returned an average of 6.5 to 7.0 percent per year (after inflation).1 Our analysis shows that market returns in the past 25 years are within that historical range (exhibit). In 2001, the market capitalization of the companies ...

Estimating the value of a company with sub-investment-grade debt (rated BB or below) can be difficult for finance professionals. Using traditional measures, such as yield to maturity (YTM), as a proxy for expected returns on a company’s debt may skew estimates of value, in part because the probability of default is higher for companies rated BB and below. A better bet when estimating the value of a company with uncharacteristically high debt levels is to compare its financial targets or ...

Companies are launching all kinds of “nontraditional” initiatives to digitize products and processes or to address looming environmental, social, and governance (ESG) concerns. In these instances, it’s critical to understand whether companies can achieve and sustain both high returns and low costs of capital in the long run. Finance fundamentals tell us this does not make sense. Consider a company with a cash flow of $100 million, growing at 2 percent in perpetuity, with a 10 ...

Executives and investors often use analysts’ consensus estimates and industry multiples to determine the value of companies. Research shows, however, that analysts’ near-term forecasts are often overly optimistic and don’t always correctly reflect operating performance.1 Business leaders and investors need to know what analysts include or exclude in their forward-looking estimates of performance and how those estimates compare with actual results in the past. They should ...