Eric Nath is the President at Eric Nath & Associates, LLC. Nath and his team specialize in business valuation, and Nath himself has valued over 600 public and private companies since 1985. Recently AppFolio was able to interview Nath, and hear his thoughts on various aspects of business valuation. In the below interview he discusses the merger & acquisition process, and the challenges many businesses encounter when facing a potential merger or acquisition.
Is the company appraisal process more an art or a science?
It's hard to say whether it's more an art or science, but I would expect that most people don't realize how much of an art it still is simply because they don't realize how far from reliable the science still is. For example, how does one measure risk? Business schools teach us that volatility is the best measure of risk – think of "beta" in the Capital Asset Pricing Model (CAPM). But risk in a fundamental sense is actually far more complex. Among other risks besides volatility there is the risk of absolute loss of principal. I'm sure that the betas of the airlines, Lehman Brothers or Bear Stearns a year or so before these companies went bankrupt could hardly have quantified the actual risk of these investments for the equity holders who would shortly be wiped out. And, the calculation of beta itself is nothing but a backwards-looking data-crunch. Does the fact that a particular company's stock price is perfectly correlated with the marketplace over the last five years, and therefore its beta is 1.0 for the last five years, have anything to do with what will happen to that company in the future? Beta in its usual form is calculated over a specific period of history, and if you change the timeframe from five years to 20 or 50 years, a company’s beta will change. While it might be interesting to look at the way beta changes for a given company using different time periods you still will not know what the ex-ante beta should be for the company, much less the actual risk of the company. So, with this one example we can see that what appears to be scientific on the surface is really a series of subjective judgments. Ultimately, isn't that what art is?
Why is it that the majority of acquisitions by public companies destroy shareholder value?
There are probably a lot of answers to that question, but they all have a common theme of overpaying for the acquisition. The most perfect company you could ever possibly acquire will surely destroy your shareholders’ value if you pay too much. Furthermore, if you look at the literature in the last 30 years it becomes obvious that the entire system has evolved to encourage buyers to overpay. Getting you to overpay is usually the main job of the investment banker and it is also a natural consequence of the auction system.
Not only is the system rigged against you, but your MBA program might also be one of the culprits. I once interviewed a corporate development officer for a midsize ($2 billion) public construction materials company and when asked how he developed his required rate of return when pricing an acquisition he simply said that he used the cost of capital of his company! It didn't matter to him how risky the acquisition was because once it was folded into his company and became part of the "portfolio" its risk would be diversified away in combination with all the other operations and it would therefore have the same cost of capital as all the other divisions. It would be hard to imagine a better way to destroy shareholder value!
Speaking of cost of capital, do you know what your cost of capital is? The CAPM and its progeny are taught in all the business schools in the world and probably 90% of CFOs and finance directors rely on it to a greater or lesser extent to quantify their company’s cost of capital. One of the main problems with the CAPM is that it is designed to be forward-looking, but all of the data that go into the formula, except the risk free rate, are generally obtained from backwards looking data mining. Even using an implied equity premium is fatally flawed. A full in-depth analysis of the many ways that CAPM and all the backwards looking cost of capital approaches fail is beyond the scope of this interview but is presented in the following article: The Biggest Business Valuation Myth.
What are ways to enhance the value of a company in an M&A transaction?
The corollary to the observation above is to find a way to not overpay for your acquisitions. Besides having an inside track and an exclusive first look to avoid an auction, remember how investment bankers are compensated. When the banker tells you, "There's another buyer who has put an offer on the table that is $10 million above yours; would you like to reconsider your offer?", just know that 50% of the time that statement is probably not entirely true, and sometimes there really isn't even another buyer – you may be bidding against yourself. Another reason to resist overpaying is that integrating an acquisition into your business is often more costly and time-consuming than you have optimistically assumed in the heat of the bidding process. Some companies have integration down to a science – Cisco comes to mind, but they are one of the rare exceptions.
Obviously, one of the principal ways to avoid overpaying is to evaluate the acquisition using a required rate of return that truly reflects the risks of the investment itself irrespective of your own company’s cost of capital.
There is a common misperception that strategic acquisitions must command a higher price and a higher multiple than a financial acquisition. Synergy between companies certainly exists and there is no reason why some additional consideration might be paid for it if it's worth it, but why should a strategic buyer pay substantially more than the next highest bidder? Just because you could pay up to $50 million to acquire Company A doesn't mean you should. The higher the price the more downside risk. Remember the answer to the question – how do you make money on an investment? – Buy low, Sell high!
Can you provide some tips for an accurate M&A appraisal?
There probably is no such thing as a truly accurate M&A appraisal. Despite the relative science that goes into forecasting cash flows, residual value and required rate of return for a given level of risk, every one of these variables is subject to a great deal of judgment, and even wisdom. We now have some efficient and easy-to-use tools, which allow us to run Monte Carlo simulations on all sorts of nodes within a forecast, and therefore identify specifically which areas of the forecast, are subject to judgment. The best way to get as close as you can to "accurate" is to rationally and deliberately identify and quantify your assumptions throughout the forecast model and your required rate of return. When combined with reasonable probability distributions at each node and running the model 100,000 times you will get a good sense of the limits you should place on price, and a better feel for those points of vulnerability and sensitivity in the acquisition that are heightening your risk.
What's the difference between investment or strategic value vs. fair market value in an M&A?
Let's not forget the definition of fair market value – willing buyer/willing seller; adequate information known by everyone; no compulsion to buy or sell. Fair market value is a notional concept which is particularly useful in situations where no current transaction is actually contemplated (for example, estate and gift tax, stock option strike price, dispute resolution, etc.) but we need to know what might have happened if a transaction had actually taken place under the constraints of the definition. The willing buyer and willing seller are generally assumed to be hypothetical parties; i.e., the buyer and seller are "prudent persons" and not specific buyers or specific sellers. Does this have any application in an M&A? Perhaps as a starting point for thinking about a contemplated deal.
When buyers in a particular industry are exclusively strategic, and there are lots of strategic acquisitions happening, there is an overlap between strategic value and fair market value because all hypothetical buyers are strategic buyers.
Investment value, on the other hand, is generally thought of as the value of a particular company to a specific buyer. This is where it gets tricky. Suppose the investment bankers know that Company A would be particularly suited as a bolt-on to your business. They know that you know. And they use every trick in the book to try to make you pay for every investment benefit that you might realize from the acquisition. Let's go back to the second question and reflect on the best way to destroy shareholder value!