Aswath Damodaran on Acquisitions: Just Say No
Aswath Damodaran has a blunt message for companies considering an acquisition: “Don’t do it.”
“I firmly believe that acquisitions are an addiction, that once companies start to grow through acquisitions, they cannot stop,” he told the audience at the CFA Institute Equity Research and Valuation Conference 2018. “Everything about the M&A process has all the hallmarks of an addiction.”
That’s why he titled his presentation, “Acquirers Anonymous.”
And like every addiction, the acquisitions habit exacts a heavy toll from its abusers and those who rely on them.
“If you look at the collective evidence across acquisitions,” Damodaran said, “this is the most value destructive action a company can take.”
Ways to Create Value
The dilemma comes down to how companies generate growth. And it turns out there are really only a handful of strategies that can accomplish that, Damodaran said, referencing data from a McKinsey study.
“The very best approach of creating growth historically has been to come up with a new product,” he said. “Look at Apple. Between 2001 and 2010, the company went from being a $5 billion company to a $600 billion company, and they built it on the iPhone, the iPad. Basically new product, new product.”
But creating new products is like playing the lottery. When you win, the payoff is huge, but wins are rare and losses common. “Think of the contrast with Microsoft’s new products in 2001 and 2010,” Damodaran said. “You can’t remember any of them, right?”
The second best strategy for growth is expansion, either into a new market or by finding new users within your market. Coca-Cola and Levi’s went global in the 1980s, Damodaran explained. As for finding new users, he pointed to over-the-counter painkillers: “You know how much bigger the aspirin market got once people discovered it was potentially something you could take to not have a heart attack?”
The third most effective approach, McKinsey found, was to grow or maintain market share in an expanding market. “Think of Apple and Samsung between 2011 and 2015 in the smartphone market,” Damodaran said. “Apple’s market share actually decreased between 2011 and 2015, but their value increased. Why? Simply because the smartphone market itself was growing. When you’re in a growing market, it gives you this buffer to have your market share drop off and still grow.”
Companies can also try to increase market share in a stable market, but that is even less effective at achieving growth and is often value destructive. Because to acquire that market share, you have to cut prices. “You will get a higher market share but your margins collapse,” he said. “Your value, in fact, becomes much more unpredictable.”
“The Very Bottom of the Barrel”
And then McKinsey gets to the dregs, what Damodaran calls “the very bottom of the barrel.”
What is the very worst way to grow?
“Go do acquisitions,” he said.
The evidence isn’t in dispute: It is piling up and pretty well disseminated. Yet the industry has yet to reach rock bottom. “This is something we’ve known for 40 years,” Damodaran said. “And as you look at M&A study after M&A study, collectively, this is not a process that creates value, and I’m afraid the disease is spreading.”
Of course, if you’re the targeted company, being acquired is a great thing. Your stock price goes up. “Targets win,” Damodaran said. “You wake up the next morning and thank God for capitalism . . . . You will never want this process to stop. This is a gravy train that is going to keep giving.”
Why is that? Because acquiring companies tend to overpay. By a lot.
“I’ve seen companies destroy 20 years of hard work in one day with one acquisition,” he said. “I remember when Eastman Kodak was a great company. It was one of the Nifty Fifty, considered an extraordinary well-managed company. Until the day they bought Sterling Drugs, a growth company in the pharmaceutical business.”
How pharma and cameras and film fit together was not especially intuitive. “They claimed synergy,” Damodaran said, “overpaid by $2.2 billion and that was the beginning of the end for the company because, after that, nobody trusted them.”
Examples like this abound. And the word synergy tends to pop up quite a bit.
Indeed, according to a KPMG study of about 9,000 mergers, synergy was the most often cited rationale.
“Synergy sounds magical,” Damodaran said. “But let’s put our value hats on. If there is really synergy, what is it? Where will it show up? How will I value it? How much should I pay for it, right?”
The first step is to value both the acquiring and target companies as stand-alones. Then add those two values together. The third step is to take the combined company and add in whatever form synergy will take. That might mean a boost in revenue growth, lower cost of capital, increased market share, etc.
“Value the combine company with those changes put in, and what you should get in step three should be higher than the sum of values you got in step two,” Damodaran said. “The difference is the value of synergy. That’s it.”
So what percentage of mergers actually have synergy?
In around half of the mergers KPMG studied, there wasn’t any evidence of synergy, according to Damodaran. And in about one third of the mergers, there was evidence of reverse synergy. “You know what that is, right?” he asked.
McKinsey has made similar inquiries for the last several decades. One of the questions they ask is, Does the merger create a return on capital?
“Again, in two thirds of all mergers, what they find is the mergers fail that very simple capital budgeting question with synergy incorporated in the returns,” Damodaran said. “And here’s the most final and most damning evidence that mergers don’t work: Do you know half of all mergers are reversed within 10 years of the merger? The company that did the acquisition phase finally shows up and says, ‘Didn’t work.’”
Given this mountain of collective evidence that companies pay too much for acquisitions and that they destroy more value than they create, why are they still so popular? Why is the moment of clarity still so elusive?
Damodaran believes that the reason for this lies not in the deals but rather in the M&A process itself. “The ecosystem is full of people who feed your addiction,” he said. “Starting with who? Starting with consultants who come in and say, ‘Your growth seems to be leveling off. We have just the right solution for you.’”
Then the typical deal involves four players: the acquiring firm, the target firm, and their investment bankers — All of whom likely are incentivized to complete the deal.
“There is not pushback in this process, right?” he said. “Are you going to be the skunk at the party saying, ‘You know what, guys? That revenue growth might not show up.’”
So what implications does this have for Damodaran as an investor?
“I have 53 stocks in my portfolio, and I have one trigger that will lead me to sell the stocks right away,” he said. “You do a big acquisition, I’m out of your stock. I don’t care what justification you give me. Because I know my history. If you do a big acquisition, the odds are loaded up against you.”
In other words, just say no.
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16 thoughts on “Aswath Damodaran on Acquisitions: Just Say No”
Harold Geneen and ITT started the “conglomerate” party and no one has done as well since. Nevertheless it should be remembered that equity investors can lose no more than their purchase price and it can be leveraged indefinitely. There will always be a case for “buying debt” — watch Bristol Myers/Celgene.
An acquisition only works if it can be integrated within the parent company and on the premise that a fair price is paid.
Disney shows the pros and cons of acquisition. When Disney purchased Pixar Studios, Marvel Comics and Lucas Films in hindsight they worked out brilliantly. Why because Disney had the infrastructure to scale up a great idea but it was short on ideas. Also, the price they paid for such acquisition were not huge relative to the market cap of Disney.
On the other hand, 20th Century Fox was a mistake. Disney paid such a high price the room for error is minimal if things don’t work out it can be catastrophic. Unfortunately in the entertainment industry is ” like playing the lottery. When you win, the payoff is huge, but wins are rare and losses common”.
Like most, I have huge respect for Damodaran. All of us have seen many “promising” acquisitions fail to meet their promise.
At the risk of having my CFA charter revoked, I would note that, while perhaps most acquisitions don’t work, many do. More importantly, there are serial acquirers who have repeatedly had success with acquisitions.
For instance, SSNC has made dozens of acquisitions, generally in their niche, that have worked, it seems.
And Huntsman, particularly in the old days when Jon Huntsman was buying chemical subsidiaries of multinational oil companies at the bottom of the chemical cycle. He understood buying low.
And then in the theme of the classic conglomerate, acquiring unrelated businesses, there is Berkshire Hathaway. Warren Buffett and Charlie Munger, having started by buying public equities, have bought many entire companies, now forming a conglomerate. A successful one. Maybe because they approached acquisitions as if they were investments.
Agreed that there are many, many examples in which acquisitions were “not a process that creates value”. But there are meaningful outliers.
I totally agree that acquisitions usually destroy values, but the right question should be for whom. Usually, all the people involved in the transactions stand to benefit, except the shareholders and employees laid off for the infamous ‘synergies’. Indeed, Investment Banker make huge fees in the transaction, the management of the acquired company either gets a fat bonus to go or get a promotion with better salary in the new conglomerate, and the management of the acquiring company can justify a higher salary and bonus due to the bigger size of the company they now manage. The right question would therefore be how do you solve the misalignment of interest between acquiring shareholders and management.
Do the research findings only apply to corporate M&A transactions, or to sponsor-backed private transactions as well? Are corporate M&A transactions fundamentally different in terms of value creation vs. sponsor-backed PE acquisitions? I would assume that PE funds are much more focused on creating value than management of publicly held companies, and that there is a lot more ego and empire building behavior involved at larger publicly listed firms. What do you experts out there think?
Yeah but it creates fees for Investment Bankers, and then 10 years later they get fees when they recommend that the company spin-off it’s acuqisitions.
I think that there has to be a purpose why the acquisition has to be done , if it is for ego you should not but there has to be a higher purpose …
We have done 22 acqusitiins and all of them are well integrated and doing well and I feel that everyone deserves a second chance ! Most of our companies we took over were left for dead (bankruptcies) , hence generalisations are a big mistake since listing we have grown over 7000 times over 25 odd years and everyone is a winner !!!
Saying ‘NO’ sounds in theory, but far from easy in practice. Ultimately corporate decisions are also driven by investor demands.
Consider the pharmaceutical sector (2014). Investor obsession with M&A led to Allergan (highly respected company/ management) being subject to an extremely hostile, toxic takeover battle. Management said ‘NO’ to being acquired and resisted pressure to do value-destroying acquisitions instead. Yet despite the solid business case for AGN to remain independent, the firm was ultimately forced to capitulate and was acquired by a ‘white night’.
It was then an ‘eat or be eaten’ world in pharma, where investors/ management became irrationally focused on M&A. Until, of course, the bubble finally burst a year later.
I like Charlie Munger’s quote on acquisitions:
“Two thirds of acquisitions don’t work. ours work because we don’t try to do acquisitions — We wait for no-brainers.
Of course, acquiring Berkshire Hathaway originally as Warren Buffet notes was a mistake.
Acquisitions do make sense when the target firms are running out of cash or unfairly trading below the tangible book value. These things happen quite often when there is irrationality and fear run deep when the economy is in the downturn.
Unfortunately, the corporate world does act appropriately, they buy their stock when the market is booming and make the acquisitions when the prices are high.
Prudent investors like Buffett builds cash pile during the final stages of the economic expansions, and wait patiently for the recession pulls the trigger when there is a blood bath on the street. End of the day, what price the target is acquired is more meaningful than the so-called synergies. Because it is hard to quantify the synergies. There is a good old saying, you make a profit on the day you buy not the day you sell.
Your comment reminds me of what Howard Marks said about value investment: “It is not what you buy but how well you buy it.”
I disagree, it may not be the best option for growth but it’s one of several options. Saying it’s the riskiest option would be a better conclusion.
Nothing is binary in life. E.g. consider Facebook. Instagram and Whatsapp are each worth upwards of $100 bn now. Similarly with Android, Youtube for Google. Cisco built almost its entire portfolio in its early days on the back of acquisitions.
Professor Damodaran’s approach seems correct in the way Buffet’s approach seems correct. If the professor can’t discern which acquisitions are likely to create value, he should sell, just as when Buffet can’t understand a company, he doesn’t buy. It does not seem correct if it is interpreted as “don’t do acquisitions” any more than Buffet’s approach seems correct if it is interpreted as “don’t buy tech companies.”
Whether you buy the whole company or just one share, it is the price that you pay that matters. When a company pays too much for an acquisition, it can be devastating. Look at Teva as an example, paying $40 billion, largely borrowed, for a business worth less than $20 billion. Another example is Empire’s purchase of Safeway in Canada at around eight times operating income. It resulted in major one time loss. However Cerberus bought Safeway in the US at around four times operating income and was a very profitable acquisition.
To make a sweeping observation that acquisitions are bad is just incorrect.