Anybody who has attended our courses knows that we applaud companies who talk not only about their earnings but also about the returns they are making on the capital they are using. Increases (or decreases) in EPS tell you just that – they have increased or decreased, but no more. Much more interesting for investors is how much capital has been used to generate that growth in EPS, as measured by return on capital invested.
So we always examine the commentary in financial press announcements, particularly in M&A situations, not just for the impact on EPS (such as whether the deal is accretive or dilutive), but also if there’s any comment about whether the deal will cover its cost of capital. Our belief is that this shows that the company understands how investors think.
Yesterday’s announcement from WPP on its $540m acquisition of AKQA actually contained no details of its financial impact on WPP, but what caught my eye was Sir Martin Sorrell’s comments in the FT today when he was reported to have said that the deal would be accretive in the first year and “would meet WPP’s 6.1% cost of capital’. So applause to him for discussing not just the EPS impact but also commenting on the fact that it would cover its cost of capital.
But then, stop for a moment and consider that cost of capital. 6.1%? How on earth does he get to that figure? Measuring the cost of equity capital is an imprecise science, despite what the academics would have you believe with the betas and the risk-free rates, and there’s lots of scope for subjectivity, but you’d go a long way before you found an analyst who’d agree with Sir Martin’s estimate of WPP’s cost of capital. But then, if he was to confess that it was somewhere nearer 9% (which I’d reckon it to be), the acquisition of AKQA would nowhere near cover its cost of capital and be destroying shareholder value. And that would be confessing that he paid too much for it, which investors (being good at this sort of thing) know anyway.