Applause, with a raised eyebrow

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.


CGI/Logica and shareholder value

It’s always interesting to take a close look at the press release announcing a deal.  People who have been on courses at FinanceTalking know full well about how we go on about the creation of shareholder value, by which we mean that the management of a company generate cash flows at rates of return that exceed the company’s cost of capital.  We add that growth matters too, because higher cash flows are obviously more valuable than lower ones.  And that’s it really.  That’s all that management has to do to create value.

We also teach that there’s too much emphasis on earnings per share.  It’s an easy metric to play with because on the face of it the company with higher earnings is making higher profits and then it’s easy to apply a multiple to earnings to get a sense of value – the price/earnings ratio.  But what EPS doesn’t tell you is how much capital needs to be invested to generate that growth and it can easily result in two companies with exactly the same revenue and profit profiles into the future being given the same value, even though one company’s cash flows are half of the other’s because of the greater need to re-invest.

So we always look for the bit in M&A releases that talk about the returns the acquisition will make on the capital being invested to purchase it and whether and when the acquisition will cover its cost of capital.  No mention of it in the CGI release yesterday on the acquisition of Logica.  Just the usual stuff about enhancing earnings per share (albeit by a very healthy amount, which suggests they’re buying it on the cheap).  The drafters of the release should check out the bible on Valuation written by McKinsey: “Deals that strengthen EPS and deals that dilute EPS are equally like to create or destroy value.”  Talk instead, McKinsey suggest, about the cash flow returns on capital and whether they are in excess of the cost of that capital.  That’s creating value, and that’s what will bring investors to invest in the story.