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.