Strategic Decisions Must Have Quantitative Backing For Success
The proper measurement of risk and reward is what distinguishes the mediocre from the superior executive. While perhaps the easy way out is to forgo investment opportunities altogether, historically noteworthy investors have shown the assumption of risk can bring on large returns. On the other hand, as we clearly see in the case of HPQ, the inappropriate assumption of risk can destroy value.
Why is it then, that mega-corporations, with their enormous resources, including sophisticated investment bankers and experienced Boards of Directors, and investors, continue to see the misapplication of risk in financial models, as reflected in poorly constructed business combinations and similar decision -making? For the answer we need to look no further back than the worldwide credit crises, when an “others are doing it” philosophy permeated corporate culture, almost bringing down the entire financial system.
Risk analysis, as defined by the uncertainty to the firm’s cash flows and impact to cost of capital, must meet with greater clarity and weight if errors are to be minimized.
Unfortunately, many decisions are not grounded on the cash-based return on invested capital, but rather, so called “strategic” decisions. These might include a “best practices” approach or one involved in buying market share. Once the exuberance and inertia of a proposed strategic deal takes hold, it is often difficult to contain. Its major proponents are often successful convincing even dubious fellow team members of the potential benefits, even when they lay outside the realm of the true bottom line, free cash flow in relation to cost of capital.
By definition, the risk of a large business acquisition could result in either outsized benefits or financial distress to shareholders. Once a few successful business acquisitions have become fully integrated, I have found executives’ propensity for larger deals develops, even though follow-on acquisitions often involve considerably greater risk.
The replacement of qualitative for quantitative reasoning is most often the genesis of a failed business decision.
Those reviewing prospective deals, whether an M&A team or a securities analyst, must thoroughly review the spread between the cash-based return on invested capital (ROIC) and cost of capital over at least a full industry and business cycle. Where one does not exist, such as in the case of a newer firm, the increase in risk must be particularly well-thought out, given the effect of the purchase price on remaining resources and flexibility. The expected benefits must be cash flow, not market share. As many Board members are not financially inclined, it is still their responsibility to direct their attention to an area in which they are not expert. They must understand the added financial risk of a substantial decision as measured by the range of potential outcomes, and the affect each has on cash flows, cost of capital and the firms’ equity and enterprise value.
The Board must be convinced their firm has the requisite skill sets to successfully integrate the planned acquisition. Are key employees of the target company on board? Who might be alienated? How realistic are the assumptions to take out costs and any projected cash tax savings, whether due to stock awards or other costs allowed to be deducted for tax purposes? On the other hand, are the target firm’s commitments and conceivable contingency liabilities thought out and reflected in a scenario? Are pension and other benefits, including stock awards taken into account?
Understanding the harmful effect a single bad deal on cash flows due to the assumption of excessive risk results in higher cost of capital, less financial flexibility and lost confidence by employees, suppliers, creditors, and stockholders.
For the shareholder, the sole benefit to a business combination or acquisition is an increase in the free cash flow per share while maintaining a reasonable spread to cost of capital. If it fails to meet this test, it is almost never worth doing.
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- The Role of Insurance in Security Analysis
- Investors Overlook Cost of Capital To Their Detriment
Disclosure: No positions
Kenneth S. Hackel, CFA
President
CT Capital LLC
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