How to Evaluate an Acquisition

To evaluate an acquisition, judge five things: the price paid relative to the value received, the strategic logic, how the deal is funded, the return the acquirer expects to earn on the capital, and management’s track record with past deals. Most acquisitions destroy value, and the usual cause is overpaying, so price is the decisive test.

When a company you own announces a big acquisition, the share price often jumps on the excitement. Your job is to ignore the excitement and ask a colder question: did management just make you richer or poorer?

Where this fits: this guide supports Criterion 3 (aligned management) of the Five Criteria. It extends the hierarchy of capital allocation, where acquisitions rank second among the uses of cash.

Why Acquisitions Deserve Suspicion

Acquisitions are the use of capital most likely to destroy value, and it is worth understanding why before you look at any single deal.

The incentives are stacked towards doing deals. A bigger company usually means a bigger pay packet and more prestige for the chief executive. Investment banks and advisers are paid when a deal closes, not when it succeeds. And “synergies”, the cost savings and extra revenue a deal is supposed to unlock, are easy to promise in a slide deck and hard to deliver in reality.

The result is that the premium paid, often a large markup over the target’s market price, frequently exceeds the value actually created. The acquirer’s shareholders, you, foot the bill.

This does not mean all acquisitions are bad. Some of the finest capital allocators built great companies through disciplined buying, as our guide to the hierarchy of capital allocation describes. But the base rate is poor, so start sceptical.

The Five Tests

Here is a practical framework. Run every deal through these five questions.

Test	The question to ask	Good answer
Price	Is the price sensible relative to value?	A fair multiple, modest premium
Logic	Does the deal make strategic sense?	Related business, understood well
Funding	How is the deal paid for?	Cash or modest debt, not cheap shares
Return	What return on the capital is expected?	Comfortably above cost of capital
Record	How have past deals turned out?	Few write-downs, deals earned their keep

1. Price relative to value

This is the decisive test. Buffett’s line from his 2008 letter says it all: “Price is what you pay; value is what you get.”

Look at what the acquirer is paying relative to the target’s earnings, free cash flow and assets, and compare it with what the target is worth on a conservative view. A large premium over the market price is common, but a premium only makes sense if the target is worth more to this buyer than to the market, and even then only up to a point.

Ask the simple question: at this price, what return will the acquirer earn on the money spent? If a company pays a price equal to 25 times the target’s free cash flow, it is buying a 4% initial cash return, before any growth. That had better come with real improvement, or it is a poor use of capital compared with the alternatives.

2. Strategic logic

A deal should make sense as a business, not just as a transaction. The best acquisitions tend to be in areas the acquirer already understands, often the same industry or an adjacent one. They extend an existing strength rather than lunging into something unfamiliar.

Be wary of “diversification” for its own sake, of deals in industries the management does not know, and of transformational bets that depend on everything going right. A company straying outside its circle of competence is more likely to misjudge both the target and the price.

3. Funding

How a deal is paid for tells you a lot.

• Cash or modest debt. This puts the acquirer’s own capital on the line and imposes discipline. As long as the balance sheet stays sound, afterwards, this is usually the cleanest route.
• New shares. Issuing shares to pay for a deal dilutes existing owners. Whether this is good or bad depends on the price of the acquirer’s own shares. Using expensive, overvalued shares as currency can be shrewd. Using cheap, undervalued shares to buy an expensive target destroys value twice over.
• Heavy debt. A deal that pushes net debt well above two times EBITDA leaves the company fragile. Check it against our thresholds in long-term debt explained.

Watch, too, for the dilution that share-funded deals create. If the share count jumps, your slice of the business shrinks, a point covered in stock dilution explained.

4. Expected return on the capital

Every acquisition is an investment, and like any investment it should earn a return above the cost of the capital used. Try to estimate the return.

Take the target’s normalised operating profit after tax, add any genuine, realistic synergies, and divide by the total price paid including debt assumed. That is roughly the return on the capital the acquirer is committing. If it sits comfortably above the cost of capital, the deal has a chance of creating value. If it is below, the deal destroys value from day one and only improvement can rescue it.

Treat synergy promises harshly. Assume cost savings arrive later and smaller than claimed, and assume revenue synergies may not arrive at all. If the deal only works on full, optimistic synergies, it probably does not work.

5. The acquirer’s track record

Past behaviour is the best guide to future behaviour. Look back over the acquirer’s previous deals.

The clearest evidence is goodwill write-downs. Goodwill is the premium paid above the fair value of a target’s net assets. When an acquired business underperforms, the acquirer must write that goodwill down. A large write-down is an admission, in the accounts, that management overpaid.

A history of deals followed by write-downs is a serious mark against a management team. A history of deals that quietly earned good returns, with few write-downs, is a strong point in their favour. This is a core part of the capital allocation scorecard.

A Hypothetical Deal

Imagine Company A announces it is buying Company B. (This example is hypothetical.)

Company B earns 100 of operating profit after tax. Company A is paying 2,000, funded half in cash and half in new shares, and claims 50 of annual synergies.

• On the target’s own earnings, the initial return is 100 / 2,000 = 5%.
• Add the full claimed synergies and it rises to 150 / 2,000 = 7.5%.
• Haircut the synergies to a realistic 25 and it is 125 / 2,000 = 6.25%.

If Company A’s cost of capital is around 8%, this deal destroys value even on the full synergy claim, and more so on a realistic one. The strategic story may be appealing, but the arithmetic says management is overpaying. You would mark it down.

Now suppose the price were 1,200 instead. The realistic return becomes 125 / 1,200, over 10%, comfortably above the cost of capital. The same business, bought cheaper, becomes a good deal. Price, again, decides everything.

Common Mistakes Investors Make

• Cheering the strategic story and ignoring the price. A good story at a bad price is a bad deal.
• Accepting synergies at face value. They are the easiest number to inflate and the hardest to deliver.
• Forgetting the dilution. Share-funded deals can quietly shrink your ownership even as the company grows.
• Judging on total earnings. A deal can raise total profit while lowering profit per share, which is what actually matters to you.
• Ignoring the record. Management that overpaid before will likely overpay again.

Frequently Asked Questions

Why do most acquisitions fail to create value? The most common reason is overpaying. Acquirers often pay a large premium over the target’s market price, justified by optimistic synergies that rarely fully materialise. Integration is also harder than expected, and the incentives of advisers and empire-building managers push deals through regardless of price.

What is the most important factor in judging an acquisition? Price relative to value. A good business bought at a high price can be a poor deal, while a fair business bought cheaply can be a good one. As Buffett put it, price is what you pay and value is what you get.

How does the way a deal is funded matter? Deals funded with cash or modest debt put the acquirer’s own capital at risk and impose discipline. Deals funded by issuing lots of new shares dilute existing owners and can mask a bad price, especially if the acquirer’s own shares are cheap.

What is a goodwill write-down? Goodwill is the premium an acquirer paid above the fair value of a target’s net assets. When the acquired business underperforms, the acquirer must write down that goodwill, reducing reported equity. A large write-down is effectively an admission that management paid too much.

Your Next Step

Next time a company you follow announces a deal, run it through the five tests above and estimate the return on the capital committed. Then read the capital allocation scorecard to see where acquisitions fit, how to identify great management, and value the combined business with the DCF intrinsic value calculator.

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About the author: Cameron Hayes is a senior investor relations and finance professional who has worked in IR at Nasdaq Copenhagen-listed companies including Nilfisk and Maersk Drilling. He holds an MSc from Copenhagen Business School and a BCom from the University of Ottawa, and founded Gingernomics to teach individual investors the Five Criteria framework. More about Gingernomics.

The content on Gingernomics is for educational and informational purposes only and does not constitute financial advice. Always do your own research and consult a licensed financial advisor before making any investment decisions. Past performance is not indicative of future results.