Cash Acquisitions by Companies with Low P/Es Work Best

With the market outlook mixed on mergers-and-acquisition activity, companies need an edge in evaluating targets. An analysis by KPMG International and University of Chicago Graduate School of Business Professor Steven Kaplan of 510 corporate deals found that cash transactions involving companies with below-average price-to-earnings ratios are most likely to improve shareholder value.

"An acquirer with high P/Es may have trouble improving on their return to shareholders when their stock is already priced relatively high compared with their peers," --Steven Kaplan, Chicago Graduate School of Business

The study analyzed corporate deals that were announced during 2000-2004 and measured stock price improvements one year and two years later. The research also found that the most successful transactions were:

• Aimed at building financial strength and improving distribution
  channels, demonstrating that some acquisition objectives are more
  likely to yield success;
• Completed by companies with lower market caps, pointing to a potential
  need for larger companies to focus more on their transaction process
  and due diligence approach;
• Done by acquirers that made just one or two other deals in the previous
  two years, indicating that integration becomes difficult when too many
  acquisitions are made.

"An acquirer with high P/Es may have trouble improving on their return to shareholders when their stock is already priced relatively high compared with their peers," Kaplan said. "Conversely, acquirers with a relatively low P/E may be more cautious when making a purchase, since their own stock is not overvalued in the market, and, as you can expect, targets with low P/Es may represent better deals as their stock is not overpriced."

Based on normalized stock returns - stock price returns of companies relative to others in their industry - the average cash deal showed a 15.1 percent return after one year, and a stellar 27.5 percent return after two years, the study said. Meanwhile, deals financed with cash and stock had a 3.9 percent return after one year and a 9.8 percent return after two years, while all-stock deals returned a negative 2.1 percent at the 12-month mark and a positive 3.6 percent return after two years.

Tiemann explained that companies may view their stock as a less expensive alternative to cash, and the pattern may be more pronounced when the stock market generally has a higher P/E ratio. In one example, the U.S. markets P/E ratio was 26 at the height of the Internet bubble in 2000. Yet, one year later, companies that completed cash deals showed a normalized return of more than 25 percent, while those using other means of financing had stock returns averaging just 1.5 percent.

Interestingly, when the acquirer and target had low P/Es, the deal usually was more successful. Acquirers in the lowest quartile of the study posted an average return of 21.6 percent a year after the deal was closed, and 42.2 percent in year two. And, acquirers that purchased companies with below average P/E ratios also had higher returns. Purchase of targets in the lowest quartile brought the buyer a return of 14.8 percent in the first year, and 34.4 percent after two years.