Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 282

6 checks on whether acquisitions create value

In the current economic environment many companies are finding it difficult to grow earnings organically so they are turning to acquisitions more frequently. Adding further incentive for management teams to acquire businesses is the disparity between the valuation of an ASX-listed public company and a private company. This can create an opportunity for valuation arbitrage as a listed company is generally valued at a greater multiple. When earnings of a private company are added, they benefit from applying the public company multiple.

However, acquisitions are often unsuccessful, and worryingly we don’t see many management teams providing a track record of these in their annual reports. Here are some factors we look for when assessing the potential value of an acquisition:

1. Why is the company making the acquisition?

Too often we see only the strategic merits touted, but we need to discover the underlying motivation. If management is diluting earnings ratios in their existing business with a new one, then we need to know what benefits this new business will provide to the existing business. This is particularly important with larger acquisitions relative to the company’s existing size.

2. Is there organic growth in the existing business?

Always identify the organic earnings growth within the existing business. This is particularly pertinent where companies are making such frequent acquisitions that they are considered a ‘roll-up’. If the company is not growing organically, then inevitably all good things will come to an end when the acquisition pipeline dries up.

3. Are acquisition prices increasing?

Acquisition prices can tell you a lot about the opportunity available. If a company has made several acquisitions in the same industry and the prices for those acquisitions increase each time, this can be a sign of management becoming desperate to acquire when faced with a lack of opportunities.

4. Are accounting levers being pulled?

One benefit of an acquisition is the flexibility it provides management in relation to the accounts. There is opportunity to shift certain costs into what is called a ‘non-recurring’ item, but often these items are recurring. Acquisition accounting also gives companies a full 12 months to adjust the value of acquired assets and liabilities, meaning they can create certain provisions without dragging on the profitability of the business.

5. Is a contingent consideration in the price?

We often see a contingent consideration as part of an acquisition price, but this won’t be included in the headline price paid. Contingent considerations can be a great way to incentivise an existing management team, however, the details are not often disclosed. The accounting treatment for contingent consideration is also highly subjective as they are recognised at the present value of a likely future payment. Any adjustments to these figures are taken through the profit and loss which can result in a positive impact on profit and loss even if an acquisition is underperforming.

6. Where is the genuine value creation?

Finally, we need to look at how much value is being created by these acquisitions. Instead of simply looking at headline growth each year, we try to focus on the incremental profit growth in relation to the extra capital being employed by the business. This gives us a clearer view on whether the acquisition is actually working or if it is diminishing shareholder returns.

This is not an exhaustive list of items to consider, but rather some key considerations. There are numerous ways for a company to grow and in the current environment, acquisitions are proving popular. Not all acquisitions are bad, but more seem to go wrong than right. A management team which can allocate its capital effectively and continue to grow shareholder returns should see their share prices well rewarded over the longer term.

 

Ben Rundle is a Portfolio Manager at NAOS Asset Management. This material is provided for general information purposes only and must not be construed as investment advice. It does not take into account the investment objectives, financial situation or needs of any particular investor. Before making an investment decision, investors should consider obtaining professional investment advice that is tailored to their specific circumstances.

NAOS is a sponsor of Cuffelinks. For more articles and papers from NAOS, please click here.

RELATED ARTICLES

Two companies with clear competitive advantages.

Five actions to watch in management share buying

Three checks to make when facing earnings downgrades

banner

Most viewed in recent weeks

Australian house prices close in on world record

Sydney is set to become the world’s most expensive city for housing over the next 12 months, a new report shows. Our other major cities aren’t far behind unless there are major changes to improve housing affordability.

The case for the $3 million super tax

The Government's proposed tax has copped a lot of flack though I think it's a reasonable approach to improve the long-term sustainability of superannuation and the retirement income system. Here’s why.

The revolt against Baby Boomer wealth

The $3m super tax could be put down to the Government needing money and the wealthy being easy targets. It’s deeper than that though and this looks at the factors behind the policy and why more taxes on the wealthy are coming.

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

The super tax and the defined benefits scandal

Australia's superannuation inequities date back to poor decisions made by Parliament two decades ago. If super for the wealthy needs resetting, so too does the defined benefits schemes for our public servants.

Latest Updates

The revolt against Baby Boomer wealth

The $3m super tax could be put down to the Government needing money and the wealthy being easy targets. It’s deeper than that though and this looks at the factors behind the policy and why more taxes on the wealthy are coming.

Superannuation

How to prevent excessive superannuation balances

There is an alternative, simpler approach which could be used to mitigate some of the difficulties that the proposed super tax has for holders of large assets such as properties, businesses and farms in SMSFs.

Shares

US shares: Ambitious multiples on ambitious EPS forecasts

Here's a detailed look at how current valuations and profit forecasts for the S&P 500 stack up versus history. The answer? Both seem excessive, making the market vulnerable to a correction or worse.

Taxation

Family trust tax: When is a loan not a loan?

A recent ruling could change the tax payable by beneficiaries of family trusts. If the ATO has previously demanded extra payments on unpaid present entitlements in your family group, you should watch this space.

Property

Things you must consider before subdividing a property

Subdividing can offer a lucrative first step into property development. Yet it comes with legal, planning and unexpected tax considerations that should be understood from an early stage to avoid surprises.

Investment strategies

5 insights that put market volatility in perspective

Though it may feel like this time is different, markets have shown resilience throughout history when confronted by wars, pandemics and other crises. In many cases, the best course of action has been none at all.

Strategy

Concerns about China's rise to power seem overblown

China has always managed its affairs in a very different way to Western countries and empires. For those concerned about China's rise as a global power, the big question is whether this approach could change.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.