Confidence in the markets plays an important role in the level of deal activity. It’s like the use of yeast when it comes to bread-making. Too little yeast, and no reaction will occur. Too much, and the end result will be quite different from the original intention. Like baking, there must be a balance of the right ingredients in order to generate value.

There was a shortage of mergers and acquisitions in the aftermath of the Global Financial Crisis. In 2013, confidence started to return, and so too did management’s appetite for deals. This has intensified in 2014, and investors should be watching closely to ensure that the balance between deal activity and value creation is being maintained.

In Australia, the total value of all M&A deals for the first three months of 2014 was $4.5 billion, according to Mergermarket. This is three times the total deal value in the same period last year.

In America, the value of takeovers announced in 2014 hit $1 trillion, according to Bloomberg. This was the fastest pace in seven years. If it continues at this rate, then 2014 would be the second-most active year for M&As ever. The most active year? 2007.

Risk of too much confidence

Investors and management alike can be drawn into the hype of deal activity and lose sight of the underlying value that is being created or destroyed. Indeed, the evidence suggests that companies typically pay a sizeable premium for control of a company, but seldom realise the expected benefits from the deal.

How does this happen? Well, too much confidence certainly has an effect. Amid the excitement that is generated from a buoyant market, management may become more aggressive in order to secure a company, or overestimate their ability to do more with the assets than the existing owners. The more confidence there is in the markets, the less focus there tends to be on the underlying value of the combined entity.

To illustrate the first point, let’s return to 2007 with the acquisition of Coles by Wesfarmers. In that year, Coles reported a profit of about $747 million. In its balance sheet from the same year, Coles reported about $3.6 billion of equity in 2006, and $3.9 billion of equity at the end of 2007. Using only these numbers we can estimate that the return on average equity of Coles was around 19.9%.

Wesfarmers paid $22 billion for Coles, which on this basis would imply a return on equity of about 3.4%. Even if the management team was comprised of brilliant retailers, it is difficult to justify this return as reasonable for many investors.

The other reason combined companies may underperform is the failure to realise expected synergies. Value is created when the acquiring firm can earn a higher return on the existing assets of the acquired firm. This can be done by way of cost reduction or revenue growth.

Eliminating costs is typically easier than growing revenues, as many expenses may be duplicated upon integration, such as call centres and IT systems. Management can demonstrate cost control by picking the easiest fruit first. But when the pipeline of acquisitions slows, it can be difficult to grow the business organically. It’s worth noting that Wesfarmers has gone some way in justifying the synergies implied by the takeover price, as the performance of Coles has improved markedly under new stewardship.

Watch a company’s acquisitions

What should you do when companies that you hold positions in begin to announce acquisitions? For starters, you should understand what the acquired company is worth if it were to continue operating separately from the bidding company. You can then get a sense of the price that is implied for the synergies and the likelihood that they can be realised. Keep in mind that it is easier to integrate a business when it is smaller, has similar operations to the acquired firm, and has a complimentary culture.

With any investment, the price that is being offered must present a sufficient margin of safety. If at the end of this process you believe that the acquisition is unlikely to add value, then it may be prudent to reassess your position.

Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able’