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I was reading over the Kraft Cadbury deal and found an article that "justifies" the 50% premium to Cadbury's market share price that Kraft is offering http://dealbook.blogs.nytimes.com/2010/01/19/cadbu...

So I am wondering, why do so many companies overpay for acquisitions?

If the market prices a stock at a certain value, why would a company pay more? Does the company see a better story than other investors do? Maybe it is the prospects of "growth" and "better margins" but why overpay for these?

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Comments (27)

  • Marcus_Halberstram's picture

    I'd say it comes down to a few factors:

    i. management team wants something and doesn't want to lose (i.e. a CEO/CFO/Biz Dev team decides they HAVE to have something, and when their initial bid is rejected, they keep justifying upsizing the bid); in plain simplest terms, its a combination of the ego of alpha-personalities and a 7 year old who wants wants wants, no matter what the cost.

    ii. An offshoot of point (i) above, management always seems to overestimate and be too optimistic in the value they can squeeze out of an acquisition. They overestimate their team's/company's ability and underestimate the depth of the challenges they may face. The result is that actual value resulting form merger is X and perceived value management is willing to pay for is 1.2*X.

    iii. you have an advisory team (bankers) who have a significant interest in the deal consummating, so it is very seldom that bankers cannot come up with a plausible scenario (projections/strategic position) to justify the price tag.

    There's also great round table discussion published by HBS re: M&A which is a good/quick read.

  • bankergirl's picture

    i would also like to point out that as a strategic play, kraft is projecting x amount of synergies from the deal. the cost savings they'll be able to generate as a combined company will probably offset some/most/all of the premium they'll willing to pay. at least that's what they're hoping.

  • In reply to bankergirl
    jjpp18's picture

    bankergirl:
    i would also like to point out that as a strategic play, kraft is projecting x amount of synergies from the deal. the cost savings they'll be able to generate as a combined company will probably offset some/most/all of the premium they'll willing to pay. at least that's what they're hoping.

    They're also banking on emergering markets growth to complement the synergies and reduce the gap as you say.

  • Marcus_Halberstram's picture

    I just re-read your question and I think there's 2 questions in there.

    Firstly, to "overpay" has nothing to do with what the company is trading for. You overpay for something when you pay more than its worth. You don't know this, until everything plays out and you realize/don't realize your projections.

    To pay more than a company is trading at is to pay a premium. Just because you pay a premium doesn't mean you overpay.

    So while Kraft may buy Cadbury for a 50% premium, they haven't actually overpaid until the reality sets in that the value the Cadbury acquisition generated was/was not commensurate to a 50% premium.

    The reason firms overpay is outlined in my first response. Firms pay a premium is for a few reasons:

    i. Control: the shares being traded in the public market are for a non-controlling interest. Shareholders of a public company are large and diffuse, and when you purchase shares on the public market at the trading price, most likely those shares don't entitle you to walk into the board room and dictate how that company will be run. If you were to have the right of control, that has an incremental value not captured in the trading price of a single or even hundreds or thousands of shares of a company. The ability to control a company has value, and if you're acquiring a controlling interest in that company you have to pay above and beyond the market price of that company's share price. This is generally considered to be about a 20% premium.

    ii. Synergies: companies believe that through an acquisition they can implement various synergistic measures, primarily cost cutting initiates, increased purchasing power, headcount reduction, elimination of redundant facilities, elimination of redundant one-time expenses, etc... many of those overlap, and generally fall under the umbrella of economies of scale. In addition to this, you have strategic initiatives. For example, Company A sells widgets, company B sells Widget oil. If Company A buys Company B, they can sell widgets to Company B's Widegt Oil customers, and can sell Widgets Oil to Company A's widget customers. This would be a more strategic play and isn't always a horizontal play (entering a new market: selling more products and/or selling in a new locale) but is often a vertical play. So Company A makes widget out of steel and lime jello. And Company C makes lime jello. Company A generally buys Lime Jello from Company C and its competitors, obviously at a price above and beyond what it costs to manufacture lime jello. So Company A buys Company C, and now produces its own Lime Jello which it uses to manufacture its widgets.

  • monkeyman2010's picture

    Well put Marcus, I think many people I speak to also misconstrue premium vs. overpayment.

  • Industry's picture

    You make some good points about why acquisitions take place. It seems they mostly fall under the "strategic" or "stupid" umbrellas. In the first case, companies attempt to make smart acquisitions to utilize economies of scale or get into new markets, whereas in the second case, companies do it for the wrong reasons such as ego or overly optimistic evaluations -- for example, AOL TimeWarner.

    What I wanted to answer originally is the rationale to purchase another company at a premium to the value. Marcus, as you pointed out, value is subjective and the market price does not always reflect the true value of a company. For example, buying a company to become more vertically integrated and lower costs might have ecnonomies of scale vs. two separate companies. But when bankers are pitching the combination they factor in the synergies as cost savings and then they value the combined entity at some multiple of earnings. And usually, this multiple is at a premium. So why are investors so willing to go along with the merger because there really is a premium over the value of the combined companies?
    I have seen very few examples of value acquisitions where the buyer got a great deal for their money and the outcome was even better than projections (compare that to how often acquisitions fare worse than projections and the result is writedowns). I guess the obvious exception is distressed sales, but without going into that, I want to rephrase my question to ask:
    Why do so many companies embark on acquisitions when the value of the combined company is usually at a premium, even after the synergies are considered? Can any of these reasons be justified quantitatively? Are they valid?

    I haven't read too many case studies about mergers so if anyone has any good articles, links, or personal reports to discuss, that would be great.

    Another factor that came to mind when thinking about the rationale for acquisitions was to eliminate competitors and raise the barrier for entry into the market, solidifying the market leader's role. I can see this being a valid reason to overpay for an acquisition (within reason).

  • squawkbox's picture

    Based on net tangible assets, you might think companies are "overpaying" for acquisitions.

    However, GAAP does not capitalize certain intangibles such as brand name growth or R&D.

    This is why accounting goodwill is recorded when a company is acquired above the fair market value of its tangible assets.

    You might think that Kraft is "overpaying" for Cadbury. But you need to consider that Cadbury has become the dominant candy brand in the emerging markets. Unfortunately, they cannot quantify this dominance on their balance sheet even though it is certainly valuable to have.

    Also consider young pharma companies with candidates in Phase 2 and 3 trials. They have zero net income and their assets will be marginal. But in a year or so, they might be a cash machine. The present value of those future cash flows will justify paying a premium for the company.

    AOLTimeWarner happened because AOL's stock was extremely overvalued and Steve Case aggressively used the AOL stock as currency to acquire TimeWarner.

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  • Marcus_Halberstram's picture

    I would argue that the only acquisition rationale thats not stupid is one that's not "strategic", (i.e. one that IS driven off of pure and simple economies of scale). I don't recall where I heard this -- it may be from the HBS book I referred to above -- but a CEO of a well known F500 company once said everytime I hear a banker tell me "strategic" all I hear is "too expensive".

    The mergers that make/made the most sense are the ones that are simplest to look at.. e.g. Dow/Union Carbide, Exxon/Mobile, etc... Any merger that is looking to an overly "strategic" means of achieving synergies is setting itself up for failure as these are often the most difficult synergies to identify, implement and capture.

  • BespokeAnalyst2010's picture

    How do you justify these bear hugs as a financial adviser? (ex. $1bn offer, then up it to $1.2bn, then up it again to say $1.5bn...) I think the best example would be the JPM/Bear Stearns deal, where the deal was fair at $2...and fair at $10! How do you spin that? It amazes me.

    --------------------------------------------------
    "Whenever I'm about to do something, I think, 'Would an idiot do that?' And if they would, I do NOT do that thing."
    -Dwight Schrute, "The Office"-

  • Marcus_Halberstram's picture

    JPM/Bear was obviously an atypical situation and the government had a strong hand in the acquisition. But in general, the advisers come up with a value for the company based on projections and synergies. And that value may be $1.6 bln., yet they only bid $1.0 bln. Therefore $1.6 bln is their cieling in what they think the company is worth. But more often than not, the bankers/executives come to realizations of all these other ways to untap value, which they had previous "missed" back when they thought the $1.0 bln. bid would be enough. So say they had projections with a $200 mln. synergy forecast and a stretch synergy goal of $350 mln. Well they sometimes bring in management consultants and pay them several hundred dollars an hour and when its all said and done, guess what... the expert consultants determined that the $350 mln. stretch figure is actually much closer to what the base case expected scenario should be.

    Or they'll say they expect synergies to be realized in full in 4 years, but after a new piece of info comes to surface, it looks like the full synergy run-rate can be achieved in 2 years.... improving the economics of the deal at a higher purchase price.

    Its really the bankers job to make sure the deal gets done. And thats what they do. So they start slicing and dicing until they get the numbers to make sense for a bid that is accepted.

  • In reply to BespokeAnalyst2010
    squawkbox's picture

    BespokeAnalyst2010:
    How do you justify these bear hugs as a financial adviser? (ex. $1bn offer, then up it to $1.2bn, then up it again to say $1.5bn...) I think the best example would be the JPM/Bear Stearns deal, where the deal was fair at $2...and fair at $10! How do you spin that? It amazes me.

    No one knew the value of those assets. It was done to save the financial system from crippling (e.g. Lehman Brothers). The $2 amount was also a rush job done in 3 days because Bear would have failed otherwise. The $2 bid gave JPM a few more days to analyze the assets properly.

  • In reply to Industry
    tbcthk's picture

    Industry:
    You make some good points about why acquisitions take place. It seems they mostly fall under the "strategic" or "stupid" umbrellas....

    Can someone answer this as well? Thanks!

  • TheKing's picture

    Not to take away from the serious discussion, but I think the answer is simple.

    Have you ever had a Cadbury Cream Egg? Shit is delicious. I'd pay just as much if I were in their shoes.

  • MarginCalling's picture

    because most companies are run by terrorist CEOs who have no regard for their duty to shareholders.

    the only people who have an incentive to keep prices down - shareholders - have no voice generally.

  • BananaStand's picture

    One of the more horrific examples I can think of in recent memory is Ken Thompson running off and buying GoldenWest. Talk about overpaying, he paid a massive premium to book with the rationale that home prices only go up, Wachovia HAD to be in California to compete and that the Sandler's (who owned the business for decades) were selling because they wanted to retire (not because they thought the housing market was overvalued).

    Talk about overpaying. I believe Wells purchased Wachovia for less than the goodwill that was created in the GoldenWest merger.

    Good example of an unchecked CEO believing he just HAD to have some property for strategic reasons. I believe ML advised on that one. Looks like their model assumptions on resi loan performance took them down too. Ironically, Goldman, who was apparently short sub-prime resi, advised GW on the sale.

  • ws67's picture

    control premiums are really high right now for most transactions due to depressed market cap's... market price doesn't incorporate synergies, or control. if you did a similar transactions study for the past 3 years, 50% premium over market probably wouldn't seem to outrageous.

  • BespokeAnalyst2010's picture

    Which quote do you agree most with in regards to M&A deals? I know it's never this or that...but just trying to see.

    1. "It's all about how much buyers are willing to pay for it."

    or

    2. "It's all about how much the seller is demanding."

    3. or a bit of both?

    What do you think?

    --------------------------------------------------
    "Whenever I'm about to do something, I think, 'Would an idiot do that?' And if they would, I do NOT do that thing."
    -Dwight Schrute, "The Office"-

  • turukturuk's picture

    CEOs want to expand their paychecks which often means being a "man of action" and making acquisitions. By the time they pan out poorly, the CEO will be long gone.

  • Barboone's picture

    Why would you ask a question that is answered in the article itself....
    "With Cadbury’s help, Kraft should be able to lift the cost savings to 7.5 percent of Cadbury’s annual £6 billion in sales. That would imply synergies with a present value of more than £3 billion. On this math, Kraft might have justified a bid close to 900 pence a share."

    synergy: 1+1=3

    "The higher up the mountain, the more treacherous the path"
    -Frank Underwood

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