Computing Buyers’ Return in an M&A Deal
Make no mistake: Buyers don’t enter into an M&A transaction because of feel-good business-book babble like “the right fit” and “synergy.” They make acquisitions for one simple reason: profit. Besides EBITDA, Buyers measure profitability in various ways. The following presents the main methods.
Return on equity
Return on equity, or ROE for short, is simply the amount of income divided by the total amount of the company’s equity. If the company has $1 million in after-tax income and $10 million in equity, the ROE is 10 percent.
ROE is a measure of how well a company is able to generate profits from invested capital. It helps Buyers measure each acquisition’s profitability and continue to monitor whether acquired companies remain profitable enough. If the ROE is too low, management may decide that it can more profitably use the capital tied up in the company elsewhere and that selling the company is the best option.
Return on investment
Return on investment (ROI) is similar to ROE, except it accounts for the acquisition price and the sale price of a business. You calculate it by subtracting the sale price from the acquisition price and dividing that difference by the acquisition price; the result is a percentage. If you acquire a company for $10 million and sell it for $15 million, the ROI is 50 percent.
Internal rate of return
Internal rate of return (IRR) is a favorite of PE firms and is the main metric investors use when comparing one fund to another. It’s a discounted rate of return; that is, the anticipated future earnings of a company are discounted. A dollar today is worth more than a dollar next year, so the more time that expires, the lower the potential IRR.
That’s why PE firms are often very open to selling off a portfolio company sooner rather than later; keeping it may not be beneficial if the IRR is likely going to decline.