How to Create Value with M&A

What increases the value of a firm, generally? The answer: increasing the expected value of future cash flows. If the expected future cash flows to equity rise, the equity value increases accordingly.

Therefore, to create value through M&A, you must acquire a business where you can increase the expected future cash flows to equity.

However, simply acquiring a company does not inherently create value. If a business is worth $100 million and you buy it for $100 million, your equity value remains unchanged. You’ve exchanged $100 million in cash for $100 million in assets—no value is created.

On the other hand, if you acquire $100 million worth of assets for $70 million, you’ve instantly increased your equity value by $30 million. This is a positive NPV (Net Present Value) investment. Thus, the most direct way to create value through M&A is to acquire a business at a price that yields a positive NPV. No matter how promising a deal may seem, if you overpay, the NPV will be negative—and value will be destroyed.

You might conclude that the key is to hunt for bargain deals. Not necessarily. You can pay 20x EBITDA or even 200x EBITDA for a company if the investment still generates a positive NPV. A high price can still be a good price if the expected returns exceed the cost.

In short: M&A creates value when you acquire a business that increases expected cash flows to equity at a price that results in positive NPV.

That said, not all acquisitions perform as expected. Each deal may have had a positive expected NPV at the time, or it likely wouldn’t have been approved. But NPV is difficult to estimate with precision—it can only be known with certainty at the end of the investment horizon. Future results often deviate from forecasts, sometimes materially. So, how can you de-risk your estimated NPV and improve the odds of a successful deal?

There are two main strategies:

1. Pay less—increasing your margin of safety.

2. Improve the business after acquisition.
   
   

A margin of safety means paying well below your estimated NPV, so that if things don’t go as planned, the price still represents a good deal.

Improving the business means increasing revenue growth, improving profit margins, or ideally, both. This raises the NPV relative to the purchase price. In contrast, buying at a discount lowers the price relative to the estimated NPV. Both strategies help protect value and increase upside.

Many underperforming M&A deals suffer because the acquired business fails to grow revenue or profit as projected—or worse, shrinks in size or profitability. In such cases, purchase prices that once looked reasonable often turn out to be too high in retrospect.

Without a margin of safety, operational improvements, or both, M&A will not create value.

While paying the right price and improving the business are central to value creation, there are also qualitative deal attributes that serve as indicators of potential success. Chief among these is strategic alignment—whether the deal supports a broader corporate strategy that is itself well-conceived. In addition, there are the 5 C’s of value creation:

The 5 C’s of Creating Value with M&A:

• Acquiring complementary products or services

• Acquiring new customers

• Acquiring a new channel to market

• Realizing cost synergies

• Acquiring a competitor (horizontal integration)

In summary: To create value through M&A, you must acquire a business that increases the expected future cash flows to equity at a price that yields a positive NPV. This is most likely to occur by:

• Paying a price that provides a margin of safety,

• Improving the business post-acquisition, and ensuring the deal is aligned with a strong corporate strategy, ideally offering benefits like new customers, complementary offerings, new channels, cost synergies, or market consolidation.
  
  

The more of these value-creating factors present in a deal, the greater the likelihood of long-term success.