Invested Credit

0_02909.jpgOver the last few articles we have been discussing the pros and cons of using EBIT and EBITDA metrics to choose investment opportunities. While the revenue-bias of the metric can be fairly well balanced out by balancing out the evaluation with a few more conservative cost-side metrics, it is important to understand exactly what it is that we need to be using these checks and balances, if nothing else for the sake of motivation.

During periods of economic growth, companies begin to aggressively expand their operations so as to make the most of the macro opportunities while they are available. While the smaller companies will do this by aggressively pursuing increased revenues through sales and distribution, larger companies will begin actively acquiring the smaller ones in order to keep their percentage rate of expansion at an acceptably high level. Eventually, this leads to an environment in which leveraged buy-outs become a popular venue for acquisition.

However, as companies continue to pursue debt for the sake of expanding their enterprise value, interest rates will begin to climb to fight the ensuing inflation. This will in turn force companies to find alternative means of financing their acquisitions.

The second source of financing that managers will turn to once interest rates have risen to unfavorable levels is equity. Companies will leverage their equity base in order to obtain funds at a lower cost of capital in comparison to debt, and to buffer out the debt that they have already acquired on their balance sheet. While this is generally accomplished by selling shares on public exchanges, it becomes somewhat more dangerous as it progresses into the acquisitions themselves.

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Essentially, companies can eventually hit a point at which they are able to use the value behind their shares to acquire their target firms. The result is that companies will effectively have access to their own currency reserve, which is anchored by the value of their operations, which are expanding with every new acquisition.

When companies begin purchasing new assets using equity as a medium of exchange, they will usually issue new shares to facilitate the transaction. Similar to the way in which inflation dilutes the value of a currency, new share issuances for the purpose of acquisition will dilute the value of the shares held by existing shareholders. However, because of the way in which an acquisition will be anchored in the tangible value that is transferred in the acquisition, the shareholder will not see a great deal of tangible dilution, because of the way in which the net asset value has increased against the dilution.

That being said, when companies start acquiring at a premium, investors start to take on great deals of risk through these sorts of transactions, because there is less and less tangible value to compensate for the dilution of the market value of their shares. Such a problem then reaches an extreme when the acquired companies are entirely intangible, such as with a technology company.

In these situations, acquiring companies have been known to dilute themselves to the point of insolvency by printing great volumes of shares to acquire companies without tangible value, and then see their acquisitions drag their earnings into oblivion because of the way in which these properties never produce a tangible return, or sap away resources from competitive endeavors.

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What’s worse, because of the way in which EBITDA metrics masked the true costs of these failed acquisitions by ignoring depreciation and interest expenses, managers were given an incentive to continue diluting tangible shareholder value, so long as their share prices traded with a market value.

While all of this might come off as a bit confusing, the key deliverable to remember is twofold. Firstly, the pursuit of acquisition through leverage or equity-transaction, purely for the sake of bolstering returns, can be destructive to shareholder value by degrading tangible asset value. What’s more, managers can proceed to hide these dilutions to tangible value by ignoring the way in which depreciation and amortization expenses consume top line revenues.