With numerous recent initial public offerings (IPOs) having been complete flops – for example take a look at the share price performance since listing of Vocation Ltd (ASX: VET) and PAS Group Ltd (ASX: PGR). They are down 95% and 44% respectively – investors should remember that it is very much a case of 'buyer beware' when it comes to new floats.
The hype that surrounds IPOs during a bull market can be extreme and many companies fail to live up to the expectations which come built into their offer price.
It's not just the IPO market where investors need to remain alert for excessive pricing and misguided valuations however. The merger and acquisition (M&A) space is also full of risks which an investor must navigate.
Consider this
It's a very common statement by management these days when they announce an acquisition that the transaction will be "earnings per share (EPS) accretive". As growth in EPS is a major driver of a share price, it's not surprising that management teams choose to focus on this metric and highlight it to the market. There is a problem with this focus however…
In a low interest rate environment such as the one we find ourselves in today, a company can borrow funds at very low rates. Let's assume a large company can borrow at just 3% – this effectively means the company could pay around 30x earnings and still claim the acquisition will be EPS accretive!
So the statement "we expect the transaction to be EPS accretive" is no reason for jubilation by investors, rather it is a statement which requires investigation and clarification.
Take for example the recent acquisition by leading law firm Slater & Gordon Limited (ASX: SGH). Slater & Gordon purchased the UK-based Quindell's Professional Services Division earlier this year and in announcing the deal management stated that the "proposed transaction is expected to be substantially EPS accretive (greater than 30%)".
The clarification by management of 30%-plus accretion, coupled with disclosure of the acquisition multiple (6.9 times) is important information for shareholders as it allows for a more informed analysis of the transaction to be made.
Indeed, in this instance the details suggest the deal could be a good one – assuming the earnings they are buying are maintainable.
There's a risk that companies currently being rewarded by the market for making EPS accretive acquisitions in this low interest rate environment will suffer a significant de-rating when interest rates rise. To avoid the pain of owning these "at-risk" businesses, it may be wise for investors to focus on fundamental values. For example whether a company is paying a fair price for an acquisition in terms of the expected through-the-cycle return on capital.
