In the data-intensive field of early-stage M&A work, it can be daunting to decide which metrics to focus on. It’s also crucial to your ability to assess opportunities and create plans that truly capture them.
So which M&A deal evaluation metrics will give you the most realistic picture, and how can you be sure that you’re assessing them correctly? First, you’ve got to define your goals—to understand whether you’re making a sales or product driven play, increasing your capacity or footprint in a target market, eliminating a competitor, and so on.
After that, I like to focus on evaluating the Sales-Inventory-Operations-Planning, or SIOP, process. Within a company, people are selling things, making things, and keeping track of how it’s all going. Take a look at each step, think about your goals, and ask yourself: where are the gaps, and how are you going to improve them?
Let’s take a closer look.
Key question: How does the company perform relative to the market?
- Company vs. market trends. If performance isn’t at least as good as—if not better than—the market average, why do the deal? Look at year-over-year growth rates for the last three years along with projections for the next three. Market context matters: explosive growth in a hot market might not be impressive.
- Customer concentration. It’s an obvious red flag if the bulk of revenue comes from a handful of customers. You can put a finer point on your analysis by examining the concentration of distributors. How much power is in the distribution channel?
- Industry concentrations. Assess whether the industry is consolidating, fragmenting, or static. If the industry is consolidating, is there an existing oligarchy, and what is its relative size, position in marketplace, strengths, and financial performance? If the industry is fragmenting, what is the disruptor, and how quickly is it changing?
- Employee sales vs. cost ratio. Evaluating the ratio of revenue to employee—and comparing it with the industry average—is one of the best ways to gain insight into a company’s performance and potential. Typically, a lower-than-average ratio indicates problems that might range from brand and market positioning to sales process efficiency to overstaffed departments and a lower level of automation. You’ll also want to look at the cost of sales per employee, and as a percentage of revenue.
- Service-Level Agreements (SLAs). Look at the targets set for order fulfillment, lead time, and so on. Then examine not just how well the company meets them, but to what extent the market demands it. Does the value-add justify the cost, or are the SLAs not, in fact, a true competitive advantage?
Look out for:
When it comes to projections, it’s seldom a bad idea to double your pessimistic numbers. In particular, make sure your performance predictions include an assessment of what happens if there’s business contraction in the next 3 to 5 years.
2. Inventory and operations
Key question: Where’s the waste in the company’s processes?
- Inventory turnover. Turnover is a good indicator of opportunities to increase cash flow or reduce working capital. Look at annual inventory turns for the past three years. If there are fewer than 10 turns per year, it suggests there’s a problem; in a product company, a general rule of thumb is one per month. Then look at SLA and supply chain length. Importing from China, for instance, can add one month of inventory and tie up that much more working capital.
- Reinvestment. Reinvestment in a business is crucial to long-term viability. Is the company building for the future, coasting, or milking it into the ground? First, compare average gross and operating margins for the last three years to industry averages. But don’t stop there. Instead, gauge how well the investment process is being managed by examining the ratio of direct labor headcount to sales, indirect labor, and SG&A expenses. Capital investment per employee is another important indicator.
- Age of technology. There’s almost always room for improvement when it comes to technology. But these improvements aren’t always worth the investment. One of the metrics that’s useful for assessing value is the ratio of accumulated depreciation to the total capital asset base. You should also take a look at the level of factory automation, the most recent large CapEx purchases, and whether or not the company is ISO certified.
Look out for:
Finance typically bets on productivity improvements to make deals work. But many productivity improvements are more difficult and more expensive to realize than the optimal scenarios typically referenced in financial justifications suggest. One integration I led involved the installation of new technology in a factory. Two weeks in, we discovered that employees were sneaking back each night to undo the work. We did eventually succeed, but it was an expensive learning experience.
Key question: Are the efficiencies as attractive as they seem?
- SG&A ratios. A few pure finance ratios—from debt-to-equity to current and quick—are among the best-known M&A metrics. Their relevance varies according to the deal’s goals. More broadly revealing, in my view, are comparisons of the target company’s SG&A headcount to that of the buyer and industry averages. Why? Because it’s an indication of the effectiveness of a company’s office automation and how much bureaucracy it has.
- Supply chain metrics. The complexity of a company’s supply chain offers a number of opportunities to add value. Moving towards a leaner supply chain can reduce G&A expenses and improve profit margins, but be careful—if you go too far, you’ll cripple your vendor base. Performance metrics matter here, too. Are lead time, on time, defects, and price measured? If so, what do they look like and how might they be improved?
Look out for:
It’s tempting to overestimate the efficiencies you’ll gain by consolidating SG&A functions. First of all, context matters: if the target company’s SG&A functions are weak, it may be a function of circumstance rather than ineptitude. Second, you’ll need to make sure you include the cost—in time and money—of redesigning business processes and switching IT infrastructure. (And then double it.)
Put Your Metrics Where Your Strategy Is
Early-stage M&A work is a hunt not just for obvious red and green flags: variances from industry norms, say, or under-valued assets. It’s also an opportunity to align the numbers with your topline growth strategies. So as you assess your target and work to identify under-performing aspects, keep the deal’s strategic rationale in mind, identify root causes for each metric, and be honest about how easy (and how expensive) it will be to improve the situation.
Steve Carnes is an M&A expert with deep experience in automated manufacturing, cost-reduction, product portfolio management, and turnarounds. He's helped BTG clients evaluate acquisition targets, prepare Closing strategies, and implement TPM programs.