The importance of relative profitability

Many of us recognize how important relative profitability is for the attractiveness of an acquisition target, i.e. the difference between two companies in the same market, one that returns 22% EBITDA vs. one that achieves 10% EBITDA. One of my client CEOs prefers to focus on what he calls hard money performance like absolute profits, instead of other criteria like organizational efficiency etc. So I was asked by the CEOs board to explain the importance of relative performance in terms of % EBITDA.

 

As my old boss used to tell me, Jeff, my good man, where you stand on an issue depends upon where you sit. It was profound advice. Naturally, our CEO sits in a different seat than the buyer. The CEOs criteria for company performance, centered on return on capital/assets employed as measured by hard money, is an appropriate measure. However, it is not the only important measure and the CEO should also acknowledge what he does inherently in his decision making. He inherently assumes the buyers perspective when he evaluates new company initiatives, the capital and human resources required to carry out the initiative, the opportunity cost, the associated risks and the return on investment, because he has alternative initiatives to evaluate and he needs a basis to compare the options. How does he know that his money and time wouldnt be better spent invested in real estate or stocks instead of in software company growth?

 

The buyer has multiple options, too, and needs a basis for comparison of the relative merits of one acquisition vs. another. Every buyer has used league tables and the club of comparison to decide whether to proceed with the acquisition and to negotiate the best deal possible with the seller. If they choose to proceed, each buyer is ready, willing and able to challenge the sellers perspectives on profits and valuation, whether the seller likes it or not.

Posted by , Senior Vice President on 20 July 2011
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