Timing is key as companies weigh whether to make strategic investments now or wait for clear signs of recovery. Scenario analysis can expose the risks of moving too quickly or slowly.
April 2009 • Richard Dobbs and Timothy M. Koller
It may be a nice problem to have, but even companies with healthy finances face a quandary: should they pursue acquisitions and invest in new projects now or wait for clear signs of a lasting recovery? On the one hand, the growing range of attractive—even once-in-a-lifetime—acquisitions and other investment opportunities not only seems hard to pass up but also includes some that weren’t possible just a few years ago. Back then, buyers faced competition from private-equity firms flush with cash, governments applied antitrust regulations more strictly, and owners were less willing to sell. What’s more, investments in capital projects, R&D, talent, or marketing are now tantalizingly cheaper than they have been, on average, over the economic cycle. On the other hand, many indicators suggest that the economy has yet to hit bottom. Companies that move too soon risk catching the proverbial falling knife, in the form of share prices that continue to plummet, or spending the cash they’ll need to weather a long downturn.
Timing such moves is bound to be difficult. How quickly the world economy returns to normal—and indeed, what “normal” is going to be—will depend on hard-to-predict factors such as the fluctuations of consumer and business confidence, the actions of governments, and the volatility of global capital markets. Identifying market troughs will be particularly hard because stock indexes can rally and decline several times before the general direction becomes clear. In previous recessions, as many as six rallies were followed by market declines before the eventual troughs were reached. During the current downturn, market indexes fluctuated by an average of 20 percent each month from November 2008 to March 2009.
Given the uncertainty, executives may easily give up in frustration, hunker down, and await irrefutable evidence that the economy is turning around. But this approach could be a recklessly cautious one. Instead, executives must make educated decisions now by weighing the risks of waiting or of moving too early. And while better timing of acquisitions, and therefore the prices paid for them, can make a big difference in their ability to create value, the best way to minimize risk is to ensure that investments have a strong strategic rationale.
Executives considering whether to jump back into M&A or to make other strategic investments now must understand what lies behind earnings and valuations. To illustrate the risks, we conducted an analysis of a hypothetical acquisition. Real US market and economic data allowed us to build a range of scenarios embodying different assumptions about future US economic performance. We found that even scenarios assuming conservative levels of market performance (as indicated by the experience of past recessions) suggest that many industries may be reaching the point when acting sooner would be as appropriate as—if not better than—acting later. Managers who wait may be failing to maximize the creation of value.
Analyzing scenarios
The primary drivers of capital markets are levels of long-term profits and growth, so we define our scenarios in those terms. Long-term profits are tightly linked to the economy’s overall performance: over the past 40 years, they have fluctuated around a stable 5 percent of GDP(Exhibit 1). It’s therefore reasonable to assume that a return to normal for corporate profits would mean a return to their long-term level relative to GDP and that long-term growth in corporate earnings will also be in line with long-term GDP. For our scenarios, we assume that US corporate profits will revert to some 5 percent of US GDP, although that estimate could be a conservative one if the trend to higher profits in the years leading up to the crisis resulted from a structural change in the economy. One can tailor this analysis to the circumstances of individual industries by developing a more detailed understanding of the linkages among GDP, revenue, and earnings.
Growth in the labor force and productivity drive the long-term growth of real GDP. Since it has historically grown in the range of 2.5 to 3.0 percent a year and returned to its former trend line in all US downturns from the Great Depression onward, with no permanent loss in GDP once the economy recovered, our base scenario assumes that both of those trends will continue. (We also examined scenarios reflecting the possibility that long-term GDP growth might be lower as a result of changing demographics, declining productivity growth, and the effects of the current financial crisis or that GDP might fall permanently by as much as 5 or 10 percent.) Finally, in normal conditions the market as a whole has a price-to-earnings ratio ranging from 15 to 17. We used that multiple in our 2.5–3.0 percent growth scenario and a lower one (14 to 16) in our 2.0–2.5 percent growth scenario. Both multiples are consistent with a discounted cash flow valuation of companies.
