MoF Issue 20

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McKinsey onFinance

Perspectives on

Corporate Finance

and Strategy

Number 20, Summer

2006

Learning to let go: Making better exit decisions 1

Psychological biases can make it dicult to get out o an ailing business

Habits of the busiest acquirers 8

M&A executives at the most successul US companies understand not

only how acquisitions create value but also how to enlist the support o

the organization.

Betas: Back to normal 14

Betas that were articially low ater the market bubble o the 1990s hav

returned to normal.

The irrational component of your stock price 17

In the short term, emotions infuence market pricing. A simple model

explains short-term deviations rom undamentals.

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McKinsey on Finance is a quarterly publication written by experts

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This publication oers readers insights into value-creating strategies

and the translation o those strategies into company perormance.

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Copyright 2006 McKinsey & Company. All rights reserved.

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Learning to let go:

Making betterexit decisions

Psychological biases can make it diicult to get out o

an ailing business.

John T. Horn, Dan P. Lovallo,

and S. Patrick Viguerie

When General Motors launched Saturn,

in 1985, the small-car division was the

companys response to surging demand

or Japanese brands. At rst, consumers

were very receptive to what was billed as

a new kind o car company, but sales

peaked in 1994 and then drited steadily

downward. GM reorganized the division,

taking away some o its autonomy in order

to leverage the parent companys economies

o scale, and in 2004 GM agreed to invest

a urther $3 billion to rejuvenate the brand.

But 21 years and billions o dollars ater

its ounding, it has yet to earn a prot.1

Similarly, Polaroid, the pioneer o instant

photography and the employer o more

than 10,000 people in the 1980s, ailed to

nd a niche in the digital market. A series

o layos and restructurings culminated in

bankruptcy, in October 2001.

These stories illustrate a common

business problem: staying too long with

a losing venture. Faced with the prospect

o exiting a project, a business, oran industry, executives tend to hang on

despite clear signs that its time to bail

out. Indeed, when companies do nally

exit, the spur is oten the arrival o a

new senior executive or a crisis, such as a

seriously downgraded credit rating.

Research bears out the tendency o

companies to linger. One study showed that

as a business ages, the average total return

shareholders tends to decline.2 For most

o the divestitures in the sample, the selle

would have received a higher price had it

sold earlier. According to our analysis o

broad cross-section oUS companies rom

1993 to 2004, the probability that a ailin

business will grow appreciably or become

protable within three years was less tha

35 percent. Finally, researchers who studi

the entry and exit patterns o businesses

across industries ound that companies ar

more likely to exit at the troughs o busin

cyclesusually the worst time to sell.3

Why is it so dicult to divest a business a

the right time or to exit a ailing project a

redirect corporate resources? Many actor

play a role, rom the act that managers

who shepherd an exit oten must elimina

their own jobs to the costs that companie

incur or layos, worker buyouts, and

accelerated depreciation. Yet a primary

reason is the psychological biases that a

human decision making and lead executivastray when they conront an unsuccessu

enterprise or initiative. Such biases routin

cause companies to ignore danger signs,

to rerain rom adjusting goals in the ace

o new inormation, and to throw good

money ater bad.

In contrast to other important corporate

decisions, such as whether to make

1Alex Taylor III, GMs Saturn problem,

Fortune, December 13, 2004.

2Richard Foster and Sarah Kaplan, Creative

Destruction: Why Companies That Are Built

to Last Underperform the Marketand How

to Successfully Transform Them, New York:

Currency, 2001.

3Richard E. Caves, Industrial organization

and new ndings on the turnover and mobilityo rms,Journal of Economic Literature,1998, Volume 36, Number 4, pp. 194782

(www.aeaweb.org/journal.html).

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McKinsey on Finance Summer 2006

acquisitions or enter new markets, bad

timing in exit decisions tends to go in one

direction, since companies rarely exit or

divest too early. An awareness o this act

should make it easier to avoid errors

and does, i companies identiy the biases

at play, determine where in the decision-

making process they crop up, and then

adopt mechanisms to minimize their impact.

Techniques such as contingent road

maps and tools borrowed rom private

equity rms can help companies to decideobjectively whether they should halt a

ailing project or business and to navigate

the complexities o the exit.

The psychological biases at play

The decision-making process or exiting

a project, business, or industry has three

steps. First, a well-run company routinely

assesses whether its products, internal

projects, and business units are meeting

expectations. I they arent, the second

step is the dicult decision about whether

to shut them down or divest i they cant

be improved. Finally, executives tackle the

nitty-gritty details o exiting.

Each step o this process is vulnerable

to cognitive biases that can undermine

objective decision making. Four biases

have signicant impact: the conrmation

bias, the sunk-cost allacy, escalation

o commitment, and anchoring and

adjustment. We explore the psychology

behind each one, as well as its infuence on

decisions (Exhibit 1).

Analyzing the project

Lets start with a brie test o a persons

ability to analyze hypotheses. Imagine that

someone deals our cards rom a deck,

each with a number printed on one side and

a letter on the other.4 Which pair would

you choose given an opportunity to fip over

just two cards to test the assertion, I

a card has a vowel on one side, then there

must be an odd number on the other side?

Most people correctly choose the Ubut

then incorrectly select 7. This patternillustrates the conrmation bias: people tend

to seek inormation that supports their

point o view and to discount inormation

that doesnt. An odd number opposite

Uconrms the statement, while an even

number reutes it. But the 7 doesnt provide

any new inormationa vowel on the other

side conrms the assertion, but a consonant

doesnt reveal anything, since consonants

Four biases

Analyze theproject orbusiness unit

Decision-making

process

Description Cognitive bias Definition of bias Prescriptive advice

Is the project or businessliving up to initial expectations?

Has it met or exceeded thegoalposts initially set?

What have been the historicalrevenues and costs, andhow do they compare toexpectations?

What is the expectedprofitability?

Decide whether toexit or divest

Should the project beterminated or the businesssold, or do future profitsjustify continued activity(ie, can the project beturned around)?

Confirmationbias

Sunk-costfallacy

Proceed with exitor divestiture

Who is the natural ownerof the business to be sold?

What is the minimum accept-able price for the business?

Anchoring andadjustment

Escalation ofcommitment

Seeking outinformation thatsupports theargument anddiscounting thatwhich does not

Factoring inunrecoverablecosts alreadyincurred whenmaking a decision

Tendency to adjustestimates insufficientlyfrom an initial value

Investing additionalresources even whenall indicators pointto failure of continuedinvestment

Replace incumbentswith a new manager

Create additionalaccountability

Set up contingentroad maps

Use zero-basedbudgeting

Use caretakermanagers

Employ independentevaluators

4This example comes rom P. C. Wason,Reasoning, in B. M. Foss, ed.,New Horizonsin Psychology I, Harmondsworth, United

Kingdom: Penguin, 1966, pp. 13551.

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can have even or odd numbers on their fip

sides. The correct choice is the 8 because

it couldreveal something: i there is a vowel

on the other side, the statement is alse.

Now imagine a group o executives evaluat-

ing a project to see i it meets perormance

hurdles and i its revenues and costs match

the initial estimates. Just as most people

choose cards that support a statement

rather than those that could contradict it,

business evaluators rarely seek data

to disprove the contention that a troubled

project or business will eventually come

around. Instead, they seek market research

trumpeting a successul launch, quality

control estimates predicting that a product

will be reliable, or orecasts o production

costs and start-up times that would conrm

the success o the turnaround eort. Indeed,

reports o weak demand, tepid customer

satisaction, or cost overruns oten give rise

to additional reports that contradict the

negative ones.

Consider the ate o a US beer maker,

Joseph Schlitz Brewing. In the early 1970s,

executives at the company decided to use

a cheaper brewing process, citing market

research suggesting that consumers couldnt

tell beers apart. Although they received

constant evidence, in the orm o lower sales,

that customers ound the taste o the

beer brewed with the new process noticeably

worse, the executives stuck with their

low-cost strategy too long. Schlitz, once the

third-largest brewer in the United States,went into decline and was acquired by rival

Stroh in 1982. Likewise, when Unilever

launched a new Persil laundry detergent

in the United Kingdom, in 1994, the

company tested the ormula on new clothes

successully but didnt seek disconrming

evidence, such as whether it would damage

older clothing or react negatively to common

clothing dyes. Consumers discovered that it

did, and Unilever eventually had to return

to the old ormula.

Deciding which projects to exit

At this stage, the sunk-cost allacy is

the key bias aecting the decision-makin

process. In deciding whether to exit,

executives oten ocus on the unrecoverab

money already spent or on the project-

specic know-how and capabilities alread

developed. A related bias is the escalation

o commitment: yet more resources are

invested, even when all indicators point t

ailure. This misstep, typical o ailing

endeavors, oten goes hand in hand with t

sunk-cost allacy, since large investments

can induce the people who make them to

spend more in an eort to justiy the

original costs, no matter how bleak the

outlook. When anyone in a meeting justi

uture costs by pointing to past ones, red

fags should go up; whats required inste

is a levelheaded assessment o the uture

prospects o a project or business.

The Vancouver Expo 86 is a classic

example.5 The initial budget,

CAN $78 million in 1978, ballooned to

CAN $1.5 billion by 1985, with a decit

o more than CAN $300 million. During

those seven years, the expo received sever

cash inusions because o the provincial

governments commitment to the project

Outrageous attendance estimates

were used to justiy the added expense (th

conrmation bias at play). Predictions

o 12.5 million visitors, which would havestressed Vancouvers inrastructure,

grew at one point to 28 millionroughly

Canadas population at the time. Moreov

Canadians had seen budget decits or big

events beore: the 1967 Montreal Exposit

lost CAN $285 millionsix times early

estimatesand the 1976 Montreal

Olympics lost more than CAN $1 billion

though no decit had been expected.

Learning to let go: Making better exit decisions

5Jerry Ross and Barry M. Staw, Expo 86: Anescalation prototype, Administrative Science

Quarterly, Volume 31, Number 2, pp. 27497.

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Contrast that with the story o the

Cincinnati subway. Construction began in

1920. When the $6 million budget ran

out, in 1927, the leaders o the city decided

that it no longer needed the subway, a

point suggested by studies rom independent

experts. Further construction was stopped,

though crews had nished building the

tunnels.6 The idea or the subway had been

conceived in 1884, and the project was

supported by Republicans and Democrats

alike, so this decision was not a whim;

World War I and shiting demographic needs

had altered the equation. Fortunately

or Cincinnatians, during the past 80 years,

reerendums to raise unds or completion

have all ailed.

Proceeding with the cancellation

The nal bias is anchoring and adjustment:

decision makers dont suciently adjust

uture estimates away rom an initial value.

Early estimates can infuence decisions in

many business situations,7 and this bias is

particularly relevant in divestment decisions.

There are three possible anchors. One is

tied to the sunk cost, which the owner

may hope to recover. Another is a previous

valuation, perhaps made in better times.

The thirdthe price paid previously or

other businesses in the same industry

oten comes up during merger waves, as it

did recently in the consolidation o dot-com

companies. I the rst company sold or,

say, $1 billion, other owners may think that

their companies are worth that much

too, even though buyers oten target the best,most valuable company rst.

The sale o PointCast, which in the 1990s

was one o the earliest providers o

personalized news and inormation over

the Internet, shows this bias at work.

The company had 1.5 million users and

$5 million in annual advertising revenue

when Rupert Murdochs News Corporation

(NewsCorp) oered $450 million to acquire

it. The deal was never nalized, however,

and shortly thereater problems arose.

Customers complained o slow service

and began deecting to Yahoo! and other

rivals. In the next two years, a number

o companies considered buying PointCast,

but the oer prices kept dropping. In the

end, it was sold to Inogate or $7 million.

PointCasts executives may well have

anchored their expectations on the rst

gure, making them reluctant to accept

subsequent lower oers.8

Axing a project that fops is relatively

straightorward, but exiting a business or

an industry is more complex: companies

can more easily reallocate resources

especially human resourcesrom

terminated projects than rom ailed

businesses. Higher investments, which loom

larger in decision making, are typically tied

up in an ongoing business rather than in

an internal project. The anguish executives

oten eel when they must re colleagues

also partially explains why many closures

dont occur until ater a change in the

executive suite. Divestiture, however, is

easier because o the possibility o selling

the business to another owner. Selling a

project to another company is much more

dicult, i it is possible at all.

When a company decides to exit an entire

business, the characteristics o the company

and the industry can infuence the decision-

making process (Exhibit 2). I a faggingdivision is the only problematic unit in an

otherwise healthy company, or instance, all

else being equal, managers can sell or close

it more easily than they could i it were

the core business, where exit would likely

mean the companys death. (Managers

might still sell in this case, but we recognize

that it will be hard to do so.) It sometimes

(though rarely) does make sense to hang on

6Allen Singer, The Cincinnati Subway: Historyof Rapid Transit, Chicago: Arcadia Publishing,

2003.

7John T. Horn, Dan P. Lovallo, and S. Patrick

Viguerie, Beating the odds in market entry,The McKinsey Quarterly, 2005 Number 4,pp. 3445 (www.mckinseyquarterly.com/

links/22192).

8Linda Himelstein, Dusti ng cobwebs o a

Web staple, BusinessWeek, July 14, 2003.

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One petrochemical company, or instance,

created a road map or an unprotable

business unit that proposed a new

catalyst technology in an attempt to turn

itsel around (Exhibit 3). The road map

established specic targetsa tight range

o outcomesthat the new technology had

to achieve at a series o checkpoints over

several years. It also set up exit rules i the

business missed these targets.

Road maps can also help to isolate thespecic biases that may aect the corporate

decision-making process. I a signpost

suggests, or example, that a project or

business should be shut down but executives

decide that the company has invested too

much time and money to stop, the sunk-cost

allacy and escalation-o-commitment bias

are quite likely at work. O course, the initial

road map might have to be adjusted as new

inormation arrives, but the changes, i

any, should always be made solely to uture

signposts, not to the current one.

Contingent road maps prevent executives

rom changing the decision criteria in

midstream unless there is a valid, objective

reason. They help decision makers to ocus

on uture expectations (rather than past

perormance) and to recognize uncertainty

in an explicit way through the use o

multiple potential paths. They limit the

impact o the emotional sunk costs o

executives in projects and businesses. And

they help decision makers by removing

the blame or unavorable outcomes

that have been specied in advance: the

explicit recognition o problems gives an

organization a chance to adapt, while a

ailure to recognize problems beorehand

requires a change in strategy that is oten

psychologically and politically dicult to

justiy. Beore the invasion o Iraq in

2003, or example, it was uncertain how US

troops would be received there. I the Bush

administration had publicly announced

a contingency plan providing or the

possibility o increased troop levels should

an insurgency erupt, the president would

most likely have had the political cover to

adopt that strategy.

When companies are nally ready to sell

a business, the decision makers can

overcome any lingering anchoring and

adjustment biases by using independent

evaluators who have never seen the initialprojections o its value. Uninfuenced by

these earlier estimates, the reviews o such

people will take into account nothing but

the projects actual experience, such as the

evolution o market share, competition,

and costs. One leading private equity rm

overcomes anchoring and other biases

in decision making by routinely hiring

independent evaluators, who bring a

A contingent road map

Technology test(15 months)

Sell or form alliancewith partner withsuperior technology

Sell or formalliance

Sell or close

Continue

Profitmargin test(12 months)

Disguised example of petrochemical company

Company considers sale or closure of unprofitable business unit Company monitors risks from

technology, market acceptance,and response from competitors

Management identifies$100 million improvementwith new catalysttechnology

Source: Hugh Courtney, / Foresight: Crafting Strategy in an Uncertain World, Boston, MA: Harvard Business SchoolPress,

Marketacceptance test(12 months)

Goodacceptance

Pooracceptance

Technologysuccessful

Technologyfails

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new set o eyes to older businesses in

its portolio.

There are ways to ease the emotional

pain o shutting down or selling projects

or businesses. I a company has several

fagging ones, or example, they can

be bundled together and exited all at once

or at least in quick successionthe

business equivalent o ripping a bandage

o quickly. Such moves ensure that

the psychological sense o ailure that oten

accompanies an exit isnt revisited several

times. A one-time disappointment is also

easier to sell to stakeholders and capital

markets, especially or a new CEO with a

restructuring agenda.

In addition, companies can ocus on exiting

businesses with products and capabilities

that are ar rom their core activities, as P&G

did in 2002, when it divested and spun o

certain products in order to ocus on others

with stronger growth prospects and a more

central position in its corporate portolio.9

Although canceling a project or exiting

a business may oten be regarded as a sign

o ailure, such moves are really a perectly

normal part o the creative-destruction

process. Companies need to realize that i

this way they can ree up their resources

and improve their ability to embrace new

market opportunities.

By neutralizing the cognitive biases that

make it harder or executives to evaluate

struggling ventures objectively, compani

have a considerably better shot at making

investments in ventures with strong grow

prospects. The unacceptable alternative

is to gamble away the companys resource

on endeavors that are likely to ail in the

long run, no matter how much is investe

in them. MoF

John Horn ([email protected]) is a

consultant in McKinseys Washington, DC, oce

Dan Lovallo is a proessor at the Australian

Graduate School o Management (o the Universi

o New South Wales) as well as an adviser to

McKinsey; Patrick Viguerie (Patrick_Viguerie@

McKinsey.com) is a partner in the Atlanta oce

Copyright 2006 McKinsey & Company. All

rights reserved.

9Procter & Gamble annual report, 2002.

Learning to let go: Making better exit decisions

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Habits of the busiest acquirers

M&A executives at the most successul US companies understand

not only how acquisitions create value but also how to enlist the support

o the organization.

Robert N. Palter and

Dev Srinivasan

A thin line divides the kind o merger

that nurtures a companys growth rom

one that destroys value. No surprise,

then, that M&A practitioners go to great

lengths to tilt the odds in their avor. They

hire world-class M&A teams, modiy the

organizational design o their companies, or

add systems, tools, and processes to smooth

integration and to accelerate the capture

o synergies. Yet a mergers perormance over

time is subject to so many variables that

its dicult to analyze whether such moves

really work.

To unearth the practical insights that can

help companies succeed in planning

and executing acquisitions, we went directly

to the executives most responsible or

overseeing M&A at the top US acquirers.1

Over the course o 20 interviews with

business-development ocers, we explored

their thinking on what does and doesnt

work in M&A. Then, to see what companies

rewarded by the capital markets were

doing dierently, we compared the dierentapproaches o these companies with

their general perormance during an active

period o acquisitions.

Our ndings provide a road map or the

way companies should think about

and execute acquisitions to improve their

odds o success. We ound, or example,

that development ocers at most o the

rewarded acquirers tend to treat M&A

as a tool to support strategy, not as

a strategy in itsel. Moreover, they use

M&A to complement a companys

distinct capabilities. They understand the

limitations o acquiring a company in

order to acquire its superior management or

operational know-how. And to implement

the details o integration, they involve

individual business units in dierent ways,

depending on the type o merger.

One lesson rom the experts clashed

directly with conventional M&A lore:

world-class M&A teams made up o

ormer investment bankers and lawyers

are not a dierentiator o perormance.

Companies with talented M&A teams are

as likely to be rewarded by the markets

as not. Moreover, talented teams are airly

common, and the proessionals who

belong to them are abundant. Instead, the

tenure o an executive was a dierentiator;

companies with longer-tenured executives

during a period o acquisitions weremore likely to be rewarded. Other necessary

actorsincluding organizational design,

people, systems, tools, and processes

are insucient without a solid approach to

acquisitions and integration.

M&A is a tool, not a strategy

Many companies act as though acquisitions

are their growth strategy. These companies


1O the top 75 US companies by marketcapitalization and the top 75 by revenues as

o June 2005, 33 had accumulated at least30 percent o their market value through

acquisitions. The executives most responsibleor M&A activity at 20 o those companiesagreed to sit down or a rigorous hour-long

conversation covering more than 100 questionsabout the organizations, processes, tools, andmetrics used in acquisitions and integration.

We then compared the activities o acquirersthat were rewarded by the marketsthosewhose total returns to shareholders exceeded

the returns o their peer group rom December1994 to December 2004with the activitieso acquirers that were not rewarded during the

same period.

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acquire repeatedly or the sake o top-

line growth, without a clear plan to capture

additional growth once the target is

integrated and synergies are captured. An

acquisition can be a powerul

builder o short-term value

or these companies, but they

inevitably alter as the number

o value-creating targets declines

or as they bump up against

regulatory hurdles. Investors

quickly realize when companies

reach the end o their potential to grow

through acquisitionsstock prices then sag,

refecting anticipated slower growth.

The business-development executives

we interviewed had similar motives (includ-

ing adding capabilities, expanding

geographically, and buying growth) or

their acquisitions. Yet the executives

at companies that reaped market rewards

insist that M&A shouldnt be a strategy

on its own. Instead, it ought to be a tool to

ll strategic holes (such as diversiying

an asset prole or expanding a geographic

ootprint) that cant be lled as eciently

on an organic basis. As a strategy executive

at a consumer goods company told us,

Once the corporate strategy was settled, wed

look or opportunities, both organically

and through M&A, to pursue that strategy.

We were not simply out shing or good

acquisition targets; we were executing a

strategy. The connection between successul

acquirers and their adherence to an over-

arching strategy is also shown by the actthat none o them acquired companies

or deensive purposesthat is, to block a

competitor.2 For these companies, it

would seem, M&A strategy is proactive

rather than reactive.

This observation isnt meant to downplay

the importance o acquisitions in overall

company strategy. When used correctly,

acquisitions are a necessary part o a

large companys growthindeed, recent

McKinsey analysis shows that many

large companies generate more than a thir

o their long-term growth through

acquisitions.3 However, acquisitions shou

be viewed within the context o the overal

corporate strategy.

One high-tech company, or instance, used

a combination o acquisitions and organ

growth to pursue its twin strategic goals:

reducing costs and becoming the leading

company in its industry. Pursuing its goals

only organically would have taken too lo

because it needed an immediate nationwid

presence to capture market share during

the early stages o the industrys growth

cycle. In any case, the cost o growing

organically would have been extremely h

A partnership would meet the companys

time constraints but deliver just a ractio

o potential protability. In addition,

neither organic growth nor a partnership

would help the company lower its costs.

A merger or acquisition, by contrast, wou

quickly and protably oer the company

the nationwide presence it sought, along w

the potential or signicant cost synergie

The companys eventual no-premium

merger with a competitor created value

equaling nearly hal the cost o the

merger. One o the keys to success was t

combined entitys ability to drive organic

growth, which nearly doubled in ve year

Contrast this long-term success story withe experience o a nancial-services rm

that relied almost entirely on acquisition

to uel its growth in the 1990s. The

companys stock skyrocketed as it captur

all the synergies, and it signicantly

outperormed its peers. However, hidden

in the massive top-line growth and

market appreciation was the act that th

company was devoid o organic growth.


2In rare situations, a deensive acquisition maymake sense.

3This analysis is based on a sample o 50 tele-communications, utility, and high-tech

companies.

Executives at companies thatreaped market rewards insist thatM&A shouldnt be a strategyon its own

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0 McKinsey on Finance Summer 2006

As ewer and ewer accretive acquisition

opportunities remained, the companys

share price declined. Since then, its shares

have signicantly underperormed those

o its peers, partially because its underlying

organic growth rate has continued to be

lower than that o the economy as a whole.

Involving business units

The integration phase o an acquisition

is oten the time when deals go wrong;

some studies blame poor integration or

up to 70 percent o all ailed transactions.

According to the vast majority o acquirers

we spoke with, the responsibility or

integration alls to the business units. Not

that they are to blame or all o the widelypublicized ailures, but in the words o

one business-development executive, Our

biggest challenge is to make sure that

the corporate M&A team and business

unit executives work in concert on

an acquisitionan important insight.

Acquirers generally try to ensure this kind

o collaboration by using documented

procedures that make everyone aware o

their own and others responsibilities, as

well as tools to track the progress o the

integration eort. However, rewarded

acquirers do so much earlier in the process,

particularly in the due-diligence phase

(Exhibit 1). Also, their procedures are

generally better documented overall than

those o the unrewarded acquirers.

How and when should individual business

units become involved? It depends on

whether the type o transaction a company

pursues alls within or outside its

existing operations. At rewarded acquirers,

the business units were heavily involved

in transactions or bolt-on acquisitions

those within the realm o a companys

existing operationsduring the origination

and integration phases. Furthermore,

rewarded acquirers were more than twice

as likely to involve their business units

in acquisitions rom start to nish, including

origination, due diligence,negotiation,

and integration.

Indeed, while the M&A teams involvement

is essential or ensuring that all transactions

are pursued rigorously, an M&A team

that identies synergy opportunities without

signicant participation by the relevant

business unit can engender resentment and

bring about charges that the team is

setting unattainable targets. Many rewarded

acquirers thereore say that having

business units lead the entire process or a

bolt-on acquisition can dramatically

improve estimates o synergiesand the

likelihood o capturing them.

In particular, the rewarded acquirers

involved their business units during the

due-diligence phase. Some o them ormally

organized teams consisting primarily o

high-level business unit executives, members

o the M&A and legal teams, and other

experts as warranted (or example, tax

accountants or environmental experts).

Rewarded companies typically charge such

Origination 5038

Due diligence 8963

Integration 8986

Communication 10086

Rewarded acquirers (n = 11)1

Unrewarded acquirers (n = 8)1

% of respondents who answered most or all procedures documented

Though small, this sample of respondents makes up nearly two-thirds of the relevant population of the largest US companies(by market capitalization/revenues as of June ) with >% of growth achieved through acquisitions.

When are procedures documented?

More effort up front

8/14/2019 MoF Issue 20

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teams with the responsibility or driving

the process through to integration. During

the due-diligence phase, they are especially

active in identiying and quantiying

opportunities and risks.

Unlike unrewarded acquirers, which

tend to look outside the organization or

M&A talent, rewarded acquirers are

more likely to promote rom within.

Although M&A executives in both groups

had similar levels o tenure in their

present positions, M&A executives at

rewarded acquirers had signicantly more

experience at their companies, albeit

in dierent roles (Exhibit 2). The act that

an M&A executive at a rewarded acquirer

has a deeper knowledge o the culture,

people, and capabilities o the company

undoubtedly helps the executive to navigatecorporate politics and identiy targets

that truly address a companys needs. It also

ensures support rom key people in the

business units.

For transormative transactionsthose

involving acquisitions outside the realm

o a companys operationsthe most

rewarded acquirers typically ask M&A

teams to take the lead in bringing the

acquirers core capabilities into new

industries. The involvement o business

units in such acquisitions is quite low.

Deals are originated primarily by the

M&A team, which oten has a better

position than the leaders o business uni

to think up game-changing ideas. As one

executive said, In origination, the guidin

principle is to get ideas. Id tell my team

to get out o the oce and nd the

new ideas. Our job is to get transormativ

game-changing growth.

Still, in certain situations, it makes sense t

involve business units in transormative

acquisitions. An executive at one rewarde

acquirer said that his company had

been looking to transer its distinctive

distribution capabilities to related

industries. The deals success hinged on

the ability o the acquiring companys

sales orce to sell the new products

to current clients. Although the sales or

had only a limited knowledge o these

products, involving it in the transaction

rom start to nish helped the acquirer

to quantiy potential revenue synergies, to

minimize the loss o clients during

the transition, and to keep salespeople ull

committed to selling the new products

once the acquisition was complete.

Understanding limitations

Oten, when a company aces declining

margins or market share or other dicult

in its core operations, it tries to solve these

problems by acquiring a better-perormicompetitor with greater capabilities. Such

an acquirer thinks it can buy the competito

know-how and management and apply

them to its own operations and thereby

improve its perormance.

While this logic seems reasonable, it can b

dangerous. In our experience, its very

dicult or an underperorming acquire

to improve its perormance dramatically


At current employer

Average number of years

14.04.7

In current position 5.53.3



Though small, this sample of respondents makes up nearly two-thirds of the relevant population of the la rgest US companies(by market capitalization/revenues as of June ) with >% of growth achieved through acquisitions.

Where do they cut their teeth?

8/14/2019 MoF Issue 20

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by acquiring a leading competitor and

extracting its capabilities. Unortunately,

unrewarded acquirers are much more

likely to take this approach. Many executives

at such weak perormers told us that

the primary intent o their acquisitions was

to import the targets best practices to

their own company. Unrewarded acquirers

may also be expecting too much rom

M&A; when asked to choose rom a listo possible motives or pursuing an

acquisition, they picked an average o three,

compared with only two or rewarded

acquirers (Exhibit 3).

One national retailer, or instance, attempted

to augment its weak geographic coverage,

poor store conditions, and inerior merchan-

dising strategies by acquiring another

retailer in the hope that the targets strong

management team could turn around its

own ortunes. The market clearly

disapproved. Analysts immediately pointed

to the targets negative sales and margin

trends and questioned the generous

premium paid by the acquirer. Investors

shaved nearly 5 percent rom its

share price. In one executives candid

assessment, the target company turned

out to be a laggard that oered little

to the acquirer. Buying it or its human

capital was a major ailure, and

now both entities are struggling.

This isnt to say that companies should

never acquire a target or its capabilities.

Indeed, all o the high-perorming

acquirers we spoke to had executed

such transactions and explicitly regard

them as a tool to ll small but important

capability gaps. The dierence may

be that rewarded acquirers look or

acquisitions that supplement their unique

characteristics, capabilities, and assets.

They also search or targets that would

benet rom their distinctive strengths.

One corporate executive summarized

his companys acquisition strategy

simply: We look at what weve been able

to do better than the competition

and get more o it through acquisitions.

In practice, this perspective makes it critical

to scan or opportunities at a very detailed

level during the due-diligence phase rather

than ocusing on operating metrics or

building a nancial model that estimatesaccretion or dilution or the internal rate

o return. Take the experience o a

transportation company with a record o

more than ten sizable transactions during the

past ve years. Its due-diligence team scans

transport routes, mile by mile, rom top to

bottom, looking or opportunities to sign up

new customers or to become more ecient

by changing routes and thus to make the

very best use o its own capabilities. This

What motivates acquirers?

% of respondents

Add capabilities 6488

Expand geographically55

75

Buy growth 3638

Consolidate 1825

938

Diversify portfolio

90

Innovate

025

Defend business

Increase scale 1812



What are your goals foracquisitions?

Though small, this sample of respondents makes up nearly two-thirds of the relevant population of the largest US companies(by market capitalization/revenues as of June ) with >% of growth achieved through acquisitions.

8/14/2019 MoF Issue 20

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level o detail, though generally dicult to

achieve in the short time period o an

acquisition, can yield powerul benets.

Companies that have consistently added

value through their acquisitions share some

practices that may explain their success.

They balance acquisitions with organic

growth, leverage the entire organization to

drive the process rom start to nish, and

understand how they can use their own

strengths to create a competitive advanta

MoF

The authors wish to thank James Shilkett or his

contribution to this article.

Robert Palter ([email protected])

is a partner and Dev Srinivasan (Dev_Srinivasan

McKinsey.com) is a consultant in McKinseys

Toronto oce. Copyright 2006 McKinsey &

Company. All rights reserved.


8/14/2019 MoF Issue 20

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8/14/2019 MoF Issue 20

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Betas: Back to normal

Volatility is not the culprit

Rolling -month beta; beta is measure of assets risk relative to market; a given stocks beta is >. if, over time, it moves ahead of market an

8/14/2019 MoF Issue 20

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After the bubble

Electric utilities

Beta is measure of assets risk relative to market; a given stocks beta is >. if, over time, it moves ahead of market and

8/14/2019 MoF Issue 20

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The irrational component of

yourstock price

In the short term, emotions inluence market pricing. A simple

model explains short-term deviations rom undamentals.

Marc H. Goedhart, Bin Jiang,

and Timothy Koller

Investors, as no one should be surprised

to learn, dont always act rationally.

Their biases, myopia, and expectations o

long-term stock perormance may not

systematically cause share prices to deviate

rom undamentals in the long term, but

in the short term they can cause shares to

deviate rom intrinsic valuation levels long

enough or some observers to raise doubts

about a companys value and strategic

direction. In general, such deviations rom

undamental valuation levels correct

themselves quicklyin around three years

or the market as a whole and, typically,

much sooner or individual companies. But

thats more than long enough to complicate

lie or managers as they struggle to make

tactical decisions on matters such as

the timing o mergers or the timing and

quantity o equity issuances.

Ideally, i managers understand what is

happening when short-term share prices are

o, they will be more likely to stick to their

long-term strategic plans. One way weveound to muster this perspective involves

modiying a undamental valuation model

or the stock market so that the model

explicitly measures the eect o investors

behavioral biases about infation, interest

rates, and earnings projections. Changing

the undamental valuations assumptions

in these areas helps managers to recognize

the conditions that would be most likely

to make share prices or their company an

sector, and or the stock market as a wh

deviate rom undamentals.

Modeling investor bias

To illustrate the short-term bias o investo

we built two modelsone based on

valuation undamentals, the other refect

the behavior o investorso the S&Ps

value or the years 1965 to 2005. Both

models are based on discounted cash fow

which rely on assumptions about the

key drivers o value: corporate prots an

infation-adjusted prot growth, expected

corporate returns on capital, the infatio

adjusted cost o capital, and expected

infation. Each model produces an estima

based on the assumed drivers o value,

o the median P/E ratio o the companies

the index or each year studied. In both

models, we assumed that the expected

return on capital, the long-term growth

rate o corporate prots, and the infatio

adjusted cost o capital are constant

during the 40-year periodan assumptioconsistent with the historical evidence.1

However, the models diverge in their

assumptions about infation and the short

term trajectory o prot growth. In the

undamental model, we assume investors

expect infation that deviates rom the lon

term trend o 3 percent to quickly revert

to that level. In the behavioral model, we

1The median return on equity during the past

40 years was very stable, at around 13 to14 percent. The long-term g rowth o corporate

prots is cyclical, but the proportion o protsto GDP remains stable around an average o6 percent. Finally, we estimated the real

cost o capital: 7 percent. See, or example,Bing Cao, Bin Jiang, and Timothy Koller,

Balancing ROIC and growth to build value ,

McKinsey on Finance, Number 19, Spring2006, pp. 126 (www.mckinseyquarterly.com/links/22143); and Marc H. Goedhart,

Timothy M. Koller, and Zane D. Williams,The real cost o equity,McKinsey onFinance, Number 5, Autumn 2002, pp. 115

(www.mckinseyquarterly.com/links/22144).

8/14/2019 MoF Issue 20

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assume that infation remains at a level that

refects recent history. Thus, when high

infation is cooling o, investors overestimate

long-term infation, and vice versaan

assumption that is consistent with behavioral-

nance theory. Periods right ater high

current infation, such as those during the

late 1970s and early 1980s, translate into

the behavioral models assumptions about

high long-term infation, thereby driving P/E

ratios down more than actual levels bear out.

We used a similar approach to deal with

the way investors orm expectations abouta companys uture protability. Using

the growth trajectory o actual aggregate

earnings or the S&P 500 companies

during the past 40 years, the undamental

valuation model applies a airly accurate

trend line to realized earnings growth and

then obtains an estimate or long-term

growth (Exhibit 1). In the behavioral

approach, we assumed that investors take

current earnings as an anchor or projecting

uture earnings. As a result, during

earnings peaks, such as in 2000, investor

expectations tend to overshoot long-term

uture earnings, driving P/E ratios above

their intrinsic levels. When earnings are

below the trend line, as in 1992, investors

tend to undershoot, so P/E ratios are low

as compared with intrinsic value. This

assumption is consistent with what we

know o analysts earnings orecasts, which

also tend to be too high when markets

peak and to be too low in troughs, both or

the market and or cyclical companies.

Both models converge on P/E ratios close

to the long-term median o about 16.

But the behavioral model, based on the

investors assumption that recent conditions

will prevail over the long term, ts the

actual, year-by-year P/E ratios better than

the undamental model does (Exhibit 2).

In act, when we calculate the relative

Misdirected expectations

EBITA1 for S&P 500, $ billion

Earnings before interest, taxes, and amortization; excludes nancial-services companies.

Anchored on current earnings(behavioral valuation model)

Actual earnings Anchored on long-term earningstrend (fundamental valuation model)

Projected future earnings

0

200

400

600

800

1,000

1,200

1985 1988 1991 1994 1997 2000 2003 2006 2009

8/14/2019 MoF Issue 20

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The irrational component of your stock price

dierences, the P/Es rom the behavioral

model are mostly within 20 percent o the

actual P/Es. The behavioral model refects

the importance o short-term infation in

explaining the variation o actual P/E levels

over time. Changes in expectations about

short-term infation were clearly the most

important drivers or changes in actual P/E

levels in the 1970s and 1980s, or example.

The behavioral model ts the actual market

P/Es better than the undamental model

does, explaining around 90 percent oP/E

variability over time, versus 80 percent

or the undamental model. But this result

does not mean that the behavioral model

is superior. It is better than the undamentalmodel at describing the markets current

P/E levelor its level in the short term. The

undamental model, in contrast, better

describes where the markets P/E level should

be, so it more accurately predicts market-

pricing levels in the longer term.

In addition, the behavioral model shows

how market valuations adjust to undamen-

tals over the long term because o the

cyclical pattern in infation and earnings

Since actual earnings and infation tend

to return to long-term trends (as they ha

during the past 40 years), the behavioral

model sooner or later refects undament

exactly as the market does.

Implications for managers

Managers and investors should not be

misled. Short-term biased behavioral

valuations may t better with market P/E

ratios at a given point in time, but strate

nancial decisions are still best made on

the assumption that the undamental mo

holds true in the long term and that

markets will eventually recognize long-tergrowth and earnings potential.

Managers making tactical decisions on th

timing o equity issuances or M&A

transactions, or example, may well bene

rom an understanding o when and why

market deviations occur. The behavioral

model provides insights into why markets

could deviate rom undamentals and wh

Modeling investor behavior

Median P/E for S&P 500

Actual1

Behavioral model1

1965 1970 1975 1980 1985 1990 1995 2000 20050

5

10

15

20

25

For correlation between actual P/E and behavioral-model P/E, r = .; r is the proportion or percentage of variance explained by a regressi

8/14/2019 MoF Issue 20

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0 McKinsey on Finance Summer 2006

conditions would make markets return to

undamentals (as happened in the 1980s,

when market values moved up as short-term

infation declined).

What holds or the stock market as a whole

is likely to hold or sectors and companies

as well. Investors tend to anchor their

expectations or growth and protability

too much in the recent past and need time

to revise these expectations to refect long-

term undamentals. In the short term the

stock market could thereore overvalue (or

undervalue) sectors or companies that have

experienced strong upturns (or downturns),

as investors expectations tend to overshoot

(or undershoot) the undamentals. From

empirical evidence, we know that this is

precisely the type o bias that shapes

analysts orecasts or companies in cyclical

industries.2 MoF

Marc Goedhart ([email protected])

is an associate principal in McKinseys Amsterdam

oce, and Bin Jiang ([email protected])

is a consultant in the New York oce, where

Tim Koller ([email protected]) is a

partner. Copyright 2006 McKinsey & Company.

All rights reserved.

2Marc Goedhart, Tim Koller, and David

Wessels, Valuation: Measuring and Managingthe Value of Companies, ourth edition, NewYork: John Wiley & Sons, 2005, pp. 65362.

8/14/2019 MoF Issue 20

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Toward a leaner finance department

Borrowing key principles from lean manufacturing

can help the finance function to eliminate waste.

Richard Dobbs, Herbert Pohl, and Florian Wol

Learning to let go: Making better ex

decisions

Psychological biases can make it difficult to get ou

an ailing business.

John T. Horn, Dan P. Lovallo, and

S. Patrick Viguerie

How to escape the short-term trap

Markets may expect solid performance over the s

term, but they also value sustained performance

over the long term. How can companies manage b

time frames?Ian Davis

All P/Es are not created equal

High price-to-earnings ratios are about more t han

growth. Understanding the ingredients that go

into a strong multiple can help executives make the

most of this strategic tool.

Nidhi Chadda, Robert S. McNish, and

Werner Rehm

The value of share buybacks

Companies shouldnt confuse the value created by

returning cash to shareholders with the value

created by actual operational improvements. After

all, the market doesnt.

Richard Dobbs and Werner Rehm

The misguided practice of earnings

guidanceCompanies provide earnings guidance with a variety

of expectationsand most of them dont hold up.

Peggy Hsieh, Timothy Koller, and S. R. Rajan

Reducing the risks of early M&A

discussions

Used early in negotiations, a third-part y clean team

can help companies assess a deal and protect

sensitive data.

Seraf De Smedt, Vincenzo Tortorici, and

Erik van Ockenburg

Smoothing postmerger integration

It takes less time than you think for a clean team

to make valuable contributions to the integration of

businesses.

Nicolas J. Albizzatti, Scott A. Christofferson, and

Diane L. Sias

PodcastsDownload and listen to these McKinsey on

Finance articles using iTunes. Check back

regularly for new content.

8/14/2019 MoF Issue 20

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Copyright 2006 McKinsey & Company

MoF Issue 20

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