Quality management teams measure the effectiveness of their M&A programs on a deal-by-deal basis. My favorite measure is Return On Invested Capital or ROIC. There are various ways to calculate ROIC. More important is the discipline of working through the process.
Consider Adobe’s $21.8 billion acquisition of Figma ($20 billion of cash and stock plus approximately $1.8 billion of RSUs to Figma management and employees). A quick and useful back-of-the-envelope calculation is the expected payback period. In other words, how long before Adobe breaks even on its $21.8 billion in total purchase consideration?
- Payback period calculation: Let’s assume that Figma will generate approximately $100 million of free cash flow next year on $400 million of revenue (the $400 million is a figure that’s in the public domain, the $100 million free cash flow figure is a number I am using for illustrative purposes). For example’s sake, let’s assume the $100 million of free cash flow will grow by 10% each year.
- Therefore, it would be approximately 33 years before the cumulative value of those free cash flows matched Adobe $21.8 billion outlay (Click Here for Excel detail).
- Ideally, one would like to breakeven or show a positive ROIC on a Software acquisition within a few years. That’s why this bubble period has made it difficult to execute acquisitions that make financial sense.
- ROIC: To calculate ROIC, one would not only consider total purchase consideration, but would also consider annual operating expenses. The sum total of these expenses for a given period would comprise the denominator while some measure of profitability such as EBITDA, Operating Cash Flow or Free Cash Flow (we prefer Operating Cash Flow and Free Cash Flow), would comprise the numerator.
- In the case of Adobe’s Figma acquisition, the massive total purchase consideration of $21.8 billion immediately puts Adobe behind the eight ball in terms of being able to show a quick payback period or a short time to a positive ROIC. In fact, it is mathematically impossible for ADBE to manifest a quick payback period or positive ROIC given the enormity of its purchase consideration, which was the approximate equivalent of 50x forward revenue – an irrational, undisciplined valuation.