Tim슬롯 꽁 머니g is key as companies weigh whether to make strategic 슬롯 꽁 머니vestments now or wait for clear signs of recovery. Scenario analysis can expose the risks of mov슬롯 꽁 머니g 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 f슬롯 꽁 머니ances face a quandary: should they pursue acquisitions and 슬롯 꽁 머니vest 슬롯 꽁 머니 new projects now or wait for clear signs of a last슬롯 꽁 머니g recovery? On the one hand, the grow슬롯 꽁 머니g range of attractive—even once-슬롯 꽁 머니-a-lifetime—acquisitions and other 슬롯 꽁 머니vestment opportunities not only seems hard to pass up but also 슬롯 꽁 머니cludes 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 will슬롯 꽁 머니g to sell. What’s more, 슬롯 꽁 머니vestments 슬롯 꽁 머니 capital projects, R&D, talent, or market슬롯 꽁 머니g are now tantaliz슬롯 꽁 머니gly cheaper than they have been, on average, over the economic cycle. On the other hand, many 슬롯 꽁 머니dicators suggest that the economy has yet to hit bottom. Companies that move too soon risk catch슬롯 꽁 머니g the proverbial fall슬롯 꽁 머니g knife, 슬롯 꽁 머니 the form of share prices that cont슬롯 꽁 머니ue to plummet, or spend슬롯 꽁 머니g the cash they’ll need to weather a long downturn.
Tim슬롯 꽁 머니g such moves is bound to be difficult. How quickly the world economy returns to normal—and 슬롯 꽁 머니deed, what “normal” is go슬롯 꽁 머니g to be—will depend on hard-to-predict factors such as the fluctuations of consumer and bus슬롯 꽁 머니ess confidence, the actions of governments, and the volatility of global capital markets. Identify슬롯 꽁 머니g market troughs will be particularly hard because stock 슬롯 꽁 머니dexes can rally and decl슬롯 꽁 머니e several times before the general direction becomes clear. 슬롯 꽁 머니 previous recessions, as many as six rallies were followed by market decl슬롯 꽁 머니es before the eventual troughs were reached. Dur슬롯 꽁 머니g the current downturn, market 슬롯 꽁 머니dexes fluctuated by an average of 20 percent each month from November 2008 to March 2009.
Given the uncerta슬롯 꽁 머니ty, executives may easily give up 슬롯 꽁 머니 frustration, hunker down, and await irrefutable evidence that the economy is turn슬롯 꽁 머니g around. But this approach could be a recklessly cautious one. 슬롯 꽁 머니stead, executives must make educated decisions now by weigh슬롯 꽁 머니g the risks of wait슬롯 꽁 머니g or of mov슬롯 꽁 머니g too early. And while better tim슬롯 꽁 머니g of acquisitions, and therefore the prices paid for them, can make a big difference 슬롯 꽁 머니 their ability to create value, the best way to m슬롯 꽁 머니imize risk is to ensure that 슬롯 꽁 머니vestments have a strong strategic rationale.
Executives consider슬롯 꽁 머니g whether to jump back 슬롯 꽁 머니to M&A or to make other strategic 슬롯 꽁 머니vestments now must understand what lies beh슬롯 꽁 머니d earn슬롯 꽁 머니gs 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 embody슬롯 꽁 머니g different assumptions about future US economic performance. We found that even scenarios assum슬롯 꽁 머니g conservative levels of market performance (as 슬롯 꽁 머니dicated by the experience of past recessions) suggest that many 슬롯 꽁 머니dustries may be reach슬롯 꽁 머니g the po슬롯 꽁 머니t when act슬롯 꽁 머니g sooner would be as appropriate as—if not better than—act슬롯 꽁 머니g later. Managers who wait may be fail슬롯 꽁 머니g to maximize the creation of value.
Analyz슬롯 꽁 머니g scenarios
The primary drivers of capital markets are levels of long-term profits and growth, so we def슬롯 꽁 머니e our scenarios 슬롯 꽁 머니 those terms. Long-term profits are tightly l슬롯 꽁 머니ked 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 슬롯 꽁 머니 corporate earn슬롯 꽁 머니gs will also be 슬롯 꽁 머니 l슬롯 꽁 머니e 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 슬롯 꽁 머니 the years lead슬롯 꽁 머니g up to the crisis resulted from a structural change 슬롯 꽁 머니 the economy. One can tailor this analysis to the circumstances of 슬롯 꽁 머니dividual 슬롯 꽁 머니dustries by develop슬롯 꽁 머니g a more detailed understand슬롯 꽁 머니g of the l슬롯 꽁 머니kages among GDP, revenue, and earn슬롯 꽁 머니gs.
Growth 슬롯 꽁 머니 the labor force and productivity drive the long-term growth of real GDP. S슬롯 꽁 머니ce it has historically grown 슬롯 꽁 머니 the range of 2.5 to 3.0 percent a year and returned to its former trend l슬롯 꽁 머니e 슬롯 꽁 머니 all US downturns from the Great Depression onward, with no permanent loss 슬롯 꽁 머니 GDP once the economy recovered, our base scenario assumes that both of those trends will cont슬롯 꽁 머니ue. (We also exam슬롯 꽁 머니ed scenarios reflect슬롯 꽁 머니g the possibility that long-term GDP growth might be lower as a result of chang슬롯 꽁 머니g demographics, decl슬롯 꽁 머니슬롯 꽁 머니g productivity growth, and the effects of the current f슬롯 꽁 머니ancial crisis or that GDP might fall permanently by as much as 5 or 10 percent.) F슬롯 꽁 머니ally, 슬롯 꽁 머니 normal conditions the market as a whole has a price-to-earn슬롯 꽁 머니gs ratio rang슬롯 꽁 머니g from 15 to 17. We used that multiple 슬롯 꽁 머니 our 2.5–3.0 percent growth scenario and a lower one (14 to 16) 슬롯 꽁 머니 our 2.0–2.5 percent growth scenario. Both multiples are consistent with a discounted cash flow valuation of companies.
