M&A activity still faces obstacles on its way to recovery. In the first half of 2024, global deal volumes dropped by 25% compared to the first half of 2023. M&A buyers continue to approach acquisitions cautiously, accounting for higher-for-longer interest rates, valuation challenges, and geopolitical turbulence.
Given the prevailing uncertainty, selecting the right acquisition targets is more important than ever. So this article explores industry-leading practices M&A buyers use to identify potential acquisition targets.
What makes a company an attractive acquisition target?
Attractive acquisition targets typically demonstrate a combination of good financial health, strategic fit, and regulatory simplicity. Let’s delve into these traits in more detail.
Financial health
Financial health is one of the decisive “attractiveness” factors for M&A targets. Let’s break down a few important financial metrics.
EV/EBITDA
Enterprise value (EV) is the total cost of acquiring the company, whereas earnings before interest, taxes, depreciation, and amortization (EBITDA) measures the target company’s core profitability. The EV/EBITDA ratio shows whether the target company’s valuation is fair relative to its core profitability.
EV/EBITDA below 10 is generally considered good, depending on the industry. This indicates that the target’s enterprise value is lower than its earnings potential, making it an attractive M&A target.
EPS
Earnings per share (EPS) measures the company’s profit per outstanding share of common stock. It shows the target’s absolute profitability and signals its attractiveness. The higher the EPS, the greater the economic value the company can deliver to potential investors.
Stocks with an [EPS] 80 or higher rating have the best chance of success.
Investor’s Business Daily
P/E Ratio
The price-to-earnings (P/E) ratio (share price divided by earnings per share) suggests how much investors are willing to pay for each dollar of the target’s earnings. Generally, low P/E ratios are considered attractive, while a higher P/E ratio means the target company acquisition is overvalued (however, other factors should be considered).
FCF
Free cash flow (FCF) measures the cash the target company generates after covering all operating expenses, taxes, and capital expenditures. Positive cash flow indicates that the target company runs a sustainable operation. A stronger FCF indicates high liquidity, making it an attractive M&A target.
ROIC
The return on invested capital (ROIC) provides insight into how the target company generates profit from the capital contributed by its investors. When the target company’s ROIC is higher than its weighted average cost of capital (WACC), this indicates that the company generates value for its shareholders and is therefore considered an attractive investment.
Revenue growth rate
The revenue growth rate measures how the target company’s revenue increases over time. Sustainable revenue growth reflects a robust business model, making a company an attractive M&A target.
Gross margin
Gross margin measures the target company’s revenue after accounting for the cost of goods sold (COGS). It shows profitability after direct expenses, making it a useful company valuation metric.
Competitive advantage
Corporate strategists typically see if an M&A target can give a potential buyer a competitive edge. The nature of this advantage can vary depending on the buyer’s competitive landscape, corporate strategy, and M&A aspirations. Let’s explore a few examples of how M&A targets can make M&A buyers more competitive.
Expanding market reach
A well-established player in the local high-growth market can become the right acquisition target for an acquiring company looking to enter that market. By acquiring such a player, the buyer inherits its customer base, supply chains, distribution channels, and brand awareness, securing a stronger market position. This is one of the main reasons for mergers between industry competitors.
Enhancing product offerings
An M&A target may offer products and services that complement the buyer’s offerings. In acquiring this target, the buyer expands its product lines and benefits from cross-selling opportunities.
Gaining technology advantage
An M&A target may possess valuable intellectual property, including patents, trademarks, and technology systems. It is common in innovation-driven sectors, like biopharma, renewable energy, and artificial intelligence. With this acquisition, an M&A buyer gains a technological advantage and strengthens its market position.
Achieving economies of scale
When aiming to achieve economies of scale, M&A buyers usually seek potential candidates with complementary manufacturing capabilities. Combining and scaling operations can lower the cost per unit, improving the buyer’s profitability and competitiveness.
Explore more advantages of merger and acquisition in our dedicated article.
Regulatory attractiveness
Today’s M&A transactions face heightened regulatory scrutiny, particularly in industry consolidation and cross-border transactions. This scrutiny can delay or cancel deals, particularly those valued at more than $10 billion, potentially eroding value and derailing target company integration processes.
According to the Global Legal Post, over 40% of cross-border acquisitions for the past four years were canceled by industry regulators. Even those deals that pass regulatory approval, face delays. According to Boston Consulting Group (BCG), 40% of deals between 2010 and 2022 didn’t close within planned time frames (globally).
The most common reasons for the delays were regulatory issues and the complexity of deal structures.
BCG
Today’s regulatory landscape pushes M&A buyers to consider M&A targets that are not only financially profitable and strategically sound but also attractive from a regulatory standpoint. Such targets typically exhibit the following traits:
- Limited market power
- Minimal market overlap
- < $1 billion in size
- Sound financial reporting practices
- Strong data security compliance
- International jurisdiction compatibility
How long does a company acquisition take? Find this out in our dedicated article.
Four common types of strategic acquisition targets
M&A buyers typically seek acquisition targets based on their chosen strategies:
- Horizontal
Horizontal M&A buyers aim for market expansion by acquiring competitors.
- Vertical
Vertical M&A buyers achieve supply chain efficiency by acquiring target companies in the same industry but at different production stages.
- Concentric
Concentric M&A buyers improve operations by acquiring target companies in related industries that offer complementary products and services.
- Conglomerate
Conglomerate M&A buyers diversify revenue streams by acquiring target companies in unrelated industries.
So let’s see which acquisition targets typically fall under these M&A strategies.
| Acquisition strategy | Acquisition target | What attracts M&A buyers |
|---|---|---|
| Horizontal | Competitors (companies in the same industry at the same level of production) | Competitive edge, market share, customers, economies of scale |
| Vertical | Suppliers, distributors, retailers, customers | Supply chain control, operational efficiency, customer access |
| Concentric | Companies offering complementary products and services | Cross-selling opportunities, expanded product lines, enhanced services, and better customer experience |
| Conglomerate | Companies in unrelated industries | Revenue diversification and financial synergies |
Three common challenges in acquisition targeting
Valuation gaps, valuation errors, and cultural nuances are the most common challenges M&A buyers face when evaluating potential acquisition targets. Let’s explore them in detail.
Valuation gaps
Amidst economic uncertainty, sellers’ expectations are typically high, while buyers’ expectations are low. This makes it challenging for cautious M&A buyers to find M&A targets that match their financial expectations.
According to Bain & Company’s annual M&A report, strategic deals declined 6% in 2022-2023 due to the validation gap. Private equity firms that usually use a significant amount of debt for acquisitions have had it even worse (37% decline in the same period).
To bridge valuation gaps, buyers have been intensively using earnouts, which are portions of the purchase price paid to the seller once the acquired business meets certain milestones. Earnouts, for instance, increased by 62% in 2023.
The time period to receive an earnout after closing can range from one to five years, with two years being the most common time frame utilized
Rachel L. Pugliese
Partner at Nixon Peabody LLP
Valuation errors
Quality financial due diligence in M&A transactions helps to make more informed decisions about target company valuations. According to Deloitte’s 2024 M&A Trends Report, it is the second most important factor for successful acquisitions.
However, insufficient qualitative data and unpredictable market conditions are among the main challenges M&A buyers face when evaluating M&A targets.
The landscape we’ve described of economic, regulatory, and geopolitical challenges makes the stakes higher all around. Mistakes and miscalculations are easier to make and will likely be more costly.
Deloitte
This pushes buyers to work closely with financial analysts and increasingly use advanced data analytics.
Cultural nuances
Cultural fit is crucial for M&A success, and organizations that adopt human-centered approaches and cultural alignment are almost three times more likely to succeed in transformation efforts than those companies that don’t.
Buyers, however, may falsely attribute cultural similarities found during pre-merger evaluations to cultural fit and skip further cultural due diligence. They risk overlooking underlying cultural differences and hindering M&A success.
Cultural similarities can create blind spots and hinder the process of understanding the cultural nuances that will inevitably exist.
EY
To avoid the risks of overlooking critical cultural differences, buyers should invest in comprehensive cultural investigations later in the due diligence process.
How to evaluate potential acquisition targets: Three best practices
Let’s explore several practical recommendations when evaluating potential M&A targets during the M&A screening phase.
Determining the acquisition value
Mergers and acquisitions are among the best corporate growth strategies but only when executives understand the value M&A targets must deliver in order to fill existing gaps in the business strategy. Is it new products, markets, revenue diversification, or tech advancements?
Conducting competitive analysis in acquisitions and carefully outlining core requirements for upcoming deals in a pre-merger strategy can help buyers consistently pick M&A targets that complement their business objectives.
Research shows that M&A buyers who systematically acquire companies that complement their existing operations (programmatic buyers) have a 2.3% median excess total returns to shareholders (TRS) versus -0.1% median excess TRS in M&A buyers pursuing infrequent large deals.
How do programmatic acquirers approach target selection? Rather than engaging in opportunistic deals, programmatic buyers build a comprehensive, structured, and disciplined approach to target screening. Let’s observe some of the main elements of this approach.
Determining attractive segments
Understanding which industry areas contain attractive M&A targets is crucial. These are usually industry segments that M&A buyers can leverage based on their growth strategies.
- Segments where businesses can successfully leverage existing strengths. For example, a smart home technology sector can be a good source of company acquisitions for a consumer electronics producer.
- Segments where companies can improve market reach, technology, and expertise. For example, bricks and mortar retailers could target online shopping brands to achieve growth in the ecommerce space.
- Segments where companies can diversify their revenue streams. For instance, electric car producers could diversify and grow their revenues by acquiring other companies in the renewable energy sector.
Doing so can yield better results during target screening. M&A buyers can select potential acquisitions from a comprehensive list of targets according to predefined acquisition criteria, like good financial health, competitive advantage, and regulatory simplicity.
Use multiple financial metrics
While executives generally use multiple financial metrics during target valuation, they may favor a few of the most convenient ones, like EBITDA. It can simplify valuation analysis but miss important contextual nuances.
While it’s generally advisable to use all available metrics, it’s also worth noting that some metrics may reveal more details in some companies than others. For instance, EBITDA typically works well for mature companies, while revenue growth rates may reflect startup performance more accurately.
| Company | Best metrics | Reasoning |
|---|---|---|
| Mature companies | EBITDA, EV/EBITDA, FCF, ROIC | These metrics are more suitable for reflecting operational performance and liquidity in mature companies with limited growth potential |
| Startups | Revenue growth, gross margin | These reflect the scalability and performance of startups that typically focus on expansion rather than profitability |
| Competitors | EBITDA, EV/EBITDA, P/E, FCF | Demonstrate the target’s potential to deliver M&A synergies and improve competitive position while being fairly priced, which is crucial in horizontal mergers and acquisitions |
| Vertical targets | EBITDA, EV/EBITDA, FCF, gross margin | Show the target’s ability to cover integration costs and maintain operational efficiency, which is crucial when integrating suppliers |
| Companies in different industries | EPS, EBITDA, EV/EBITDA, P/E | Help buyers gauge fair prices across unrelated industries and understand the targets’ potential to generate stable revenue streams without accounting for potential integration synergies |
Leveraging company culture assessment
Cultural assessments during the deal-sourcing phase can be challenging, particularly because detailed cultural insights are typically available at later due diligence stages. However, buyers can still collect valuable insights about the target’s leadership styles, communication practices, and decision-making peculiarities by doing the following:
- Researching the target company’s press releases, annual reports, social media publications, and other public materials
- Researching employee review platforms like Glassdoor where the target company’s employees share their experiences
- Interviewing the target company’s leaders about decision-making styles and cultural peculiarities during sourcing campaigns.
How to spot business acquisition opportunities: Three fundamental practices
Acquirers that approach M&A opportunities systematically improve their chances of spotting suitable acquisition targets. Here are the practices they follow.
Continuously evaluate M&A themes
Acquirers who regularly assess and evaluate their M&A themes — like market expansion, product enhancements, or diversification — are more informed about which M&A opportunities best align with their long-term goals.
[programmatic acquirers are] 1.4 times more likely than peers to strongly agree that they understand which assets they need to acquire to meet the company’s M&A aspirations.
McKinsey
Build strong M&A cases
Programmatic acquirers are more likely to build strong business cases around M&A targets and persuade board directors and shareholders to approve such M&A opportunities.
[programmatic acquirers are] 1.2 times more likely than their peers to build comprehensive business cases around M&A opportunities
McKinsey
Comprehensive business cases typically include the following elements:
- Strategic fit
Demonstrates how the potential acquisition target aligns with the acquirer’s long-term growth goals, like market expansion, vertical integration, economies of scale, or product enhancements.
- Financial analysis
Demonstrates the target’s valuation, return on investment, and projected growth suggesting that it’s a financially sound investment.
- Risk assessment
Evaluates potential acquisition and merger risks, arguing that they are manageable and outweighed by strategic opportunities.
Maintain robust M&A screening capacity
Programmatic acquirers have streamlined M&A screening processes, allowing them to scan markets and identify fitting M&A opportunities more efficiently. Key elements that make M&A screening more efficient include:
- Industry databases, market intelligence, and business valuation tools
- Strong relationships with M&A advisors and investment banks
- Proactive deal-sourcing procedures
- Standardized due diligence processes and advanced tools
- Experienced M&A screening and due diligence teams.
Key takeaways
- It’s advisable to use multiple financial metrics during M&A valuations and account for the target’s industry and growth stage. EV/EBITDA, EPS, P/E ratio, revenue growth rate, and gross margin help acquirers indicate sellers’ financial health.
- Outlining industry segments that complement buyers’ capabilities and searching for acquisition targets within improves deal-sourcing outcomes.
- To spot timely acquisition opportunities, acquirers should have the ability to continuously reevaluate M&A themes, persuade stakeholders, and build strong deal-sourcing capabilities.
