Keep your eye on the profitability ratios

Qingfeng “Wilson” Liu, professor of Finance and Business Law in JMU’s College of Business, has a restless intellect that propels his pursuit of multiple research interests.

While Liu’s primary focus is on financial instruments such as futures, options and derivatives (his doctoral dissertation at the University of Oklahoma was on electricity and natural-gas futures), he also has a long-standing interest in corporate finance, including mergers and acquisitions.

One thing he thinks he’s learned from his study of the latter topic is that “better acquirers make better acquisitions.”

In a broad, cross-sectional study published recently, Liu and collaborators Hui Sono (academic unit head for the Department of Finance and Business Law and J. Gray Ferguson Eminent Professor) and Wei Zhang (of California State University in Chico) used a new set of measurements to gauge the quality of a management team which may be considering whether to seek a combination between its own company and a potential target.

In place of traditional indicators such as price-to-earnings ratio and price-to-book ratio, they looked at “accounting profitability,” which they defined as a function of other ratios such as 1) gross profit margin, 2) operating profit margin and 3) net profit margin.

“We used those ratios to measure managerial quality,” says Liu, “and to see, when a team engages in merger-and-acquisition activity, whether there are any differences — especially long-term differences — in the return to investors arising out of that activity.”

The traditional measurements, he says, contain a market-valuation factor which is subject to market mispricing. Such mispricing can make it more difficult to draw reliable conclusions about management quality. According to Liu, it has contributed to some of the inconsistency of the findings previously reported in the literature on the topic.

He and his co-authors assert that the accounting-profitability measurements, on the other hand, are generally free of market-misevaluation “noise.” This puts them in a better position to provide useful guidance concerning a management team’s likely future performance.

Based on the three indicators of accounting profitability, Liu and his co-authors looked for relationships between the ratios and management teams they deemed to be of superior quality. For example, are those teams making better decisions about which firms to acquire, in terms of producing higher returns for investors?

Liu states that the bedrock principle underlying all financial management is maximization of the wealth of those investing in a business concern. If the three profit-margin measurements indicate that the management of an acquiring company is of subpar quality, then its involvement in merger-and-acquisition activity may well result, in the long run, in erosion of the company’s value to investors.

When a merger-and-acquisition event is taking place, says Liu, investors should therefore keep close watch on measurements of the quality of the acquiring company’s management team, which can be expressed in terms of the three accounting-profitability ratios.

If these ratios are robust, he says, it is more likely that a business combination will produce positive long-term returns for shareholders.

Liu and his collaborators also found that top-quality management teams are typically more cautious about pursuing mergers and acquisitions.

“There’s risk inherent in any attempted merger or acquisition,” he points out.

Liu says the primary reason to proceed with a proposed business combination is synergy — “one-plus-one is greater than two.” However, there’s often considerable uncertainty around whether the hoped-for synergy will in fact materialize.

A further discovery by Liu and his collaborators was that the best management teams typically prefer to pay in cash rather than stock.

If the transaction is a good one, share prices will rise, Liu explains. Paying with cash is therefore more cost-effective than paying with stock, since an increase in share-price causes the transaction to become more expensive to the acquirer.