The value of a company is the sum of the present value of its future cash flows, discounted at some rate that appropriately compensates investors for the risk they're taking. This is one of those elegant, load-bearing tautologies, like net worth equals assets minus liabilities, or that evolution selects for the fittest, where fitness is defined by the ability to reproduce. It's a mix of "duh" and "wow." And you can build fascinating, testable predictions off of them, and advance the state of the world, just by starting with a premise that basically asserts itself, just in a way that's structured enough that you can usefully apply it to specific scenarios.

The tautological part of the discounted cash flow model is that the discount rate is whatever a given investor demands to be paid for the risk they're taking. So the DCF model is basically saying that there are two things that contribute to the price of an asset: the unknown future cash flows, and what's going on in investors' heads when they decide how much they'd want to be paid to take the risk that those cash flows won't materialize.

But it turns out to be useful, because you can decompose so many questions about how a given change in the state of the world affects the value of an asset by asking: does this change the level and timing of their future cash flows? And how does it affect how risky those cash flows are?

For M&A, there are three good levers to consider:

1. Synergy is a real thing. A merged company ends up having twice as many C-level executives as it needs, and has similar but smaller excesses moving down the org chart. It's a bigger customer for its suppliers, too, and can extract better terms. There are often opportunities to cross-sell complementary solutions into the new merged customer base. And in many cases, if two companies in a given industry merge, it will turn out that they've discovered different kinds of tacit knowledge, and that the sum of these is greater than the parts.

2. When a buyer is counting the net present value of future cash flows, they're not just looking at the cash flows of the company they're buying; they're considering their own cash flows conditional on having bought them. This can play out in a purely redistributive sense, where one less competitor means that the remaining companies can charge more. (On the other hand, if the widget industry has ten participants who have 10% market share, and one of them pays a premium to buy the other, and a nine-firm widget business can charge a little bit more—80% of the benefit goes to someone other than the buyer, but the buyer pays all of the merger premium to make it happen. And regulators pay pretty close attention when one company with, say, 70% market share tries to buy a competitor who controls half of the remaining market.) The more interesting case is when an industry is locked into a prisoner's dilemma: when airlines are fragmented, any one airline benefits from ordering more planes and thus reducing their average cost, but that means the industry as a whole is constantly overproducing, and no one has pricing power. Thisleads to a cycle where airlines in general are unstable, and unions appropriately respond to incentives by getting whatever they can while they have the opportunity. And it occasionally meant that airlines shut down literally overnight; Aloha Airlines gave passengers one day's notice that they were shutting down, Skybus was also abrupt, and Europe's fiercely competitive budget carrier industry features similar collapses like Monarch, WOW, and Germania. It's a temporary consumer subsidy, but the subsidy takes the following form: your ticket is cheaper than it otherwise would be, but your airline may or may not exist to take you on the homebound leg of your round trip. When the industry consolidated, everyone could look a little further ahead, and the industry turned out to be more operationally and financially resilient to a global pandemic in 2020 than it was to a period of elevated fuel prices in 2008.

3. The airline example illustrates something else, too: these airlines were lowering their discount rates—and so were the unions, the aircraft manufacturers, the credit card companies, etc. Once it was pretty clear that Delta, United, and American were probably going to be around in ten years, unions could ask themselves whether a 10% raise right now really made more sense than locking in, say, 5% annual raises for a few years. And when they do that, Boeing and Airbus can be more confident that someone ordering aircraft for delivery years from now will be in a position to pay for them.

And then there are some bad levers to consider: CEOs tend to have healthy egos. If they compare themselves to similarly-skilled CEOs, they'll probably think they could run things a bit better. It's almost impossible for this not to be the case to at least some degree.¹ So, they'll tend to overestimate the synergies, but perhaps underestimate the counterfactual downside of having one more competitor, and they'll almost certainly put too low a discount rate on the result.

You can just simplify this by saying that controlling a company is worth some premium over being a minority shareholder, but if that were the case, you'd expect to see that the companies with the best governance sold with a minimal premium, and that a company that's run entirely for the benefit of executives can get taken out at a giant multiple. But that doesn't really happen—partly because some companies in the latter category get taken out at a modest multiple by those same executives, as one last act of shareholder exploitation. Even if that's part of what happens, it won't be a big part, because when wealth gets transferred from the company to management, the company doesn't grow as quickly, so it's going to be a smaller share of the phenomenon regardless.

What's really going on is that the corporate wrapper around particular collections of assets, people, and company culture is not necessarily the optimal one. Sometimes, one company really ought to be two or three, and it uses spinoffs or divestitures to accomplish that. And sometimes, there are two legally-distinct companies that happen to contain a very complementary set of assets, it's obvious that they'd be more valuable together, and an M&A premium from the largest to the smallest is a good way to fairly split those gains and then get things off on the right foot.

Thanks to this tweet for the suggestion. It is, indeed, something I would write about.

Companies rise and fall, and some of them do so in an acquisition-heavy way. We’ve covered this in a few different places:

• GE had a little too much synergy ($).

• Teledyne, in contrast, got it right.

• Mergers and acquisitions create opportunities for another set of deals: betting on which ones will close.

• You can learn a lot about merger synergies from the airline business.

Join the discussion!

1  It's part of the general phenomenon where if you generalize about successful people (or organizations, or ideologies, or whatever), you're generally looking at a snapshot of who's successful right now. That means you'll include some people who were irresponsible and got lucky, and you'll exclude some people whose actions would on average make them successful, but who had bad luck. This is a pervasive problem in understanding the world, and it's understandable that it makes some people feel nihilistic. Sometimes, you just need to confidently say that if we reran the world simulation starting fifty years ago, and used a different random seed, the set of people who got rich by taking a series of insane gambles would be a completely different one. Also, if you look at old issues of the Forbes 400, you can see people who got rich in kind of dumb ways, remained dumb and risk-seeking, and ended up much poorer.