Thursday, August 18, 2005

To buy or to build?

Margsiri, Mello, and Ruckles provide a thoughtful article that models the "grow vs buy" decision.

SSRN-To Build or to Buy: Internal vs. External Growth by Worawat Margsiri, Antonio Mello, Martin Ruckes: "This paper relates growth via acquisitions to the characteristics of the possibility to grow organically"

As in most modeling papers, this should come with the standard warning that "while the conclusions laid forth in this paper are fairly straight forwards, some of the math may be more than the typcial undergraduate student (current or past) is ready to handle."

But do not dispair, I will leave the gritty details to the paper itself.

The main points:
  • There is a direct connection between the ability to grow and the price the firm would be willing to pay for an acquisition. This "important connection between the two growth
    strategies [has] organic growth..[as] the firm’s fall-back strategy and therefore has a significant impact on both the acquisition strategy as well as the acquisition price." Which is pretty intuitive: if you have have no good growth prospects, you are more willing to do an acquisition."
  • "when the growth asset is associated with a high level of volatility, firms favor growth via acquisition in order to avoid the costly time delay between the investment and the generation of revenues."
  • "a higher profitability of the opportunity to grow organically speeds up the acquisition. Since a higher value of the organic growth option leadsto a lower acquisition price, early acquisitions are profitable compared to the status quo."
  • "When a relatively high integration expense leads to a high acquisition threshold, the declining value of the outside option draws this threshold down to a lower asset value."
See that wasn't that bad. There really is a great deal more to the paper and I recommend it if you have some time (it took me a while to get through it) and you are of that temperment.

Margsiri, Worawat, Mello, Antonio S. and Ruckes, Martin E., "To Build or to Buy: Internal vs. External Growth" (March 15, 2005).

BTW If you are still confused, let's talk baseball.

For the first point, you are the GM of a major league team. You have a great catching prospect in the minors. Therefore you are less likely to acquire a free-agent catcher.

For the second point, let's take this example a bit further. Suppose you not only have a great catcher in the minors, but also a great pitching propect. Since the the volatility of pitching careers is higher than that of catching careers (stated without proof), ceteris paribus you would be more willing to sign a free agent pitcher than a free agent catcher.

One more, ok. Consider the last point. A trouble-maker has higher "integration costs". Thus even if you admire the ability of the player, you are not willing to pay as much for him.


1 comment:

Anonymous said...

Wow! I love the Baseball analogy. Thanks for the great example.