FOR some investors, most famously Warren Buffett (pic), it’s about the most important financial metric in judging corporate success – return on capital.

       The recent failure of Unilever Plc’s ￡50bil (US$68bil or RM286bil) bid for GlaxoSmithKline (GSK) Plc’s consumer-healthcare business brings the concept into sharp relief.

       For any business already making high returns, splurging on merger and acquisitions (M&A) takes some justifying.

       Buffett said nearly 30 years ago that the best business to own is one that puts large amounts of extra capital to work at very high rates of return.

       Yet analysts at RBC Capital Markets have found that this piece of wisdom hasn’t always been reflected in the performance of the consumer-goods sector.

       In the decade up to 2013, shareholders rewarded consumer companies simply for investing, regardless of the returns. But by 2020, they were rewarding those companies that invested the least.

       RBC’s explanation for the shift is that investors were recoiling at the huge deals in the second half of the decade by the likes of Anheuser-Busch InBev SA, Danone SA and Reckitt Benckiser Group Plc. All have run into difficulties.

       The stock market realised that consumer firms were doing the first bit of Buffett (deploying heaps of additional capital) but not the second (earning high returns on it).

       Against that backdrop, large deals are going to be a challenge for all companies that make, or at least appear to make, impressive returns from their existing activities.

       In 2020, Unilever’s operating profits, adjusted for taxes and one-off items, represented an 18% return on ？40bil (US$45bil or RM189bil) of invested capital (as measured by the company). One reason behind the strength of this number is the sheer profitability of branded products.

       Accounting and deal dynamics make it hard for a company like Unilever to do a major acquisition without damaging that high-teens return. In any takeover, the selling shareholders will try to push the bidder to their limit.

       When deciding how high to go, acquirers will often focus on returns in terms of the net profit boost provided by the acquisition as a percentage of the purchase price.

       So long as that’s above the target’s cost of capital, the M&A primer says the deal is sound. For consumer-staples companies, that threshold could be just 5%-10% (and often at the lower end).

       Such an approach overlooks the bigger picture that investors appear preoccupied with – the overall profit made by the combined company on its enlarged capital base.Modeling a sweetened offer for GSK’s consumer-health arm at ￡55bil (RM311bil), RBC reckoned Unilever’s return on invested capital would have been just 9% initially – almost half what it might be otherwise. Ouch.

       Might this be too harsh a criticism? After all, the returns calculation for the whole company, as opposed to just the acquisition, is a slippery one.

       The invested capital number reflects the costs of historic investments, and for a host of reasons it may be too low and so overstate the returns the company seems to be making, according to analysts in UBS Group AG’s Fundamental Analytics team.

       Still, it’s not the only imperfect metric in finance.

       And the fact remains that analysts and investors are focused on it.

       They are certainly right to keep an eye on changes in a company’s returns, if mindful of the measure’s flaws.

       When a mooted deal is so big it would absorb all of the bidder’s financial and management resources, and the scope to further expand the business isn’t clear, expect questions to be asked.

       Analysts at Bernstein argue that consumer companies should seek returns either from in-house innovation or by buying small-and medium-sized companies and taking them global.

       Such deals may look expensive based on their starting financials, but they’d pay back handsomely if the buyer can grow the acquired firm’s sales five-or tenfold (not that this is guaranteed).

       Of course, much of the negative reaction to Unilever’s attempted GSK deal reflected doubt over the management team’s ability to make it a success and the huge borrowings required to finance it.

       Perhaps a different buyer would have gotten an easier ride.

       But other companies should heed the message.

       It would be wrong to say they should only do deals that immediately reinforce existing high returns – that would rule out most M&A.

       But the bigger a takeover is, the tougher the job of explaining why there’s no better alternative investment plan. — Bloomberg

       Chris Hughes is a Bloomberg Opinion columnist covering deals. The views expressed here are the writer’s own.