In economics classes, students typically learn that a company can drive down its average cost of production by expanding. The ability to spread fixed cost across a larger base of business is supposed to result in better financial performance. We often hear companies wax eloquently about such benefits of the economies of scale when they justify their acquisitive ways.
For example, consider the March 21 comments of Rick Lindner, CFO of AT&T, who described the corporation’s pending $39 billion acquisition of T-Mobile from Deutsche Telekom by emphasizing that “. . . the scale and the combination of operational assets provide us with a path to industry-leading wireless margins. The synergies available from this combination are substantial, with a net present value that exceeds the purchase price.”
Although AT&T might do very well with the acquisition of T-Mobile, the frequency of such claims by companies begs the question as to whether larger companies actually do benefit from scale. Do large companies perform better and create more value for shareholders?
Our capital-market research on the 1,000 largest nonfinancial U.S. companies, excluding those that were not public for the full decade of the 2000s (net sample size: 748 companies), indicates that size does indeed matter — but more as a shortcoming than an advantage.
We separated the companies into four categories based on their total size in terms of earnings before interest, taxes, depreciation, and amortization (EBITDA) for the full decade. Then we assessed various measures of share-price performance, valuation, and operating performance. Since executives in large companies indicate that it becomes more and more difficult to reinvest a large percentage of cash flow back into the business as cash flow grows, reinvestment rate seems to be one very useful categorization of size.
As shown in the table below, the largest companies delivered median annualized total shareholder returns (TSR) of 2.7%, including both dividends and capital gains, versus 9.7% for the smallest group. Although the results for individual companies varied, investors were typically much better off investing in smaller companies rather than large companies.
The results also held when we assessed the valuation multiples. We examined the average forward price-earnings (PE) ratio based on the share price at the end of each of the 10 years, divided by the consensus research analysts’ estimates for earnings per share over the next 12 months. The median of the smallest companies has an average forward PE ratio of 20.9x, in contrast to 16.6x for the largest group.
Our analysis indicates these substantial share-price performance gaps can be at least partially explained by differences in operating performance. The largest companies generated 15.8% cash-on-cash returns on capital versus 19.5% for the smallest companies, notwithstanding the “scale” advantage of the biggest players. Despite the ability to spread fixed cost across a larger base of business, they are actually less profitable.