Suppose you own stock in a company, and it’s announced that the company is buying another company. As an investor, you need to know how to analyze this event to decide whether the acquisition is a good one. Here are some things to consider.
Why is the Company Making the Acquisition?
This seems like an obvious question, but sometimes investors skip this one and they shouldn’t. Listen to the reason the company, that you own stock in, gives for purchasing the other company, and see if it makes sense to you. Is the company making the acquisition to gain increased market share? Will the acquiring company have access to new product lines after they make the acquisition?
Make sure to read some of the analysis and commentary from knowledgeable independent observers regarding the acquisition, and keep theirs comments in mind as you continue your own research. The main thing to remember when you evaluate the acquisition is that a company should only acquire another if the acquisition is going to add value to the acquiring company.
When one company acquires another, it’s getting the entire business. That can contain the assets of the other company along with its business operations, and ideally the business expertise of the acquired company’s management. So what has the company whose stock you own bought? Does the acquired company’s business fit, is it compatible? Does it have similar products or complementary markets? The acquisition arrangement usually works best with closely related products, services and markets. For example, a company that makes heavy industrial vehicles might buy a company that makes heavy farm equipment. If, on the other hand, the heavy industrial vehicle maker bought an ice-cream manufacturer, that would not be a good fit.
Does the acquisition add a series of operations, such as a supply chain for a successful product line? If the heavy industrial vehicle maker bought its supplier of components and raw materials that would be vertical integration of the two companies and can often work well. Is the acquired company in a completely different business altogether? For example, the heavy industbil vehicle maker might buy an overseas consumer retail company. The combined companies end up as a conglomerate, where the two companies’ combined operations might not go together all that well. Conglomerations are often the most difficult acquisitions to do successfully.
How Much Will the Acquisition Cost?
Like buying anything else, part of assessing whether buying a company is a wise purchase is to determine if the acquiring company pays a reasonable price. A rough rule can be that a fair price is a purchase price with a ten percent premium over the acquired company’s stock price. Anything more than this is usually considered overpaying. Investors should also compare the current stock price of the acquired company to its book value to see that the stock price itself is not currently inflated far beyond book value, which can be another way to overpay. If a company overpays for an acquisition it can take several years of earnings growth, if ever, to recover that money.
How Will the Acquisition be Paid For?
The acquiring company can pay for the company that it is purchasing in cash, with stock, or debt financing. If the company, you own stock in has, excess cash to do the acquisition that can be a healthy financial sign for the acquiring business, as can buying the acquired company with stock. Look carefully at any debt financing to see if that might weaken the acquiring company’s financial structure going forward.
How Will the Earnings be Affected?
This may take some intelligent projecting, but by using financial data it is even possible for the amateur investor. Look at the history of earnings of both companies, then examine analysts’ future earnings projections of both companies and try to assess the projected future earnings of the combined company after the acquisition. This will of course be inexact, but what you are looking for is that after the acquisition the new company will increase its earnings per share via the acquisition, not decrease them. This ultimately will be the earnings bottom line which will tell whether the acquisition should be successful or not.
Other Useful Information
There are other things investors should consider when analyzing an acquisition. Will the companies’ cultures be compatible? Even companies in the same industry often have different cultures, attract different types of workers, and operate with different styles. Try to determine whether the acquisition’s business culture will fit into the company which purchased it. Also, will the management structures be compatible? Eventual success of integration an acquisition can hinge on similar management. Another factor is whether or not the acquisition was friendly or hostile, which is whether the acquiring company initially agreed to being bought, which is a friendly takeover, or it didn’t, which results in a hostile takeover. Lingering resentments from a hostile takeover can make integrating the acquired company into the purchasing company difficult.
Putting All of the Information Together
There are a number of more complicated financial measurements which professionals use to evaluate whether or not an acquisition is a sound one, but for our purposes here the above criteria will give you an effective basic analysis of any acquisition announcement. Assessing the factors such as the compatibility between the two companies, or whether or not the purchaser paid a fair price, help to assure investors that the acquiring company will be able to add value by increasing earnings in the future due to the acquisition.
The important thing to remember is that, again, the ultimate goal is to have the acquisition increase the earnings capacity and therefore the shareholder value of the company after the acquisition has been completed. With these tips on what to look for in an acquisition announcement, you can give yourself the best chance as an investor to make a wise decision in analyzing one company’s purchase of another.