Notes On Acquisitions 

Financial media loves acquisitions. They love to glorify the ones that happen, and they love to speculate on those that are rumored to happen. But do they create value? The short answer is yes, of course, but not always. Acquisitions only create value when the combined cash flows of the two companies increase due to cost reductions, accelerated revenue growth, or better use of fixed and working capital. You also have to take in the cost of labor and the time it takes to assemble an acquisition. It is A LOT of work. Therefore, if an acquisition is going to be successful, it can't just be marginal improvements on everything mentioned above; there needs to be radical performance advancements for the company.

One fallacy executives and bankers like to use to justify an acquisition is the belief that if company A buys company B, the stock market will apply A's P/E to B's earnings or vice versa. They even have a term for this; it's called multiple expansion. The idea is that the market will mix up Company A's and Company B's earnings and won't be able to tell the difference. Multiple expansions sound great, but it is not a reliable way of justifying an acquisition with no real benefits other than hoping the financial technicalities will fool the market. 

Unfortunately, companies often do justify acquisitions with that unlogical thinking. However, in the end, that logic is not sustainable for the long term. If the executives can't highlight the specific source of increased cash flow - the stock market will not be fooled. They may experience a short-term bump in EPS, but at some point, you still have to provide an annual report highlighting where your current cash flows are. 

Nutshell Summary: Acquisitions are great for media coverage and short-term bumps in EPS. However, they're only successful when the combined cash flows of the two companies increase due to cost reductions, accelerated revenue growth, or better use of fixed and working capital. And not just marginal improvements, substantial ones.