We've recently explored some of the alternatives companies have to deploy "free cash flow" to enhance value for shareholders.
We defined free cash flow as what a company has left after making the expenditures needed to maintain its standing in its industry.
A company typically has multiple options, including making incremental investments in plant and equipment to spur internal growth, paying or increasing dividends, and repurchasing the company's stock on the open market.
Perhaps the most exhilarating use of excess cash flow, from the perspective of both executives and shareholders, is to make acquisitions. In the business world, nothing gets the blood circulating faster than doing a deal.
Public companies are particularly emboldened to make acquisitions because, in addition to using free cash flow, they can use stock as currency.
On balance, we prefer to see companies make acquisitions with cash vs. issuing shares. By issuing shares, a company is, in effect, trading away a portion of its business for the assets of another.
And if a company is not diligent in assessing the intrinsic business value it is giving up, shareholder value can be destroyed. It rarely makes sense to trade away a portion of a truly great business to acquire something new.
Acquisitions, when properly structured at a rational price, can create long-term value for shareholders. But they also are an area fraught with peril.
The competitive market for acquisitions practically guarantees the payment of a full (and often a premium) price when one company buys another. When a company overpays for an acquisition with its cash, or issues its own stock and receives less in return than it gives up, existing shareholders have their wealth reduced.
During the acquisitive 1990s, companies often used purchases as a means to manipulate earnings. In so-called "big bath" accounting, companies would take large "restructuring charges" following acquisitions.
Investors were told the losses were onetime events and should be ignored. Often though, a portion of these charges was held back in reserve accounts, which were later reversed and included as income when it was necessary to "meet Wall Street's expectations."
Acquisition accounting improved dramatically in 2002 when rule-makers required companies to treat these transactions as a "purchase," with the assets and liabilities of the acquired company recorded on the buyer's financial statements at fair value.
Mergers and acquisitions can provide a means for companies to grow and become stronger. But investors should scrutinize the rationale or the "synergies" typically touted by management in any proposed business combination.
They should cast a skeptical eye toward the glowing five-year projections, precisely prepared by the company's advisers, that more than justify the proposed acquisition.
Unless the price paid in an acquisition is rational, down the road investors will be greeted with those pesky "one-time" charges.
If they were being candid, what the executives would say instead is, "We goofed up and lost money."
Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or firstname.lastname@example.org.