When one company acquires another there is a possibility that the deal will be a tremendous success, or a catastrophic failure. The key for investors is to be able to decipher the news reports and then to determine whether the deal warrants the investment in, or the immediate sale of the purchasing company. Read on for some suggestions for analyzing acquisition deals.

Gauge Cash Needs
Some companies are well capitalized. They have all the money they need for the foreseeable future to grow their businesses and remain competitive. However, many companies are not so lucky. They routinely have to tap the equity or debt markets, or seek bank loans in order to obtain funds.

For this reason, investors should read what management is saying about the company it is about to acquire, or has recently acquired. Is cash needed to fund future growth, add employees, or to build additional office space? If the company being acquired is a public company, review its most recent 10-Q or 10-K.

Check the cash position. If the company is losing money, try to determine its burn rate. This will enable you to gauge if and when the company will need additional funds.

If you think the company will need a cash infusion try to determine how it will be supplied. Does the acquiring company have ample cash to fund the acquired company's growth with no problem, or will a potentially dilutive stock offering have to be completed in order to secure funds? These are all questions that should be answered in order to determine the deal's impact on the acquiring company's financials.

You should also remember that unless a company receives an offer it simply can't refuse, companies that are on solid financial footing typically don't sell at all.

Assess Debt Loads
One of the worst things that a company can do is to acquire an enterprise that has a huge volume of debt that's scheduled to come due at some later date. After all, increased debt loads can be a tremendous distraction to the acquiring company, particularly in the troughs of a business cycle.

That said, in some instances, large volumes of debt can provide a significant opportunity for the suitor. How? Through refinancing! In fact, during the late 1990s and early 2000s, a number of high-profile casinos scooped up smaller players, and saved a ton of money for their shareholders by refinancing debt that had originally been issued at high coupon rates.

In short, lofty debt loads should send up a red flag. That is, unless the suitor has deep pockets/collateral, and a reputation as a low credit risk so as to refinance the obligations at a materially lower rate.

Consider Liability/Litigation Risk
When a deal is announced, or even suspected, and both the buyer and the seller are known, investors should immediately go to the seller's proxy statement and 10-K to review Management's Discussion & Analysis, as well as any content about risks or disclosures. The idea is to try to determine whether the suitor will be acquiring a huge potential liability.

Look for lawsuit details, or guarantees the company has offered to secure the debt of third parties. Read the fine print. You'll be happy you did.

Almost every public company at one point or another will be sued. For the most part, a large number of the suits will be settled without anyone declaring bankruptcy. However, if a number of suits are pending, and management's description of the situation is ominous, consider steering clear of the situation.

Ponder the Details of Integration
Obviously, when the acquisition is consummated, there is no need for two chief executives or two chief financial officers. In addition, there may be no need for some facilities because of these redundancies. As such, investors need to determine how long a successful integration will take and at what cost.

There will be some costs associated with the combination of two companies, particularly if two sales forces are merging. However, if the costs seem excessive, or if management is suggesting that the deal won't add to earnings for a year or more, consider bailing! Remember, there are plenty of things that can go wrong in a year's time. Ideally, you want to be on the lookout for acquisitions that are immediately accretive to earnings, or that can be soon after the deal is inked.

Determine the Severance Costs
In conjunction with the elimination of redundancies, layoffs are likely to occur. Many former employees may be entitled to pension benefits and a host of other costly payroll items. This is just one (of the many) reasons why consolidation in unionized industries isn't more popular - the cost of paying benefits to thousands of laid-off union members would be prohibitively expensive.

If a company that you're interested in announces an acquisition, be on the lookout for how much severance costs will amount to, and whether they can be booked in a short period of time. If it appears that these costs may go on for a number of years or consume a significant percentage of earnings, consider heading for the exits.

Bottom Line
Acquisitions can present tremendous opportunities or major disasters for investors. It is up to the investor to determine how a stock will be affected and, if necessary, get out before it's too late.

Related Articles
  1. Fundamental Analysis

    Mergers And Acquisitions: Understanding Takeovers

    In the dramatic world of M&As, battleground terms meld with bizarre metaphors to form the language of the game.
  2. Fundamental Analysis

    Key Players In Mergers And Acquisitions

    Strategic acquisition is becoming a part of doing business. Discover the different types of investor groups involved.
  3. Forex Education

    Mergers & Acquisitions: An Avenue For Profitable Trades

    When major corporate transactions have a big impact on the currency markets, you can benefit.
  4. Entrepreneurship

    Biggest Merger and Acquisition Disasters

    Find out which companies collapsed after merging.
  5. Insurance

    The Wonderful World Of Mergers

    While acquisitions can be hostile, these varied mergers are always friendly.
  6. Stock Analysis

    The Biggest Risks of Investing in Netflix Stock

    Examine the current state of Netflix Inc., and learn about three of the major fundamental risks that the company is currently facing.
  7. Stock Analysis

    What Seagate Gains by Acquiring Dot Hill Systems

    Examine the Seagate acquisition of Dot Hill Systems, and learn what Seagate is looking to gain by acquiring Dot Hill's software technology.
  8. Professionals

    Hard and Soft Due Diligence: What's the Difference?

    Learn about the differences between "hard" and "soft" due diligence in a mergers and acquisitions deal (M&A) and why soft diligence is increasingly important.
  9. Stock Analysis

    How UPS Plans to Benefit from Its Coyote Acquisition

    Understand the business models of UPS and Coyote Logistics. Learn about the top four ways in which UPS will benefit from the acquisition of Coyote Logistics.
  10. Investing

    A Look at 6 Leading Female Value Investors

    In an industry still largely predominated by men, we look at 6 leading female value investors working today.
  1. Can working capital be too high?

    A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>
  2. How do I use discounted cash flow (DCF) to value stock?

    Discounted cash flow (DCF) analysis can be a very helpful tool for analysts and investors in equity valuation. It provides ... Read Full Answer >>
  3. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  4. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  5. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>
  6. How can EV/EBITDA be used in conjunction with the P/E ratio?

    Because they provide different perspectives of analysis, the EV/EBITDA multiple and the P/E ratio can be used together to ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  2. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  3. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  4. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  5. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  6. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!