Paper or Plastic? It Really Matters When Your Are Buying a Company
I was thinking about the Skype acquisition by eBay the other day—some $2 to $4 billion dollars, depending on earn-outs—and how shocking that sum sounds, especially for a company with very small revenues. But management and investors both make a big mistake when they equate paying cash for a company to buying it with stock. The two are radically different transactions, and to say that they converge on a common price is to misunderstand the nature and function of currency.
Paying cash for a company makes sense for accretive acquisitions which will improve the acquiring company's financials in the coming year, top and bottom line. After all, cash is money that you could have given back to investors, and so when you don’t, it is right that you put it to work in ways that will generate immediate returns for them at your existing P/E ratio.
Paying equity for a company is an entirely different matter. It makes sense when you are making strategic acquisitions that are dilutive in the short term but which you expect will fundamentally change your competitive advantage profile, and thus your earnings potential, in the long term. In effect, you are not acquiring a going concern but instead mixing two gene pools to create a next generation of capability. You are going to create a new P/E ratio.
Equity is not actually currency, it is ownership rights, and although markets are willing to trade one for the other, they should not confuse the two. eBay gave up around 4% of its ownership rights to gain Skype. That is a good deal if Skype can change eBay’s future earnings potential by more than 4%, a bad deal if it cannot The cash value of the transaction is a distraction in this calculation.
Too many boards and CEOs are unwilling to pay up for major acquisitions because they see them only as adding in cash flows and not as marriages with the potential to create wholly new offspring. As a result they do not improve their competitive advantage sufficiently to deal with the next round of natural selection in their marketplace. Their stocks languish and eventually decline because, like marriage-averse bachelors, they are never able to take the plunge.