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Editor’s note: This article is written by Justin Teo of Investrepreneurship
It’s no secret that we all want to see growth from the companies we bought stock in. Generally, companies can either grow organically or grow through acquisitions. In this article, I will highlight some of the reasons why growth contributed by improved sales from current operations or organic growth is better than growth contributed by buying other companies.
Organic growth can be bought by simply investing lots of money in opening new stores, advertising, and etc. Growing sales and profits by 10% through putting an additional 50% more capital to work isn’t really a great thing. True, companies need to invest to growth, but management should always consider the return on investment in whatever expenditures they make, and always focus on achieving a good return on shareholder’s equity. In this article, we will assume that organic growth is reasonably profitable.
Paying a Premium
When trying to acquire quality companies, the acquiring company might need to pay a price that is higher than the intrinsic value of the company targeted for acquisition. Sometimes, the premium paid can be quite large, and may result in significant goodwill write downs and losses in the future.
Taking on More Debt or Issuing More Stock
Unless the company is an Apple or a Microsoft and have lots of cash lying on the balance sheet, it probably would have to take on debt or dilute shareholders by issuing more stock to finance its high-value acquisitions. As we all know, neither issuing more stock nor taking on a lot of debt is a good thing.
Culture ClashDifferent companies have different cultures, and it can be a challenge for a company to integrate its new employees from a company it has acquired to its culture. This can result in conflict and lower productivity. In some cases, the culture clash can be so bad, that some key employees, employees that made the acquired company great in the first place, decide to leave; this can significantly impair the intrinsic value of the investment made by the acquiring company.
For fast-growing companies, it is better to focus on growing their current operations than it is to be focusing on buying other lower-growth companies. So, unless the acquisition has strategic value, it doesn’t make sense for such companies to channel their efforts into looking for acquisitions to accelerate growth when they can just put their efforts into growing their core businesses.By spending money on acquisitions and not reinvesting in its own operations, good growth companies can not only really set their long-term growth rate back, but might miss out entirely on the opportunity for growth presented by their core businesses, due to their rivals taking market-share when they weren’t focusing on their own operations.
I’m not saying that acquisitions are bad; acquisitions that make good strategic sense and made at the right price can create long-term shareholder value. I’m just saying that organic growth is key, as reasonably profitable organic growth comes as a result of managerial expertise and cannot be easily bought.
If you like this article, you might want to check out some of the things I think about when evaluating a stock here, or maybe even just drop by my blog for a bit. Thanks for reading, and may you always sustain good returns on your portfolio.
Justin Teo is a private investor and is currently studying for his degree in international business. Investrepreneurship is a blog about investing, entrepreneurship, and business in general. You can subscribe to Investrepreneur’s feed here.
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