Large corporate acquisitions often seem not to work out. When one company acquires or merges with another, at the time the rationale often is that there will be strategic "synergies," making the combined company more valuable than the companies were worth by themselves. There might be major cost savings from eliminating duplicative overhead. Or there might be economies of scale, as when a broader product line can be sold with the same sales network, or higher output from existing production facilities reduces unit costs. Even though most acquisitions involve a considerable premium over the acquired company's stock price, executives assure skeptical investors and analysts that the takeover will be "accretive," (additive to earnings per share) in the first year--or at least in the second.
But it often doesn't work out that way. It seems that the bigger the merger, the less sense it makes. Take yesterday's announcement by Rio Tinto, the world's second-largest mining company. The company plans a $14 billion writedown of "goodwill" that it put on the books due to acquisitions of aluminum companies, the largest being Alcan for $38 billion in 2007.
Though the company will argue that the $14 billion loss is non recurring and "extraordinary," it still reduces Rio Tinto's shareholder equity by $14 billion.
Rio Tinto's management has written off $29 billion of assets since 2009. The company's stock market value is $77 billion. So, the company has written off an amount equivalent to 40% of its stock market value.
It is for examples such as this that I emphasize actual net income, after the "bad stuff" such as supposedly extraordinary asset write downs. Instead, Wall Street uses "operating" earnings, which excludes such losses. Yet, the balance sheet of a company--which presents the "net worth" of a company (assets minus liabilities) , is weakened by such write downs.
When evaluating stocks to invest in, most of Wall Street prefers to emphasize the income statement of a company's financial statements, specifically "operating" earnings per share. Actually, it's even worse, as analysts forecast what operating earnings per share will be one or two years out--which makes earnings per share in most cases much higher (and the price/earnings ratio lower), so stocks look cheaper than they really are.
I look at all three major financial statements--the balance sheet, the cash flow statement, and the income statement. But I emphasize the balance sheet and the cash flow statement, which are much less subject to manipulation by companies than is the income statement.