112  The Stock Market Is Smarter Than You Think Earnings from Mergers and Acquisitions There is yet another way for companies to increase their earnings: buying an- other company. Say a company has $1 billion of excess cash. It uses the cash to buy another company earning $50 million per year at a P/E multiple of 20 times. Its earnings will increase by $50 million, less the forgone interest it was earning on the excess cash; assuming that equals $5 million (at a 0.5 percent after-tax return on cash), the net increase is $45 million. Though the compa- ny’s earnings have increased, we can’t tell whether it has created value. At a 20 P/E purchase price, it will be earning only 5 percent on its invested capital. If it has a 10 percent cost of capital, it will need to double the earnings of the acquired company to earn its cost of capital on the $1 billion it just invested. Investors see through the accounting earnings. Chapter 31 shows that whether an acquisition increases or decreases earnings in the first year or two after the acquisition has no correlation with the stock market’s reaction to the transaction. Investors also see through the illusion of “multiple expansion,” as we dis- cussed in Chapter 3. There is no empirical evidence or economic logic that the stock market will value an acquired business at the earnings multiple of the acquiring business. The earnings multiple of two combined businesses will simply equal the weighted average of the individual earnings multiples. Any value increase must come from additional cash flows over and above those of the individual businesses. Write-Downs Executives are often reluctant to take the earnings hit from writing down the value of assets, assuming that investors will react negatively. But investors don’t respond mechanically to write-downs. Rather, they assess what infor- mation the write-down conveys about the future performance of the company. We looked at 99 companies in the United States that had written off at least $2 billion of impaired goodwill against their profits from 2007 to 2011.16 There was no statistically significant drop in share prices on the day a write- off was announced. The markets had already anticipated the lower benefits from past acquisitions and reduced the share prices long before the write-off announcements. For example, prices jumped nearly 10 percent when Boston Scientific announced a $2.7 billion write-down associated with its 2006 acqui- sition of Guidant. Prices rose almost 8 percent when U.S. Steel announced a goodwill impairment charge of $1.8 billion with its third-quarter earnings in 2013. We found a similar pattern for the 15 largest goodwill impairments by European companies from 2010 to 2012. The pattern is consistent over many 16 See B. Cao, M. Goedhart, and T. Koller, “Goodwill Shunting: How to Better Manage Write-Downs,” McKinsey on Finance, no. 50 (Spring 2014): 13–15. Myths about Earnings  113 years. Likewise, Exhibit 7.11 shows there was no statistically significant drop in share prices on the announcement of goodwill impairments in an earlier sample of 54 companies in the United States and Europe from 2002 to 2004.17 Stock markets clearly look at the underlying cash flows and business fundamentals rather than reported earnings and goodwill impairments. In the 2010 to 2012 sample of European write-offs, in fact, only one analyst re- port issued after one announcement even commented on the size of the im- pairment. Analysts did, however, comment strongly on indications of how the company would move forward. Changes in signals or explicit guidance about future operating earnings, the outlook for the market and business units, and any management actions or plans to address changing conditions are important. Employee Stock Options In the early 2000s, proposed new accounting rules requiring employee stock options to be expensed in the income statement caused much concern. Some executives and venture capitalists claimed that expensing stock options would reduce the earnings of small high-growth companies so much that they would not be able to take the companies public. Of course, there was no need for concern, because stock prices are driven by cash flows, not reported earnings. Academic research has shown that the stock market already took account of employee options in its valuation of 17 The sample comprises selected U.S. and European companies with a market capitalization of at least $500 million and an impairment charge of at least 2 percent of market capitalization. EXHIBIT 7.11  No Market Reaction to Announcement of Goodwill Impairment Cumulative abnormal return (CAR) index, n = 54 Day relative to announcement –30 –25 –20 –10 –15 15 –5 0 5 10 20 25 30 100 105 110 95 85 90 75 80 70 65 Announcement return –1/+1 days CAR 0.1% t-statistic 0.3 Average Source: SEC filings, Datastream, Bloomberg.