"Newbies"

Humor

Themes & Topics

Glossary

Lecture Notes

Trivia & Factoids

Bloopers & Blunders: Cash Flow and Value

Quotation

Commenting on WorldCom’s attempt to acquire MFS Communications, an analyst was quoted as saying that "while the agreement will significantly dilute WorldCom's earnings and its stock price, it creates a company with ‘a bigger capital base, more revenue, more access to capital and more cash flow.’" (WSJ, August 27, 1996)

Analysis

How can it be feasible to simultaneously dilute, or lower, stock prices and increase cash flow?

Let’s start with the basics. Stock prices reflect the discounted expected future cash flows, whereas the discount rate reflects the risk of the cash flows as measured by the cost of equity, or the required rate of return on equity.

In theory, such a scenario is possible if the negative impact of the increase in risk more than offsets the positive impact of an increase in cash flows. This would reduce the value of the cash flows, and thus, the price of the stock.

Now consider the merger of two companies in complementary businesses. There does not seem to be any reason why the risk of the combined company should increase. Moreover, the quotation itself says that the combined companies would have a "better capital base" and "more access to capital," indicating the risk should actually go down, not up. Thus, the combined impact should increase a stock’s price, not dilute it.

By Alex Tajirian