Investing Tip:

Accounting Shenanigans

There are a number of ways that companies can present information that is not illegal, but paints a rosier picture than actually exists. One of those ways is through growth by acquisition. Let's say that Groquick Corp. is acquiring Slogrow Inc. Groquick has 1 million shares outstanding, made $1 million in profits last year ($1 per share) and the stock is at $30 a share (a p/e of 30). Slogrow, also has 1 million shares outstanding and $1 million in profits, but because the company is considered a slow growth company, the stock is at $12 (a p/e of 12). Groquick acquires Slogrow for an all stock deal, paying 1/2 a share of Groquick for each share of Slogrow. Slogrow shareholders go for it, because they are getting $15 worth of stock (1/2 of a $30 share).

There are 1.5 million shares of the combined companies after the acquisition. And shortly thereafter the new bigger Groquick reports $2 million in earnings. The company reports earnings of $1.33 per share ($2 million divided by 1.5 million shares), a 33% increase. And Wall Street says "Wow! This company should still carry a p/e of 30 with that kind of growth" and so the stock moves up to $40 (40 divided by $1.33 a share in earnings is a p/e of 30).

But what has really happened? In reality the earnings are flat! Before the merger, $2 million in earnings for both companies. After the merger still $2 million. What is happening is that Groquick bought a company with a much lower p/e. That made the earnings look like they were growing and so people bid up the stock. Individuals and (I'm sad to say) Wall Street pros are fooled by this all the time.

This is an important lesson. You cannot invest based upon a single number. You have to do your homework, or hire someone who can do it for you. Groquick didn't lie, but their presentation of the numbers make a stodgy no growth company look like a high flier.

Back to Investing Tips

Donald Steinmann and Advanced Financial Management assume no responsibility for any actions taken due to comments made in The Investment Tip of The Week.

Check out our free services!

"A good decision is based on knowledge and not on numbers."
-- Plato