When firm sold, shareholders get paid

Q: When one company buys another, where does that money actually go? — P.S., Dalton, Georgia

A: If the acquirer pays cash, the money goes to the shareholders of the acquired company. There might also be payments to other owner classes, such as holders of preferred stock. Some of the cash tendered will occasionally go to debt holders if part of the purchase price is allocated to buying back debt.

If the acquirer pays with its stock instead of cash, then shareholders of the acquired company will get shares of the acquiring company in exchange for their shares of the acquired company. They can sell these shares for cash or keep them.

Companies typically buy other companies for more than their pre-purchase market price, paying a “premium.” Some purchases involve combinations of cash and stock.

Q: What does a company’s “market cap” refer to? — H.B., Rochester, Minnesota

A: A company’s market capitalization reflects the value the stock market is placing on it. To get it, you multiply the total number of shares outstanding by the stock price. For example, multiplying Apple’s 5.25 billion shares times its recent stock price of about $144 yields a market cap of $754 billion. That number can give you a sense of whether the company is overvalued or undervalued, if you compare it to past levels or to the maket value of peers.

That $754 billion is the biggest among all companies in the world, towering over Google parent Alphabet (recently at $608 billion), Microsoft ($524 billion), Amazon.com ($435 billion), Facebook ($425 billion) and Warren Buffett’s Berkshire Hathaway ($413 billion).

Fool’s school: Return on equity

Becoming a good investor typically involves learning to crunch numbers from companies’ financial statements. A good measure to understand is return on equity (ROE).

A company’s profit can be put to many uses, such as paying dividends, paying down debt, buying back shares of company stock or reinvesting in operations (perhaps by buying another company, buying more advertising or building another factory). A company’s ROE can give you an idea of how productive it is with its net assets (assets minus liabilities).

To calculate ROE, take one year’s (or four quarters’) worth of earnings (often referred to as “net income”) from the income statement (which is sometimes called a statement of operations). Next, find shareholders’ equity on the balance sheet. Average the shareholders’ equity by adding the figures from the beginning and end of the year and dividing by two. (You’re almost done!) Finally, divide the year’s earnings by the average shareholders’ equity. (Whew!)

As an example, consider Facebook. In fiscal 2016, it reported net income of $10.2 billion, and its average shareholder equity between 2015 and 2016 was $51.7 billion. Dividing the first number by the second yields a return on equity of around 20 percent, a solid number.

It’s instructive to look at previous numbers, too. Facebook’s ROE is much higher than it was a few years ago, but early in this decade, it topped 20 percent.

Another way to add context is to compare a company with its peers. Fellow social-media giant Twitter has been posting a string of losses in recent years, with an ROE in the red. Google parent Alphabet (which owns YouTube) is worth a look, as its business is similarly software-heavy. Its ROE is 15. Note that high debt can skew ROE upward, although both Facebook and Alphabet have little or no debt.

When evaluating companies in which to you might invest, read up on them — and assess more than just ROE. Examine factors such as profit margins, growth rates and competitive advantages. Learn more about investing at fool.com/how-to-invest and morningstar.com.

Foolish trivia:

Name that company

I was born in the Great Depression, when my founder moved to Arkansas and began delivering chickens. My business got a boost in World War II, as chicken wasn’t among the foods being rationed, and demand for it grew. Today, I’m a top global food company, producing about 1 in every 5 pounds of chicken, beef and pork in the U.S. My brands include Jimmy Dean, Hillshire Farm, Sara Lee, Ball Park, Wright, Aidells and State Fair. I employ more than 110,000, operate in more than 110 countries and rake in about $37 billion annually. Who am I?

Last week’s trivia answer

I trace my roots to the 1920s. I’m dominant in cable TV, with HBO, Cinemax, CNN, TBS, TNT, Adult Swim and the Cartoon Network. One of my divisions is the world’s leading producer of television programming and filmed entertainment. Video games such as “Mortal Kombat X” and “Batman: Arkham Knight” are also mine. Who am I? (Answer: Time Warner)