Following the money

Q: When a company purchases another company, where does its payment go? — D.W., Superior, Colorado

A: If the company makes its acquisition with cash, the money goes to the shareholders of the purchased company. Their shares in the acquired company will one day disappear, replaced in their accounts with cash (or equivalents). Other classes of owners, such as holders of preferred stock, can also receive payments. Some of the cash might go to debt holders if the purchase agreement includes paying off debt.

If the purchaser pays with its own stock instead of cash, then the acquired company’s shareholders will get shares of the purchaser in exchange for their shares of the acquired company. They can sell these shares for cash or keep the shares, as shareholders of the purchaser. Some purchases involve both cash and stock.

Note, too, that companies often buy other companies for more than their recent market value, paying a “premium.”

What makes a great company?

When investing your hard-earned dollars in stocks, find the best companies you can. Different investors will focus on different criteria. Some, for example, seek inventive companies addressing large markets, while others favor companies with simple product-solving products. Many like to see savvy managers and big returns.

The best stocks for you are ones whose businesses you can understand. Here are some other attributes you might look for:

— Consistent growth and growing market share: The company’s revenue and earnings should be growing at a reasonable rate — and ideally, its market share is growing, too, reflecting its ability to compete well against rivals.

— Growth potential: The company should have lots of room to grow — perhaps via the introduction of new products or services, or expansion into new countries or markets.

— Solid and growing profit margins: Companies can be very successful with low margins, but relatively high margins — coupled with lots of sales — are powerful.

— Sustainable competitive advantages over peers: These can include a strong brand that draws customers and allows premium pricing, and being in a business with high barriers to entry.

— Financial health: Debt should be nonexistent or manageable thanks to ample cash.

— An attractive business model: A business model is how a company makes its money. Some effective models include subscriptions and franchises. Another is the razor-and-blade model, where a product such as a razor or printer is sold at a low price, and money is made mainly from costly refills — blades or ink.

— Good management: Communications from management should be candid, inspiring confidence. Ideally, management will be long-tenured, with a record of good results in both booming and ailing economic environments.

Once you identify a great company, be sure to invest when it’s priced attractively. Ideally, for example, its price-toearnings (P/E) ratio should be low relative to those of its peers, or to its own five-year average.