Why don't companies issue more shares to create corporate empires?

Question

Why can't companies grow ever-larger into corporate behemoths by funding a large number of acquisitions using shares? Shares are like currency that the company can mint on its own. Surely management stands to gain (in terms of compensation and prestige) from controlling a large business empire. One reason I can think of is share dilution, but share dilution does not reduce value to existing owners if the increased equity earns at least the same amount of returns as the original equity.

For example, suppose the original company has an equity of $100 million and earns $15 million (i.e. 15% return on equity). Let's say the company decides to "dilute" the shares by issuing $900 million worth of shares. The equity is now $1 billion. If the company earns the same 15% return on equity on the new $900 million, the company will earn $150 million on equity of $1 billion. This has several advantages:

• Original owners of the $100 million equity will see no loss of value. Their ownership stake is diluted, but the value has not been diluted.
• The company has larger profits (earnings grew 10 times).
• Management can get a larger salary.
• The company becomes more prestigious because of increased size and increased profits.

Supposing that all these advantages are real, management can then repeat the process I described above to transform their company into a $10 billion company, $100 billion company, etc. However, in practice, small companies seem content on being small companies, so I think some of my reasoning above is incorrect. What is wrong with my argument above? Why don't companies issue more shares to create a corporate empire?

Answer 1

There are companies that grow by this method, they grow by acquisition. Sometimes it works and sometimes it doesn't.

They have to find companies they can afford, and that they believe they absorb, and can continue to generate profits. The board of directors and the stockholders have to agree with this method, and they need to generate results.

What can go wrong? They can choose poorly, and the new company isn't profitable as they believed.

HP and Autonomy:

But the real bombshell came in 2012 when HP, following an internal investigation, alleged that Autonomy had cooked its books and that the software and company was overvalued at time of purchase. HP wrote down the Autonomy purchase as a nearly $9 billion loss, sending HP's stock into a tailspin.

Sometimes the two companies don't have the synergy they thhink

Quaker oats and Snapple

However, their efforts failed miserably. Snapple had become so successful because they marketed to small, independent stores; the brand just couldn’t hold its own in large grocery stores and other retailers nationally. Pepsi and Coca-Cola themselves began releasing Snapple-like drinks and the general public’s new-found taste for Snapple beverages was beginning to wane.

After just 27 months, Quaker Oats sold Snapple for $300 million (or, for those of you doing the math, a loss of $1.6 million for each day that the company owned Snapple). CEO William Smithsburg’s reputation was forever tarnished, and numerous executives were fired.

Another way to create an empire is to try and become a monopoly but that has problems on it's own. Regulators from the government get involved.

It has been tried. And sometimes it works. Sometimes it doesn't.

Answer 2

Your example assumes that by issuing new shares, the company suddenly increases its values tenfold, and, most amazingly, substantially increases it's income over night.

This, of course, won't happen: The company has increased its number of shares, but it's fundamental value stays the same. Therefore, the sum of the value of the shares will be basically the same before and after the increase. The value of each single share will drop accordingly.

Now, it depends on what the company does with these new shares:

• A) If the new shares are distributed among the old owners proportionally to their existing shares, the net effect will be basically zero gain or loss. It's just a 'repackaging' of their existing shares.
• B) If the new shares are sold to the old owners proportionally to their existing shares: The old owners will give money to the company and receive shares in return. The company will actually have increased in fundamental value - it has more cash. The owners have less cash, but since they own the company, they did not suffer a loss per se. That's basically the same as an initial offering - shareholders invest their money in the company, and the company receives funds to work with.
• C) If the new shares are sold to new owners, the old owners will have the same number of shares as before, but these shares now represent a much smaller part of the company and its profits. The old owners therefore suffer a severe loss of value.

I guess what you're thinking about is case B): The shareholders transferred money to the company, but since they own the company, they are not really worse than before. The company now can use the fresh funds to do whatever a company wants to do. Why is this not repeated perpetually?

• The shareholders need to have liquid funds they are willing to invest in the first place
• The shareholders need to be convinced that it will be a worthy investment (better than any alternatives)
• The above points need to apply to all / a majority of shareholders or whatever local regulations demand

So in short: Increasing the equity by issuing new shares is an investment by shareholders, and it will be done if the shareholders think it's a worthy investment and they can spare the money.

Answer 3

There is a major misconception in:

For example, suppose the original company has an equity of $100 million and earns $15 million (i.e. 15% return on equity). Let's say the company decides to "dilute" the shares by issuing $900 million worth of shares. The equity is now $1 billion. If the company earns the same 15% return on equity on the new $900 million, the company will earn $150 million on equity of $1 billion.

One common way (but by no means the only way) to try to measure the success of a company is to calculate its "return on equity" – that is, divide its profits by the amount of equity. However, this does not mean that profits are a function of equity.

The amount of profit a company generates is determined (among many other things) by the size of the company's workforce, how much (income-generating) work that workforce can do or sell, and how profitable those actions are (i.e., for how much higher than operating costs can the company deliver its services or sell its products).

If you double (or even multiply tenfold) the "share capital", you still have the same workforce, producing the same amount of goods (or delivering the same amount of service), and generating the same amount of profits. Therefore, other things being equal, the "return on equity" will be halved (or divided by ten).

It is true that in cases (B) or (C) of Lykanion's excellent answer the company now has extra capital on hand. With that extra money the company:

• May be able to expand its operations (build more factories; hire more staff etc.), but simply having more capacity does not guarantee you will be able to sell more goods/services. Even if sales (and hence income/profits) can be increased, there's no guarantee that the increase will match the increase in equity.

• May decide to grow-through-acquisition. It might try to buy up competitors (to have a "bigger slice of the pie"), or companies that have a strategic fit with its activities (e.g. a manufacturer might consider buying one of its suppliers so that the supplier's profits are brought "in-house"). However, as mhoran_psprep's answer points out, such acquisitions do not always work as intended.