When one company acquires another, it generally pays more than the current market value of the target. Why do companies do this, and when is it a smart idea to use capital for M&A? In this edition of Industry Focus, host Michael Douglass and Fool contributor Matt Frankel discuss the ways companies can benefit from mergers and acquisitions, and the types of M&A that should raise a red flag.

A full transcript follows the video.

This video was recorded on Oct. 9, 2017.

Michael Douglass: Let's talk about mergers and acquisitions first, because this is the flashy stuff that always ends up in the headlines. So-and-so bought so-and-so for $1 billion, and that's when people really start paying attention to investments.

Matt Frankel: Right. One of the most common questions I get when it comes to M&As is, why are companies willing to pay more than what a stock is worth? Because generally, when a company gets bought out, shareholders get a 20% premium, or something to that effect. And the answer is generally because the business could be worth more to the acquirer than it was as a standalone company. A good example is that Amazon (NASDAQ:AMZN)-Whole Foods deal. I think Amazon paid about $14 billion and change for that.

Douglass: Something like that.

Frankel: It opens up a new sector for Amazon, whereas building that organically would have, I bet, cost more than that. So that's a good reason for M&A, and a reason why companies are willing to pay a premium to acquire another company.

Douglass: And I would say, even dragging it back to financials for a minute, think about when Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) makes an acquisition. I'm making up numbers here, but let's say there's a company trading for, it has a $1 billion market cap, Berkshire pays $1.5 billion and then invests another $1 billion into the company. So, total cost if you think about it as this billion-dollar company, it costs $2.5 billion total, in terms of both their immediate financial investment and the money they put in toward capital expenditures.

But what if that billion-dollar company was legitimately worth a billion dollars at the time, but with that additional billion dollars that's been invested in it, it has the ability to really ramp up growth and become worth, let's say, $10 billion 10 years down the road? Then, suddenly, that $2.5 billion that Berkshire paid looks like a steal, because you've got a quadruple in 10 years. And that looks really darn good. And that's been a lot of Buffett's philosophy in approaching companies. I'm not saying he's necessarily willing to pay 50% above asking or above the market price or anything like that. But that's why it's been so attractive.

Frankel: Definitely. The point is, that allows the company to achieve growth that it wouldn't be able to achieve as a standalone company.

Douglass: Right. And I think one of the key things here is growth. We've been talking about either doubling down on the same strategy, you're buying out a direct competitor, or you're trying to, like Amazon with Whole Foods, get into a different niche of the market. I'm very skeptical when people are talking about "This is going to work out with cost synergies." Basically, "We're going to combine our back-office operations and save enough money that it's going to be worth it." I tend to find that that is problematic at best.

Frankel: Yeah. Are cost synergies a real thing? Yes. Do they help? Yes. Is it worth paying a 25% premium for a company? Usually not.

Douglass: Yeah.

Frankel: That's probably the best way I could put it.

Douglass: Here's a good example of a bad merger, I guess, or, had it gone through, it would have been a bad merger. New York Community Bancorp (NYSE:NYCB) attempted to buy Astoria (NYSE:AF).

Frankel: Yes. New York Community Bancorp is one of the highest-dividend bank stocks, and for a reason. It's intentionally paid a high dividend for years to remain under the $50 billion regulatory cap. That allows it to, you know, keep its regulatory costs low and avoid becoming what's called a systemically important financial institution, I think that's what the acronym stands for.

Douglass: Right, or SIFI.

Frankel: Yes. And they decided to acquire Astoria Financial, which would have put them well over the $50 billion cap. Shareholders immediately kind of resented the acquisition idea. And it actually wound up falling apart, which drove the stock down even more, because there's a lot of unanswered questions as to why it fell apart. They weren't very clear on that. But that's an acquisition that would actually have cost the company more. Not only that -- Astoria was not nearly as an efficient bank as New York Community. And it would have added to costs. It would have lowered its efficiency, which is its big competitive advantage, and created a lot of problems with shareholders. That's not why they invested in the bank in the first place.

Douglass: Yeah. I think one of the key things to point out here is, New York Community Bancorp was and is in a really attractive niche -- specifically, rent-controlled apartments in New York.

Frankel: Yeah. That's something like 80% of their loan portfolio -- rent-controlled or rent-stabilized buildings in Manhattan.

Douglass: Right, so it's just about all there. Astoria would have diversified it a great deal, but it certainly looked like it could have been diworsification instead of diversification, in terms of putting it into a lot of less attractive market areas. So I think for a lot of reasons, that merger looked pretty problematic to shareholders.

Frankel: Right. Nobody leaves a rent-controlled apartment building. Well, very few people do, if you ask any friends in New York who have them. But single-family homes go into foreclosure a lot more frequently. Things that are on Astoria's balance sheet that would have diluted the competitive advantage, which is what it's all about at the end of the day.

Douglass: Yeah, absolutely. So there's a little bit of thinking about when a merger and acquisition can make sense, and when it seems a little bit more problematic.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.