The luxury goods and cosmetics industries are two of the hottest sectors when it comes to mergers and acquisitions. Luxury fashion company Tapestry recently announced its intent to buy Capri Holdings in an effort to combine forces and combat competition from powerhouses LVMH Moët Hennessy Louis Vuitton and Hermès International.

While many of the companies above carry significant brand awareness, one smaller player in the beauty sector is quietly making a name for itself: e.l.f. Beauty (ELF 1.86%). The cosmetics upstart has become wildly popular among the highly coveted Gen Z demographic. The company also recently announced a splashy deal of its own -- a $355 million takeover of skincare brand Naturium.

Let's explore the rationale behind the deal and assess whether e.l.f. is making the right move -- and what it could all mean for investors.

What's the deal?

According to the company's investor presentation outlining the specifics of the deal, e.l.f. is set to acquire Naturium for $355 million through a combination of cash and stock. Naturium's current annual revenue run rate is approximately $90 million, signaling that e.l.f. is paying 4 times sales for the skincare company.

To add some color around the transaction, earlier this year L'Oréal acquired Aēsop, a market leader in skincare, particularly in Asia. L'Oréal's deal for Aēsop was estimated to be around 4.7 times revenue, which is roughly in line with e.l.f.'s deal. The company's investor presentation provided a lot of detail around why e.l.f. may have been so eager to acquire Naturium. 

A person putting on makeup before recording a social media video.

Image source: Getty Images.

How does this help the business?

Part of the reason that e.l.f. has seen so much success is because the company leverages social media extensively. Interestingly, Naturium's founder, Susan Yara, is a former journalist. Given her experience in the media industry, Yara has been able to cultivate a loyal following across platforms such as Instagram and TikTok.

Moreover, part of Naturium's go-to-market strategy revolves around building relationships with content creators focusing on beauty and cosmetics. Given the obvious overlaps between Naturium's brand ambassadors, dubbed "skin-fluencers," and e.l.f.'s proven return on investment from social media, this looks like a match made in Heaven.

Another reason this transaction looks like a savvy move is the degree to which it broadens e.l.f.'s market presence. According to its investor presentation, e.l.f. currently owns about 9% of the skincare market based on retail sales. By adding Naturium to its portfolio, e.l.f. will double its skincare presence overnight. Per the company's estimates, Naturium is forecast to add $90 million in sales and $17 million in adjusted EBITDA to the overall business on an annualized basis.

By augmenting its existing market position and doubling down on social media, e.l.f. will be well-positioned to strengthen Naturium's brand awareness across its major markets in North America and the U.K.

Should you invest in e.l.f. Beauty?

The charts below illustrate the price-to-earnings (P/E) and price-to-free cash flow multiple for e.l.f. and a number of cohorts. The primary takeaway is that e.l.f. stock commands a premium above its peers. e.l.f. stock is up 175% over the past year. However, over the past month the stock has cooled off a bit, dropping by 14%. Given the roster of competitors here, I'd encourage investors to consider some additional commentary before jumping to a conclusion around e.l.f.'s valuation.

ELF PE Ratio Chart

ELF PE Ratio data by YCharts

Brands such as Estee Lauder and L'Oréal have been around for a long time. Both of these companies are competing with smaller brands like e.l.f. that have tapped into younger demographics. While Estee Lauder and L'Oréal still have mass appeal, each company may carry the same bullish sentiment among investors given its growth prospects compared to newer brands. 

Coty, for its part, seemed to have something going for it a couple of years ago when the company struck a partnership with Kylie Jenner, perhaps the most valuable social media influencer in cosmetics. However, recent reports from Bloomberg and other outlets are suggesting the Kardashian heir is considering buying back her brand from Coty. Should this occur, I think e.l.f. will be in an even better position to take on the competition.

Instead of putting all their eggs in one basket, companies such as e.l.f. and Naturium have partnered with several smaller influencers as opposed to mortgaging their future on one celebrity identity. While e.l.f. stock is not cheap compared to the competition, the premium appears to be warranted. There is plenty of reason to believe that the best is yet to come for e.l.f. as social media continues to become engrained in all facets of business and the company finds new, innovative ways to generate growth.

Now could be a great time for long-term investors to initiate a small position in e.l.f.