- July 29, 2022
- Posted by: Ramkumar
- Category: Posts
EPS Accretion VS Value Creation In M&A
Many people perceive 𝐅𝐢𝐧𝐚𝐧𝐜𝐞 𝐚𝐬 𝐚 𝐜𝐨𝐦𝐩𝐥𝐞𝐱 𝐬𝐮𝐛𝐣𝐞𝐜𝐭. However, in my view, 𝐅𝐢𝐧𝐚𝐧𝐜𝐞 𝐢𝐬 𝐚 𝐬𝐢𝐦𝐩𝐥𝐞 𝐬𝐮𝐛𝐣𝐞𝐜𝐭 𝐨𝐟𝐭𝐞𝐧 𝐦𝐚𝐝𝐞 𝐜𝐨𝐦𝐩𝐥𝐞𝐱 𝐛𝐲 𝐚𝐧𝐚𝐥𝐲𝐬𝐭𝐬.
To substantiate my viewpoint, let us look at mergers and acquisitions, which are often a dreaded subject due to their abysmal track record.
Company A, whose value is Rs.100, acquired Company B, whose value is Rs.50. Firm A does not pay any premium; thus, the purchase price is Rs.50.
Firm A issues its equity by buying Firm B.
Combined value of A+B = Rs.150
Let us assume,
A’s expected earnings = Rs.5
B’s expected earnings = Rs.3
P/E of A = 100/5 = 20
P/E of B = 50/3 = 16.67
A+B’s expected earnings = Rs.8
P/E of A+B = 18.75
𝐇𝐨𝐰𝐞𝐯𝐞𝐫, 𝐢 𝐡𝐚𝐯𝐞 𝐬𝐞𝐞𝐧 𝐚𝐧𝐚𝐥𝐲𝐬𝐭𝐬 𝐣𝐮𝐬𝐭𝐢𝐟𝐲𝐢𝐧𝐠 𝐭𝐡𝐞 𝐚𝐛𝐨𝐯𝐞 𝐝𝐞𝐚𝐥 𝐚𝐬 𝐯𝐚𝐥𝐮𝐞-𝐚𝐜𝐜𝐫𝐞𝐭𝐢𝐯𝐞 𝐝𝐞𝐬𝐩𝐢𝐭𝐞 𝐭𝐡𝐞 𝐚𝐛𝐨𝐯𝐞 𝐝𝐞𝐚𝐥 𝐚𝐝𝐝𝐢𝐧𝐠 𝐧𝐨 𝐯𝐚𝐥𝐮𝐞.
Bankers would say that after A acquires B, the stock market will apply A’s P/E to B’s earnings.
𝐈𝐟 𝐭𝐡𝐞 𝐛𝐚𝐧𝐤𝐞𝐫’𝐬 𝐥𝐨𝐠𝐢𝐜 𝐢𝐬 𝐜𝐨𝐫𝐫𝐞𝐜𝐭, 𝐭𝐡𝐞𝐧 𝐀+𝐁’𝐬 𝐞𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐞𝐚𝐫𝐧𝐢𝐧𝐠𝐬 = 𝟐𝟎*𝟖 = 𝟏𝟔𝟎, 𝐢𝐦𝐩𝐥𝐲𝐢𝐧𝐠 𝐭𝐡𝐚𝐭 𝐭𝐡𝐞 𝐜𝐨𝐦𝐛𝐢𝐧𝐞𝐝 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐟𝐢𝐫𝐦 𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐞𝐬 𝐝𝐞𝐬𝐩𝐢𝐭𝐞 𝐧𝐨 𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐞 𝐢𝐧 𝐭𝐡𝐞 𝐜𝐨𝐦𝐛𝐢𝐧𝐞𝐝 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰𝐬.
Bankers define the above as 𝙢𝙪𝙡𝙩𝙞𝙥𝙡𝙚 𝙚𝙭𝙥𝙖𝙣𝙨𝙞𝙤𝙣 𝙤𝙧 𝙧𝙚𝙧𝙖𝙩𝙞𝙣𝙜 to justify their rationale.
Let us reverse our above example with Firm B acquiring Firm A. Now bankers will justify this deal as a company B with a lower P/E purchases Firm A with a higher P/E, implying B is accelerating its growth; thus, B’s P/E should expand to A.
In my view, if 𝐦𝐮𝐥𝐭𝐢𝐩𝐥𝐞 𝐞𝐱𝐩𝐚𝐧𝐬𝐢𝐨𝐧 𝐢𝐬 𝐚𝐜𝐜𝐮𝐫𝐚𝐭𝐞, 𝐚𝐥𝐥 𝐌&𝐀 𝐝𝐞𝐚𝐥𝐬 𝐚𝐝𝐝 𝐯𝐚𝐥𝐮𝐞, 𝐛𝐮𝐭 𝐰𝐞 𝐤𝐧𝐨𝐰, 𝐢𝐧 𝐫𝐞𝐚𝐥𝐢𝐭𝐲, 𝐭𝐡𝐚𝐭 𝐢𝐬 𝐧𝐨𝐭 𝐭𝐡𝐞 𝐜𝐚𝐬𝐞.
𝗜𝗻 𝗮𝗻 𝗠&𝗔 𝗱𝗲𝗮𝗹, 𝗶𝗳 𝗮 𝗯𝘂𝘆𝗲𝗿 𝗰𝗮𝗻𝗻𝗼𝘁 𝗽𝗶𝗻𝗽𝗼𝗶𝗻𝘁 𝘁𝗵𝗲 𝘀𝗽𝗲𝗰𝗶𝗳𝗶𝗰 𝘀𝗼𝘂𝗿𝗰𝗲𝘀 𝗼𝗳 𝗶𝗻𝗰𝗿𝗲𝗮𝘀𝗲𝗱 𝗰𝗮𝘀𝗵 𝗳𝗹𝗼𝘄, 𝗶𝘁 𝗶𝘀 𝘁𝗿𝘆𝗶𝗻𝗴 𝘁𝗼 𝗳𝗼𝗼𝗹 𝗶𝘁𝘀 𝘀𝗵𝗮𝗿𝗲𝗵𝗼𝗹𝗱𝗲𝗿𝘀.