In this article, we’ll go through a hypothetical M&A transaction to look at the basic components and how to analyze one (M&A analysis).
M&A analysis is important as mergers, acquisitions, and business combinings are a big part of the financial world.
Many financial professionals – investment bankers, private equity, hedge funds and traders (e.g., merger arbitrage strategies) – will need to have some kind of background in M&A analysis.
We’ll look at the factors that go into determining whether a deal is accretive (adds to shareholder wealth) or dilutive (decreases shareholder wealth).
A general rule of thumb is that is if a higher price-to-earnings ratio (P/E) company acquires a lower P/E company, the deal is likely to be accretive as the acquirer pays proportionally less for the target’s earnings.
But, of course, it’s not that simple as businesses change over time.
The process fundamentally boils down to earnings per share analysis in a “before and after” sense based on company earnings data.
Let’s go through an example to see how things might compare:
M&A Analysis: Pre-Transaction Scenario
Let’s take two fictional companies. To give them a bit more character than Company A and Company B, let’s call them Atlas and Burbank.
Atlas plans to acquire Burbank by purchasing all of its shares in a 100% stock-for-stock deal.
Atlas has the following financial characteristics:
- Share price = $100
- Shares outstanding = 1,000,000
- Market capitalization = $100,000,000
- Net income = $5,000,000
- Earnings per share (EPS) = $4.00
- P/E = 25.0
Burbank has the following financials:
- Share price = $35
- Shares outstanding = 500,000
- Market capitalization = $17,500,000
- Net income = $1,500,000
- EPS = $1.65
- P/E = 21.2
Note that market capitalization (often terms “market cap” for short) is share price multiplied by shares outstanding, where P/E is share price divided by EPS.
In practically all M&A deals, a control premium is involved, meaning the acquirer must pay a value north of the “fair value” price of the company.
This is a direct result of a change in control within the target firm. When there is a minority stakes deal, a control premium is rarely paid due to a lack of change in decision-making power.
When a majority stakes deal is presented, a premium normally needs to be paid in order to cause this shift in power, as majority ownership comes with the perks inherent in decision-making power.
In this particular transaction, let’s assume Atlas pays a 50% control premium for Burbank. In other words, if Atlas acquires Burbank, it will pay 1.5x the amount of the fair value price to close the deal.
Consequently, Atlas will pay 50% extra for each one of its shares, or $35*1.50 = $52.50.
Next, we need to calculate the stock-for-stock exchange ratio, or the price of Atlas’ shares relative to those of Burbank.
This would come equal to:
$100/$52.5 = 1.905 shares of Atlas for every one share of Burbank.
So how many shares would Atlas need to release as part of this transaction?
We would take our stock-for-stock exchange ratio and multiply it by the number of Burbank shares.
Burbank has 500,000 shares outstanding, so we would multiply 1.905 by 500,000 and come out with 952, 380 shares.
As a combined company, Atlas-Burbank would therefore have this number of new shares plus whatever number of shares Atlas had to begin with:
952,380 + 1,000,000 = 1,952,380 shares in circulation.
The primary goal behind a mergers and acquisitions deal is to increase shareholder wealth by combining forces to augment efficiency improvements.
To find pro forma EPS, or EPS after the prospective deal’s completion should it eventually occur, is calculated by adding together total net income and dividing by the number of shares outstanding.
Pro forma EPS = (Net income combined) / (Number of new shares) = ($5,000,000 + $1,500,000) / (1,952,380 shares) = $3.84/share
So the new expected share price of Atlas-Burbank would be Atlas’ P/E multiplied by the pro forma EPS:
Atlas-Burbank share price = 25.0 * $3.84 = $96.04
Analyzing the Transaction
While a general rule of thumb holds that a higher P/E company acquiring a lower P/E company is likely to be accretive, in this scenario that isn’t the case.
Our pro forma EPS is $3.84 per share.
However, for Atlas, the EPS of the company sat at $4.00 per share.
Accordingly, this deal would be dilutive for Atlas shareholders given that EPS would actually decrease should the two firms combine.
This, however, doesn’t necessarily mean that this transaction would necessarily be a poor business decision.
Whether to go ahead with the deal isn’t a matter of thinking in binary terms – i.e., accept the deal is accretive, and don’t accept if it’s dilutive.
There is more to consider beyond those terms.
Atlas’ acquisition of Burbank is 4% dilutive (1 – $3.84/$4.00) – dilutive but not significantly so – as a result, Atlas executives and other decision-makers must use their own discretion.
Shareholders/owners may willingly accept a deal that is initially dilutive so long as the deal may be accretive at some time in the near future.
In terms of proportional ownership, Atlas shareholders would own 1,000,000/1,952,380 = 51.2% of Atlas-Burbank.
Burbank shareholders would own:
952,380/1,952,380 = 48.8% of Atlas-Burbank.
At first glance, this would be more of a win for Burbank shareholders than it would be for Atlas shareholders as a result of the pro forma EPS gain.
Moreover, if Atlas-Burbank pays out these earnings in the form of dividends (and Burbank previously did the same), the dividend amount would increase from $1.65 per share to $3.84 per share.
However, given the deal is dilutive for Atlas, dividends would, at least temporarily, drop from $4.00 per share to $3.84 per share.
From this example, we can see that not all deals involving high P/E companies acquiring low P/E companies are necessarily accretive as the standard rule of thumb goes.
Net income of the two companies is also an instrumental factor as well.
If the acquirer is purchasing a company that has a low net income, then the deal could very likely be dilutive given the pro forma EPS calculation entails using combined net income as a numerator term dividing by the new number of shares in the deal.
But by working through each of these steps, we can derive a general understanding of the viability of the deal.
However, in this case, we are not taking into account:
- the level of synergy in the deal (how much value the deal adds due to cost cutting and/or revenue growth as a combined entity) or
- value of control in a firm (the expected premium one would expect to pay to merge or takeover another company)…
…which are important considerations in the overall process.