I was asked this question during my interview in CS, but not sure if I answered it right. Hope you guys can help.
Assume company A has P/E of 8x and company B has P/E of 10x. For simplicity, assume it's a 100% stock transaction and that A buys B. What percentage in synergies would you need to break even (no dilution or accretion)?
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is the answer 2.5%?
25%
.
Could you walk through it?
Not that guy, but my understanding is that since B is priced 25% higher than A in terms of P/E, for A to break even on that transaction A needs to get expected synergies worth another 25% on top of B's expected earnings.
Where does the 25% come from?
10x/8x = 1.25x. Or think of it this way. The cost of acquisition in the all-stock transaction is the yield which is the inverse of the P/E ratio so 10%. On an intuitive level, for accretion dilution you need to compare this to the "yield" of reinvesting back into the business which would be 1/8x = 12.5%. So in order to break even by doing the transaction, the company would need to realize the difference in the yields. 12.5% - 10% = 2.5%. They mentioned 25% because an additional 25% in earnings would be needed to make up the difference. Hope this helps.
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