How does acquiring a lower P/E firm increase EPS?
I know that when a firm has a P/E of, say, 10x, and acquires a firm with a P/E of 8x it will increase EPS/be Accretive. Can anyone intuitively explain how it increases EPS? The only way I can understand why its Accretive is that they are getting earnings for a lower price, but still don't see how this increases earnings on a per share basis when they are acquiring all of the targets shares as well. Does it effect outstanding shares?
You're missing a basic component of this question which is transaction consideration.
how about say some more useful stuff?
Just use a simple example:
Acquirer: Mkt Cap: $100 Net Income: $10 P/E: 10.0x Shares: 10 EPS: $1.00 Share Price: $10
Target: Mkt Cap: $50 Net Income: $20 P/E: 2.5x Shares: 5 EPS: $4.00 Share Price: $10
As mentioned above the consideration is key - the key for the P/E analysis you are referring to is that the deal is a share deal. Assuming that is the case, the acquirer in this scenario issues 5 additional shares to acquire the Target, leaving the total shares of the combined entity at 15 shares.
Your new EPS is calculated as the combined net incomes ($10+$20=$30) divided by the new share count (15) = $2.00 which is greater than the original EPS of $1.00, hence Accretive. Intuitively, you are acquiring shares that are at the same price as your own but getting significantly more net income per share.
This gets messier as you layer on debt, synergies, PPA adjustments, fees, etc.
damn you beat me to it...by 20 seconds.
I'm not understanding this explanation. This situation being Accretive/dilutive depends on the number of shares, not the P/E of the acquirer being higher than the target. If the target has 40 shares instead of 5, the combined EPS ends up being .6, making it dilutive even though the acquirer has a higher P/E than the target.
In your scenario the 'Target' has effectively become the acquirer. With 40 shares the Target's market cap goes to $400 and then you're merging it with an acquirer with $100 market cap. The Target shareholders are going to own more of the combined entity and thus are really the acquirer. Same principle still holds; stock deal, acquirer (the entity owning more of the combined entity) with lower P/E acquiring a company with a higher P/E, ends up dilutive.
Lets consider two situations: one where the transaction is all debt/cash and the other where it is all stock. It is important to remember that this is from the perspective of the acquiring company shareholders AND that earnings are just streams of cash.
All debt: if you can borrow some cash that requires you to pay X dollars ever year or quarter or whatever and you can use it to buy a stream of cash that give you some number more than X every year or quarter or whatever, you will do that. It creates value. Lets put this in an acquisition context. You borrow $100m dollars to buy a company that produces $10mm per year of earnings, you pay 6% interest on the debt ($6mm per year). The company you acquire has no more shares outstanding and you have the same number of shares out standing. You now pay $6mm per year (pretax), have some tax shield and get to keep that additional $4mm per year with the same number of shares outstanding. This is an Accretive transaction where it does not matter what your P/E is because you used 6% money (pretax) to buy 10% money.
All Stock: think about this like the above. There is an inverse relationship between P/E and cost of equity. If you have a higher P/E then you have a lower effective cost of money. If your P/E is 20 and you buy a company with a P/E of 10, then you are using 5% money to buy 10% money. If you want more analysis, lets use the same assumptions as above. You buy a company for $100mm dollars with $10mm of earnings. They have 100 shares, so $1mm per share. Your company is also $100mm and has $10mm of earnings but you only have 50 shares, so $2mm per share. The exchange ratio here is 2/1 - that is, you can get two of their shares for one of yours. You issue 50 shares to buy their 100 shares, so now there are 150 shares outstanding but the combined company now has $20mm in earnings with 150 shares outstanding. Your EPS is now higher, so the transaction is Accretive.
Accretion dilution is such a stupid metric. Basically any conceivable cash deal is going to be Accretive and the fact that a deal is supposed to be Accretive doesn't actually move the market. We really should come up with a smarter way to look at mergers that only gives a firm credit if a cash deal generates returns above WACC (instead of just better than incremental interest expense of new debt and interest income from cash)
A lot of great, extremely detailed answers here.
But the simplest explanation is that you are using your higher value stock to acquire a target's lower value stock, which gets re-priced at the acquirer's valuation.
The big assumption is that your P/E post-acquisition is the same as what it was pre-acquisition, but in reality it often decreases to a weighted average. In that case, it is neither Accretive nor dilutive. This makes logical sense because you are simply merging 2 companies, nothing has changed except the perceived valuation of the combined entities (i.e. The post-acquisition P/E Multiple)
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