Part 2 – Lesson 15

Below are several questions regarding accretion / dilution.  Try to solve these in your head or on paper.  In other words, try it without Excel!

Question 1 – Company A trades at 20x EPS, while Company B trades at 10x EPS.  Company A has \$1 of EPS, while Company B has \$2 of EPS.  Assume Company A and Company B have equal market caps.  Company A offers to acquire Company B at no premium.  What is the EPS accretion / dilution to Company A?

Answer 1 – 50%.  Let’s go through it step by step:

1. Company A has an EPS of \$1, which we can assume to be a net income of \$1 divided by a share count of 1. Similarly, Company B has an EPS of \$2, which we can assume to be a net income of \$2 divided by a share count of 1.
2. We need to add together the net income of Company A and Company B, which yields \$3 of net income.
3. Company A has a stock price of \$20 based on 20x \$1 of EPS, and Company B has a stock price of \$20 based on 10x \$2 of EPS. We need to compensate Company B by paying them \$20 for their stock.  To do that, Company A needs to issue 1 share of their stock (currently worth \$20) to Company B.
4. Based on this share issuance, the pro forma Company A will now have 2 shares outstanding.
5. We now divide \$3 of net income by 2 shares outstanding to yield \$1.50 pro forma EPS for Company A. This is 50% accretive to the standalone Company A EPS of \$1.00.

Question 2 – Building off question 1, let’s assume that there is no increase in the value of either Company A or Company B market cap.  What is the blended P/E multiple that the combined company should trade at?

Answer 2 – 13.3x.  Let’s go through it step by step:

1. Company A has a market cap of \$20 (\$1 of net income multiplied by 20x P/E). Company B also has a \$20 market cap (\$2 of net income multiplied by 10x P/E).  If there is no change to the market cap post acquisition, then, the combined market cap should be \$40.
2. We calculated in Question 1 that the pro forma net income is \$3.
3. Taking the market cap of \$40 and dividing by the net income of \$3 yields the 13.3x P/E multiple.

Question 3 – Building off question 1 and question 2, let’s now assume that Company A will be able to maintain its P/E multiple because investors have confidence that the growth rate of the combined business will improve.  Where should Company A’s stock price trade if it is able to maintain its P/E multiple?

Answer 3 – \$30.  Let’s go through it step by step:

1. We calculated in Question 1 that the pro forma EPS for Company A is \$1.50
2. Applying the 20x P/E to \$1.50 EPS yields the \$30 stock price.

Question 4 – Let’s change up the numbers from Question 1.  Company A trades at 20x EPS, while Company B trades at 10x EPS.  Company A has \$1 of EPS, while Company B also has \$1 of EPS.  Assume Company A and Company B have equal market caps.  Company A offers to acquire Company B at no premium.  What is the EPS accretion / dilution to Company A?  If Company A trades at 15x pro forma EPS, where will Company A stock trade pro forma for the acquistion?  If Company A maintains its multiple of 20x, where will the stock trade?

Answer 4 – 33% accretion / \$20 stock at 15x multiple / \$26.66 stock at 20x multiple.  Let’s go through it step by step:

1. Company A has an EPS of \$1, which we can assume to be a net income of \$1 divided by a share count of 1. Similarly, Company B has an EPS of \$1, which we can assume to be a net income of \$1 divided by a share count of 1.
2. We need to add together the net income of Company A and Company B, which yields \$2 of net income.
3. Company A has a stock price of \$20 based on 20x \$1 of EPS, and Company B has a stock price of \$10 based on 10x \$1 of EPS. We need to compensate Company B by paying them \$10 for their stock.  To do that, Company A needs to issue 0.5 share of their stock (currently worth \$20) to Company B.
4. Based on this share issuance, the pro forma Company A will now have 1.5 shares.
5. We now divide \$2 of net income by 1.5 shares outstanding to yield \$1.33 pro forma EPS for Company A. This is 33% accretive to the standalone Company A EPS.
6. We calculate the target stock prices by applying the 15x P/E multiple to \$1.33 pro forma EPS, which yields a \$20 stock price. If Company A maintains its multiple, we get a \$26.66 stock price based on a 20x P/E multiple applied to \$1.33 EPS.

Question 5 – Company A has a stock price of \$100 and EPS of \$10.  Shares outstanding is 50mm.  Company A has \$500mm in cash and wishes to utilize all of its cash balance to repurchase stock at \$100.  What is the pro forma EPS and accretion?  If Company A maintains its current multiple, where would the stock trade?

Answer 5 – \$11.11 EPS or 11% accretion / \$111.11 stock at 10x multiple.  Let’s go through it step by step:

1. Company A will be repurchasing 5mm shares based on \$500mm buyback divided by \$100 buyback price. The pro forma share count will be 45mm.
2. Since Company A is using cash (and assuming no lost interest income), there will be no effect to the net income of Company A. The net income of Company A is \$500mm based on 50mm shares multiplied by \$10 EPS.
3. The pro forma EPS is \$500mm net income divided by 45mm shares = \$11.11 EPS
4. Multiplying the \$11.11 pro forma EPS by the current 10x multiple yields at \$111.11 stock price.

Question 6 – Company A has a stock price of \$100 and EPS of \$10.  Shares outstanding is 50mm.  Company A will fund a \$500mm buyback with new debt with an after-tax cost of 5%.  The buyback will be executed at \$100 stock price.  What is the pro forma EPS and accretion?  If Company A maintains its current multiple, where would the stock trade?

Answer 6 – \$10.56 EPS or 5.6% accretion / \$105.56 stock at 10x multiple.  Let’s go through it step by step:

1. Company A will be repurchasing 5mm shares based on \$500mm buyback divided by \$100 buyback price. The pro forma share count will be 45mm (same as in Question 5).
2. Since Company A is using debt at 5% after-tax cost, we must adjust the net income lower to account for incremental interest expense. The net income of Company A is currently \$500mm based on 50mm shares which results in \$10 EPS.  The incremental interest expense will be \$25mm based on \$500mm new debt multiplied by 5% after-tax cost of debt.  The pro forma net income is \$475mm.
3. The pro forma EPS is \$475mm net income divided by 45mm shares = \$10.56 EPS
4. Multiplying the \$10.56 pro forma EPS by the current 10x multiple yields at \$105.56 stock price.