EPS bootstrapping after merge

Hi, EPS bootstrapping occurs when acquirer P/E > target P/E under stock transacation. But in schwester notes book 7, mock 2 pm Q81, why condition “acquirer’s post merger P/E remains at the current level” is needed as well?

2012, Vol 2, Exam 1, Afternoon sesion, Q81.

Why EPS bootstraping occurs but PE is unchanged ?

Could somebody help ?

P/E should ideally adjust downwards, cos there is no real increase in earnings, and excluding any snergies, price must be the same. If P/E doesnt change, the market hasnt recognized this, as was the case during the dot com era in the late 1990s.

To second adq’s point - the market should realize what is happening. Per CFA text, if a company with high growth potential acquires a company with low-moderate growth potential (so high P/E acquires low P/E) the HG company can issue high-value shares to purchase the low-value company, so in effect the amount of earnings are combined but the amount of shares doesnt increase 1 for 1 - ( you need to issue less shares to equal the value of the low-growth firm)

The high growth company issues shares on a less than 1 for 1 basis. So, EPS will in effect go up (earnings are combined 1 for 1, but the amount of shares is less than 1 for 1)

What should happen - in an efficient market - is that the P/E of the combined firm should adjust downward. A high-growth company has purchased a low growth/mature company. There is no additional capital investment, no growth in technology, etc - but the illusion of synergy has been created through an increase in EPS. So, if EPS has increased, P/E should fall to level commensurate with each firms weighted average contribution to earnings.

If the P/E stays the same after the merger, the price of the acquirer’s stock must rise in the open market, and the company has succeeded in “bootstrapping” the price of the stock upwards (which, to the point above, was the case in the dot com era when people A.) didnt know how to value these firms and B.) waves of mergers with low-growth (p/e) companies.

I dont know the question, so I can’t answer why they would have the condition in there

brisby, in your statement about the P/E decreasing, that’s not entirely true. CFA text is clearer than Schwese.

I think you’re getting confused - the bootstrapping effect occurs if the P/E post merger does NOT drop.

The point of the lesson is that the firm has created no value through synergies (apparently), but due to the acquisition have increase Earnings without a proportional increase in the number of shares outstanding. So EPS goes up - clear on that so far?

BUT, after the acquisition, you’ve got a firm with a higher EPS. Now, two things can happen immediately after the merger, the stock price can change or it can stay the same

The price of the acquirers stock can stay roughly the same. They have a higher EPS, but the stock price is constant - implies post-merger P/E has fallen. This is what should happen, ideally with smart analysts, etc

The price of the acquirer stock can rise (to keep a constant P/E). If the price of the stock rises enough to keep the P/E constantt, b ootstrapping has occurred. "The bootstrapping effect occurs when the shares of the acquirer trade at a higher price than those of the target and the acquirer’s PE does not decline following the merger"