When the acquirer’s P/E is higher than the target’s, bootstrapping effect will happen. But how does bootstrapping effect affect the postacqusition price? I am a little confused here. My understanding here is that if the market is inefficient, the post acquisition price will increase. But if the market is efficient, the post acquisition price will stay the same as the prior-acquistion price of the acquirer. Am I right?
Jessie, Bootstrapping just means that a company (Co’ A) will issue more of its shares to acquire Co’ B. In doing so, the shares outstanding of Co’ A increase by the amount of shares needed to acquire Co’ B while the earnings of both companies will consolidate. In inefficient markets, this action will not change the stock price of Co’ A, but given that there are more shares outstanding and total earnings became larger, EPS will increase while mkt cap and earnings will just be the sum of both companies … I hope this makes sense. My understanding is that when markets are efficient, this is recognized and the price is adjusted downward … and EPS remains unchanged.
" In inefficient markets, this action will not change the stock price of Co’ A, " In efficient markets… “My understanding is that when markets are efficient, this is recognized and the price is adjusted downward … and EPS remains unchanged” No. Assuming that there are no economic gains from the transaction (which is in some sense an odd assumption), then if the acquirer is trading at a higher multiple of earnings than the target, the EPS of the combination is some weighted average of the EPS of the two companies prior to acquisition. This really doesn’t have anything to do with efficient markets, it’s just bookkeeping. The efficient markets comes into play because if you take some high growth company that is accustomed to trading at 35 times earnings and they acquire a grocery store chain, they should stop trading at 35 times earnings. The question is whether or not markets properly adjust for that. I’m pretty sure they do and I’m pretty sure there is a ton of academic literature on it and I’m totally sure I’ve never read any of it. In the 1960’s and the age of the “Nifty Fifty”, this kind of stuff went on all the time and it worked. A high growth company could acquire some cash cow and somehow look like it was creating economic value by having the combination worth significantly more than the sum of the pieces even though there was no reason to believe in any synergies.
JoeyDVivre Wrote: ------------------------------------------------------- > The efficient markets comes into play because if > you take some high growth company that is > accustomed to trading at 35 times earnings and > they acquire a grocery store chain, they should > stop trading at 35 times earnings. The question > is whether or not markets properly adjust for > that. I’m pretty sure they do and I’m pretty sure > there is a ton of academic literature on it and > I’m totally sure I’ve never read any of it. > > In the 1960’s and the age of the “Nifty Fifty”, > this kind of stuff went on all the time and it > worked. A high growth company could acquire some > cash cow and somehow look like it was creating > economic value by having the combination worth > significantly more than the sum of the pieces even > though there was no reason to believe in any > synergies. There was a study or two back in the 1990s (don’t have the citation here, but can look it up if anyone cares) that indicated that the scenario you mentioned (High P-E firm acquires cash cow) was one of the few cases where there appeared to be a bootstrapping effect. But, it wasn['t bootstrapping in the sense mentioned here. The acquisition increased the combined mkt value of the two firms, but it was a financing frictions/underinvestment/agency problem story. The explanation of the study’s authors was an underinvestment story on part the high PE firm’s side combined with an agency probelm on the part of the cash cow. In other words, acquirer had profitable opportunities that they were foregoing due to lack of financing, while the the cash cow target had money burning a hole in its pocket. So, it was almost a “financing synergy” combination. But outside of these cases, you’re correct.
^ I believe that.