When two companies are combined, a ratio of exchange occurs, denoting the relative weighting of the firms. The ratio of exchange can be considered in respect to earnings, market prices and the book values of the two companies involved.
In evaluating possible acquisition, the acquiring firm must at least consider the effect the merger will have on the earnings per share of the surviving company. We can discuss this through an illustration:
Company A is considering the acquisition by shares of Company B. The following information is also available.
Company A Company B
Present earnings Shs 20,000,000 Shs 5,000,000
Shares 5,000,000 2,000,000
Earnings per share Shs 4 Shs 2.50
Price/earning ratio 16 12
Price of shares Sh 64 Sh 30
Company B has agreed to an offer of Shs 35 a share to be paid in Company A shares.
Consider the effect of the acquisition to the earnings per share.
The exchange ratio = 35/64 = 0.546875 shares
of Company A's stock for each share of Company B's stock.
The total number of shares needed to acquire company B's share
= 0.546875 X 2,000,000 = 1,093,750 shares of Company A
The earnings per share therefore can be computed as follow:
EPS combined = Earnings of A + Earnings of B
Companies Total No. of shares
= 20,000,000 + 5,000,000
5,000,000 + 1,093,750
= Shs 4.10
Therefore the earnings for share of the combined firm is Shs 4.10.
There is therefore an immediate improvement in earnings per share for Company A as a result of the merger.
However, Company B's former shareholders experience a reduction in earnings per share. These EPS will be given by
0.546875 X 4.10 = Shs 2.24 from Shs 2.50
b. Future Earnings
If the decision to acquire another company were based solely on the initial impact on earnings per share, an initial dilution in earnings per share would stop any company from merging with another. However, due to synergetic effects discussed earlier, the merger may result in increased future earnings and therefore a high EPS in future.
c. Market Value
The major emphasis in the bargaining process is on the ratio of exchange of market price per share. The market price per share reflects the earnings potential of the company, dividends, business risk, capital structure, asset values and other factors that bear upon valuation. The ratio of exchange of market price is given by the following formula:
Market price ratio = Market price per share of acquiring company X No. of shares offered
of exchange Market price per share of the acquired company
Considering the previous example (example 4.1)
Market price ratio = 64 X 0.546875 = 1.167.
Therefore, Company B receive more than its market price per share. It is common for the company being acquired to receive a little more than the market price per share. Shareholders of the acquired company would therefore benefit from the acquisition because their shares were originally worth Shs 30 but they receive Shs 35.
The following information relates to Company X and Y.
Company X Company Y
Present earnings Shs 20,000,000 Shs 6,000,000
No. of shares 6,000,000,000 2,000,000
Earnings per share Shs 3.33 Shs 3.00
Market price per share Shs 60.00 Shs 30.00
Price/earning ratio 18 10
Company X offers 0.667 shares for each share of Company Y to acquire the company.
The market price exchange ratio = 60 X 0.667 = 1.33
Shareholders of Y are being offered a share with a market value of Shs 40 for each share they own (i.e. 1.333 X 30). They benefit from acquisition with respect to market price because their shares were formerly worth Shs 30. We can consider the combined effect.
Total earnings Shs 26,000,000
No. of shares 7,333,333
Earnings per share Shs 3.55
Price/earning ratio 18
Market price per share Shs 63.90
Both companies tend to benefit due to the merger. This can be seen by the increased market price per share for both company. This is due to the assumption that the price earnings ratio of the combined company will remain 18. If this is the case, companies with high price/earning ratios can be able to acquire companies with lower price/earnings ratio to obtain an immediate increase in earnings per share (even if they pay a premium for the share.)
d. Book value
Book value per share is not a useful basis for valuation in most mergers. However, it may be important if the purpose of an acquisition is to obtain the liquidity of another company. The ratio of exchange of book value per share of the two companies are calculated in the same manner as is the ratio for market values computed above. The application of this ratio in bargaining is usually restricted to situations in which a company is acquired for its liquidity and asset values rather than for its earning power.