Thursday, September 19, 2013

PE Magic

One of the merger motives touted during the 1960's was PE Magic.  The concept was simple: you have Firm A with a PE of 20 acquiring Firm B for cash with a PE of 10.  Suppose both firms have an EPS of 1 and 10 shares outstanding.  The market price and market value of firm A is 20 and 200, respectively.  The corresponding values for Firm B are 10 and 100.  So without synergy, if the firms joined, the market value should be 300.  

Here is where PE magic comes in.  According to PE magic, when firm A acquires firm B the market attributes Firm A's superior PE of 20 to the combined EPS of 2.  Hence the market value of the merged firm is 40 and the total market value is 400.  Voila!  100 of market value by PE magic!

This concept was used to explain the conglomerate merger wave of the 1960s.  You know, when a cement company acquired an ice cream manufacturer - not much synergy there unless you can use the cement trucks to mix the ice cream!

Ahem.  There are obvious problems with PE magic.  There are reasons that firms trade for various PEs.  The PE of firm B is only 10 for reasons related to risk, managerial talent, growth and all the factors that relate to future projected cash flows and the variability of those cash flows.  Unless Firm A is able to alter those factors there is absolutely no reason to believe the PE of the combined firm will not settle somewhere in between 10 and 20 to reflect the realities of the new firm.  If nothing  changed after merger, the combined market value would be 300, the combined EPS would be 2 and the PE would be 15.  If you adjust for the costs of integration, the PE and market values would be reduced.

Now, Firm A may  be able to alter the characteristics of the cash flow stream - but that is synergy, not magic.  The moral of the story is to beware of any explanation for merger that implies something for nothing.   See our related posts on merger motivessynergies and the power of subtraction.

All the best,


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