Acquisition Strategy and Stock Market Data
To illustrate how a predator firm can misinterpret the effects of an acquisition strategy concerning its own market performance, consider Table 12.1 that compares two takeovers.
Table 12.1: Acquisitions and Stock Market Data
In Liam's case, with lower-priced shares and identical financial indicators, the stock market data of the composite entity obviously remains unchanged post-acquisition. In Noel's situation, all else is equal except that half the number of shares are purchased for twice the price, which also corresponds to that for the predator company. As a consequence, the acquirer benefits from a 20 pence (20 percent) increase in EPS. Thus, the earnings yield rises from 5 percent to 6 percent. In other words, the P/E ratio falls from 20 to 16.66. However, all this presupposes is that the share price remains constant after the acquisition, just like Liam.
First, it seems reasonable to assume that with a 20 percent improvement in EPS, share price will rise by a similar proportion, i.e. £4.00. Therefore, an increase in share price from £20.00 to £24.00 would produce a P/E uplift from 16.66 back to 20 (yielding 5 percent). Second, it is conceivable that price will rise even further, unsubstantiated by earnings or any other trading fundamentals but from general buying pressure (think dot.com and the nineties techno boom).
The psychology behind such "crowd" behaviour applied to capital markets is explained in classic texts by Mackay (1841), Shiller (2005) and Kindleberger and Aliber (2011) documented in Chapter One. The driving forces are either fear or, in this case, greed. The combined impact of increased EPS and a proportionally sharper increase in the price of equity produces a much higher P/E ratio than that which existed prior to takeover. Assuming share price stabilizes at £28.00, you may care to verify that the P/E ratio will rise from 20 (pre- acquisition) to 28. This is equivalent to an earnings yield of approximately 3.57 percent.
Now visualize the composite entity making another acquisition, this time with a share price of £28.00 as opposed £20.00, with similar economic gains and then others, each with similar results. It would appear that a successful acquisition programme elicits vast capital gains for shareholders plus the growth, security and prestige which corporate management so desire.
Unfortunately, an element of what Mackay termed "delusion" is involved here. This stems from the confidence required on behalf of shareholders to sustain a high share price and therefore, a high P/E ratio premised not only on a rising earnings trend but extra buying pressure fed by the mania of eager investors. However, any factor that undermines this confidence can break the upward spiral and share price will fall. It may also precipitate a selling panic termed "revulsion" by Kindleberger and Aliber. Stock price reaches a bargain basement level and the predator company itself falls prey to takeover.
At least three factors can be identified. The first is the shareholders' perception of their individual positions in the spiral. Was equity received upon acquisition or purchased subsequently? If the former, the shareholder might still gain; if much later, the shareholder loses. The second factor arises because each subsequent acquisition must have a favorable impact upon the EPS of the composite entity. Since the company is not growing organically but by takeover, then either the size or the number of acquisitions must perpetually increase. Whichever applies, the strain on commercial competence grows and the probability of making uneconomic decisions increases. This final factor is crucial in the longer term.
We have explained how the combined impact of increased EPS and a proportionally sharper increase in the price of equity produce a much higher P/E ratio than that which existed prior to takeover. Both theory and evidence, based on the pioneering study by Myers (1976), have long suggested that acquisitions are therefore drawn from a limited spectrum; namely those companies with low P/E ratios.
Can you explain briefly why this is so, given our "golden rules" for investment? What are the pitfalls of such an acquisition strategy?
You will recall that a low P/E ratio could reflect an undervaluation of equity by the market relative to profit performance, thus making a company an attractive investment proposition. Equally, however, the commercial viability of the merged entity may be dubious, in as much as a low P/E ratio can also reflect investor concern that a company might be unable to maintain its profits. But in order to sustain the P/E ratios, EPS must be sustained year after year. What Myers terms the bootstrap game. Consequently, an entity acquired for essentially non-commercial reasons must produce profitable performance for an extended period, a requirement that may prove impossible.
So, shareholder panic, a bad acquisition, or declining financial performance may break the spiral. This is not to say that all spirals will break, but even composite entities, which survive to acquire again and again, can be accused of short-termism, which is eventually doomed to failure.
Recalling Liam plc in the previous numerical example, the predator might be using a higher P/E ratio as leverage in relation to that of the acquisition merely to secure an immediate improvement in EPS. If this subsequently attracts speculative investors, share price may be climbing a wall of worry, which is not supported by trading fundamentals. The company will then find it difficult to discontinue its periodic addition of relatively low P/E candidates, even to provide an illusion of EPS growth, which justifies its share price.