It’s all about the multiples. You work for BoringCo.com. You make stationary rollercoasters for the feint of heart...and you grow revenues at about 10% a year. Your stock trades at about 12 times earnings, and you really want to buy your would-be competitor LetsBounce.com, which makes concrete bounce houses. Unfortunately, LetsBounce has been growing revenues at about 15%, but because they make such a much-more-exciting-than-you-do product (people are really into inflicting pain on themselves these days), they trade at 30 times earnings.
They’re willing to be bought, but they’ll want 36x earnings for the privilege; that is, a 20% premium to where they trade today, and they only want stock...no cash. The primary shareholders would all suffer a huge tax bill if they took cash, so they only will take stock. Yours.
So this is a conundrum. You trade at a low multiple...12 times. Your shareholders own you because you are a "value story," meaning that you are cheap, but you are a low-risk company. Now if you try to buy a growth company and pay a high multiple for it, you risk alienating your shareholder base, and that’s...bad. But if you do buy LetsBounce, the combination should be really powerful. Birthday parties everywhere would be a thrill a minute.
The problem is that a 12x earnings company paying 36 times earnings to acquire a competitor is dilutive. BoringCo will earn $1 a share this year. LetsBounce will earn $1 a share this year. But BoringCo trades for $12 a share. LetsBounce trades for $36 a share. Why the huge disparity in trading prices given that the earnings are the same? Answer: Growth prospects and/or the strategic value of LetsBounce are vastly better than BoringCo. So if they merged into just one combined company, their trading multiple would likely "split the difference," and the new, combined company would trade for around $24 a share.
The combination of BoringCo and LetsBounce would have been dilutive to BoringCo, because its multiple of 12 would have been diluted down via the high multiple paid for LetsBounce, and the combination would have been accretive to LetsBounce, because now their stock will trade at around 24x earnings, instead of 30x earnings. Obviously, had both companies traded at the same multiple of earnings when they combined, there would be no dilution or accretion, and the merger would simply be called “neutral.” Sort of like someone’s reaction to a rollercoaster that neither rolls nor coasts.
Related or Semi-related Video
Finance: What is Fully Diluted EPS?1 Views
Finance allah shmoop What is fully diluted e p s
or earnings per share All right This is the company
headquarters for beef in a can the meat industry's answer
too easy cheese Okay so the earnings number came in
just fine at a dollar Twelve a share It's about
what wall street was expecting But then why did the
stock sell off so hard in the aftermarket the stock
was thirty five Fifty two with the close And now
it's only thirty three Twenty Not a huge break but
well about six ish percent is six ish percent So
what gives Well the primary earnings number was good It
beat street expectations of a buck ten But the fully
diluted earnings per share Well it sucked Why Well because
the company had granted too many stock options to its
employees There's a super competitive environment in silicon valley Teo
higher beef engineers So yes in very wall street E
Irony The company in trying to be generous with its
employees and be competitive Well it killed their stock Where's
the beef indeed Well those stock option grants were in
fact recognized by investors and those quote generous grants unquote
Ended up costing the employees well two bucks a share
and all the shareholders lost meaningful money is the stock
price sagged We'll have that work What happened Well there
are primary shares that comprise the base of a company's
ownership They are the common shares of the company and
actually owned that is they aren't just options So beef
in a can has one hundred million shares outstanding of
common shares common stock But it surprised wall street tto
learn that the company now also had twelve million options
outstanding and is the company earned one hundred twelve million
dollars then yes it had net income or earnings per
share of a dollar twelve on their primary earning things
but they're fully diluted Earnings are divided by the hundred
million common plus the twelve million options And that calculation
is made by dividing one hundred twelve million in earnings
then divided by the conveniently numbered here for this problem
one hundred twelve million fully diluted shares and options to
get only a dollar a share info fully diluted e
p s Well why is that such a problem Well
dilution is a bad thing if you're an already owning
owner of a company Your ownership i gets spread out
over more and more mouths That's gotta feed and well
you get less fat So when wall street sold off
the stock in this earning surprise the actual printed number
was just fine It was the denominator the total dilution
of option grants Well that's what feed up the stock
and yeah if you're the ceo of this company you 00:02:51.11 --> [endTime] might have a beef with that
Up Next
Accretive: the acquisition has a net positive impact on earnings per share. Dilutive: earnings per share are negatively impacted as a result of the...
What is dilution? Dilution happens when a company’s outstanding shares increase, meaning that stockowners now own a smaller percentage of the com...
What are anti-dilution provisions? Often seen in venture capital and developmental stage companies, anti dilution provisions refer to subscription...