In terms of the math and foundations behind a couple of the main types of mergers and acquisitions with respect to compensation structure, including an all-stock deal and also an all-cash deal, a 100% stock deal will be most dilutive of any compensation structure, while a 100% cash deal will be the most accretive (i.e., has the most beneficial effect on pro forma earnings per share (EPS)).
In this article we will look at a third type of M&A deal, which is naturally a mix between cash and stock. And naturally, we would expect a cash/stock combination deal to be somewhere in the middle in the accretion/dilution spectrum, depending on the percentage of each.
For purposes of this illustration, we will consider a transaction that is 50% cash and 50% stock. Overall, cash/stock deals are the most tedious to compute by hand given we have two forms of calculations to complete in these cases. In an all-stock or all-cash deal, we simply do just one type of calculation given that only one form of compensation is in play. In a combination deal, we have to figure up each component separately.
Table of Contents
Before the Transaction
For comparison’s sake, we will keep the same hypothetical scenario that we have had in each of our previous two articles. We have two companies by the name of Atlas (the acquirer) and Burbank (the target). But in this case we are going to consider the circumstance of a hybrid compensation deal, comprised of 50% cash and 50% stock.
Atlas has the following financial characteristics:
- Share price = $100
- Shares outstanding = 1,000,000
- Market capitalization = $100,000,000
- Net income = $5,000,000
- Earnings per share (EPS) = $4.00
- P/E = 25.0
Burbank has the following financials:
- Share price = $35
- Shares outstanding = 500,000
- Market capitalization = $17,500,000
- Net income = $1,500,000
- EPS = $1.65
- P/E = 21.2
Transaction
Once again, we will assume that Atlas pays a 50% control premium for Burbank. If Atlas wishes to acquire 50% of the company using stock, let’s first calculate how much Atlas will have to pay in terms of its own equity.
Given Atlas is paying essentially 150% of Burbank’s price (with the 50% premium), it will need to pay 1.5*$35.00 (Burbank’s share price) = $52.50 for one share of Burbank. The stock-for-stock exchange ratio is dictated by the formula (target share price) / (acquirer share price). In this case, Atlas is offering Burbank $52.50 for one of its shares, so we plug in that value for target share price and divide by Atlas’ share price:
- Stock-for-stock exchange ratio = $52.50/$100 = 0.525
If this was an all-stock transaction, we would then take this ratio and multiply it by the number of Burbank shares outstanding to determine how many shares Atlas will need to distribute as part of the transaction. However, being that this is only partially a stock transaction, we would multiply the number of shares dispersed by the percentage of the deal that stock will take up. In other words, we take our stock-for-stock exchange ratio, multiply it by the number of shares outstanding for Burbank, followed by multiplying it by the percentage of stock being used for compensation in the deal.
- Shares dispersed = 0.525 (exchange ratio) * 500,000 (target company shares) * 0.50 (percentage of stock in the deal as a decimal) = 131,250
By this point we can calculate the total number of new shares of the combined company, Atlas-Burbank. This will be the number of shares outstanding of Atlas as its own entity, plus the number we just calculated:
- Total shares of Atlas-Burbank = 1,000,000 + 131,250 = 1,131,250
By this point we can obtain our pro forma earnings per share (EPS) value (i.e., the EPS should the two firms combine). We combine the net incomes of the companies and then divide by the number of new shares of Atlas-Burbank:
- Pro Forma EPS = ($5,000,000 + $1,500,000) / 1,131,250 shares = $5.75/share
From pro forma EPS, we can calculate the stock price of Atlas-Burbank by multiplying by Atlas’ P/E ratio:
- Share price of Atlas-Burbank = $5.75/share * 25.0 = $143.75
Analyzing the Transaction
As a result, a 50%/50% cash/stock transaction is 43.75% accretive ($143.75/$100.00, or new share price divided by the acquirer’s original share price). This compares to 28.75% accretion for a 100% stock deal and 87.5% accretion for a 100% cash deal.
From this graph, we can determine that the more cash-based a deal is, the more accretive it will be. The relationship is not totally linear. For each 1% increase in equity that is added to the deal initially, there will be a greater than 1% decrease in the level of accretion of the deal. That is, the more stock added to the compensation structure at the highest cash levels, there will be a disproportionate decrease in the level of accretion in the deal.
Final Thoughts
By this point, we have covered the three possible compensation structures in mergers and acquisitions deals – 100% cash, 100% stock, or a combination between the two. An all-cash deal will be most accretive on average, while an all-stock deal will be the least accretive, with a cash/stock combination being somewhere in the middle.
Calculating a hybrid cash/stock deal must be done in two parts – one calculation with respect to the cash portion of the deal and another with respect to the stock component.
Adding stock into a deal may be reasonable when the acquirer believes its own shares to be overvalued and would therefore represent a way to, in effect, obtain a cheaper price as opposed to cash alone. Or it may be necessary when a firm doesn’t have the cash available, can’t obtain a large enough loan, or doesn’t want to agree to its terms.
This would come at the expense of shareholder’s wealth, due to a less accretive deal at its inception and less of an ownership fraction of the target company, given distribution of stock to the target company effectively gives them an ownership slice of the combined company. That said, mergers and acquisitions deals have become more stock-based over time, as opposed to the deals in the 1980’s, where compensation was predominantly 100% cash-based.