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September 15, 2000
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How to [Turn] a Dog into a Gorilla
One of the tricks of finance is growth by acquisition. The following illustration demonstrates that reported growth can be misleading, even with honest accounting. Real cases are never this simple, but heed the warning to be wary of growth rates reported by perpetual acquirers.
Let's assume we have an industry where all companies have earnings growth of 10% per year and are valued at 30 times earnings. Swifty, a smart financier, realizes that if he can get his company, Fido Corp, to trade at 100 times earnings, he can buy other companies at 50 times earnings in exchange for Fido stock. Swifty is a mediocre manager, and Fido's earnings have grown at the same 10% rate as competitors.
Swifty hires a good PR firm, and visits several investment banking firms, who recognize he is a canny promoter and will be able to generate a lot of business for them. Securities analysts at the brokerage divisions of these firms write glowing reports and project Fido's earnings will grow 30% annually. Stockbrokers pester their clients and Fido's stock rises to 100 times earnings. The people who bought at lower multiples are very pleased that they have made such a shrewd investment.
Swifty knows there won't be any material synergies or cost savings from acquisitions, but he knows how a company can report 30% growth in earnings per share even if it is growing internally at only 10% per year.
Immediately prior to Year 1, Fido's financials are:
Trailing 12 month (ttm) earnings: $1,000,000
Shares outstanding: 1,000,000
Price/Earnings Ratio: 100
Fido Market Capitalization: $100,000,000
On January 1, Year 1, Fido closes on the acquisition of AA Corp, whose financials are:
Ttm earnings: $500,000
Acquisition price: $25,000,000 ($500,000 x 50)
Fido shares issued for AA: 250,000 ($25,000,000/$100)
Total Fido shares outstanding: 1,250,000 (1,000,000 + 250,000)
On December 31, Year 1, Fido's financials are:
Ttm earnings: $1,650,000 [($1,000,000 + $500,000) x 1.1]
Fido Market Cap: $165,000,000 ($1,650,000 x 100)
Earnings/Share: $1.32 ($1,650,000/1,250,000)
Price/Share: $132 ($1.32 x 100)
Amazing, isn't it? EPS and the stock price have risen 32% in a year, even though AA was bought at a 67% premium to the market P/E of 30. Those analysts and stockbrokers were right. Swifty is a great corporate leader.
On January 1, Year 2, Fido is renamed as King Corp and closes on the acquisition of BB Corp, whose financials are:
Ttm earnings: $825,000
Acquisition price: $41,250,000 ($825,000 x 50)
King shares issued for BB: 312,500 ($41,250,000/$132)
Total King shares outstanding: 1,562,500 (1,250,000 + 312,500)
On December 31, Year 2 King's financials are:
Ttm earnings: $2,722,500 [($1,650,000 + $825,000) x 1.1]
King market cap: $272,250,000 ($2,722,500 x 100)
EPS: $1.7424 ($2,722,500/1,562,500)
Price/Share: $174.24 ($1.7424 x 100)
Wow!! Another year of 32% growth in EPS and stock price! The analysts now are frequent guests on TV business programs, and their stock picks enjoy strong buying and big gains. Swifty is awarded an honorary Ph. D. He's one of the greatest corporate visionaries in the nation. Fawning investors study every word of his speeches. King is featured in a Business Week cover story.
On January 1, Year 3, King Corp is renamed Gorilla Corp and closes on the acquisition of CC Corp, whose financials are:
Ttm earnings: $1,361,250
Acquisition price: $68,062,500 ($1,361,250 x 50)
Gorilla shares issued for CC: 390,625 ($68,062,500/$174.24)
Total Gorilla shares outstanding: 1,953,125 (1,562,500 + 390,625)
On December 31, Year 3, Gorilla's financials are:
Ttm earnings: $4,492,125 [($2,722,500 + $1,361,250) x 1.1]
Gorilla market cap: $449,212,500 ($4,492,125 x 100)
EPS: $2.30 ($4,492,125/1,953,125)
Price/Share: $230 ($2.30 x 100)
Magnificent!! 32% growth in EPS and share price was repeated. A business school is named after Dr. Swift, pillar of the New Economy. He is the subject of numerous biographies and is a confidant of captains of industry and rulers of nations. Time names him "Man of the Year." Gorilla, now in the Dow Jones Industrial Average, is known as the company that never misses a quarter. Heavy insider selling is reported, presumably for diversification. Then Dr. Swift retires.
Wait a minute. This doesn't make sense. All of these businesses were growing earnings at 10% annually at all times, and there were no merger synergies or cost savings. How could EPS and the stock price grow 32% annually? The problem is that the EPS growth rate in a company growing by acquisition isn't directly comparable to the EPS growth rate in a company growing internally. If an acquiring company buys another with overpriced stock, there will be deceptive EPS growth even if the purchaser overpays. That's the way the numbers work, and investors beware. A company growing by takeover does not deserve the same P/E valuation as a firm growing EPS at the same rate internally.
If Gorilla makes no acquisitions in Year 4, on December 31, Year 4 Gorilla's financials are:
Ttm earnings: $4,941,338 ($4,492,125 x 1.1)
EPS: $2.53 ($4,941,338/1,953,125)
Note that even if the P/E ratio is maintained at 100, the stock price will rise only 10%, just as EPS grows. Gorilla will have to buy other companies to raise the EPS growth rate, and the acquisitions will have to be larger and larger. Inevitably this house of cards will collapse, since this spiraling takeover process cannot continue forever. Eventually the P/E will return to 30, since 10% is the true growth rate, and 10% growth is valued at a P/E of 30 by assumption. No matter what happens, the faithful will say Gorilla's weaker performance is due to the loss of Dr. Swift's brilliant leadership.
EPS growth rates must be used with caution, particularly where there are purchases financed by issuance of stock. Acquisitions can greatly complicate analysis of a firm, even in an artificially simple case as above. Don't buy a mirage.
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