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.
That is, the combined company, if each piece were equal and they just merged as equals…would not have one half of the combined company as being valued at 12 times earnings when it was a stand-alone company, and another piece valued at 30 times as a stand alone…but combined at a price of 36 times. That’s 12 plus 36, or 48…then divided by two companies combining here, so the new company (should the stock prices all remain flat at the proposed acquisition or merger price set) would be trading at 24x earnings.
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.
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Finance: What is Dilution?77 Views
finance a la shmoop. what is dilution? ownership is a pie.
here's 100% of pie. it's divided into 20 million slices, there there you just [man holds pie]
can't see them. each is a share of ownership in the company whatever.com
well one day the CEO of whatever.com decided she wanted to buy her hated
competitor something.com for 2 million shares. then she wanted to buy her
marketing vendor sell my butt off.com for a million shares. well her stock had
been trading at 12 bucks a share for a total market valuation of 240 million
dollars .see we get that 12 times 20 million. but then after printing 3 [equation]
million more shares to buy her competitors,
well she now has 23 million slices of pie .and yes that's how it works!
companies can essentially just go to the Xerox machine and print shares of their
own stock, that they didn't formerly own. but now she has 23 million shares [printer prints shares]
outstanding and not 20 million. so at $12 a share the stock market is valuing her
company at a meaningfully higher price. 12 times 23 million is 276 million. it's
saying that the value of the three million share dilutions she took in
buying something dot-com and Sell my butt off.com [woman waves to camera]
was the difference between the 276 million in the 240 million or 36 million
bucks. but let's say the market value had stayed flat at 240 million. well now with
23 million shares out the stock is only worth 10 dollars and 43 cents a share,
instead of the previous $12 a share. in other words shares have been diluted
each share of whatever com is no longer worth as much as it used to be. that pie
isn't looking quite as appetizing now is it? [man frowns in kitchen wearing apron]
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