Example Stock Market Mergers

http://www.lrb.co.uk/v31/n10/lanc01_.html

This is partly a question of accounting. In the stock market, all money is not created equal. The price of a share is determined by what people think it’s worth – obviously. But what people think it’s worth is in turn decided by what they think the company’s prospects are. Take the example of companies A and B mentioned above. Both of them make widgets. Company A is a fast-growing internet-based firm, eWidget, which is promising to take over the world market in widgets by riding the new trend for firms and customers to order their widgets online. Last year its earnings were £200 million. The company’s pitch to the stock market runs something like this: the global market for widgets is £1 trillion. In time, say ten years, it is clear that 30 per cent of widgets will be ordered over the internet. Our ambition is to win 10 per cent of that market. (The trick is to keep these projected and made-up figures sounding sensible and achievable: don’t claim that the net will be all the market, and that you’ll get all of that business. State a huge number for the total market, and claim to be after a sensible fraction of it.) So your sensible and achievable goal is for eWidget to have 10 per cent of 30 per cent of £1 trillion, in other words £30 billion a year. Wow! It’s clear that eWidget has a big, big future, and if you get in on it now by buying a piece of the company – i.e. by buying shares – you will, in time, make out like a bandit. As a result, eWidget’s shares trade at a high price in relation to the company’s present earnings: at the already mentioned market capitalisation of £10 billion, that means the shares cost 50 times the company’s earnings. The P/E ratio, as it’s called, is 50/1. That is high, and it can only be justified by steeply rising future growth.

Company B is Goodwidget Ltd. This is a well-run old firm with members of the original founding family still in charge. It has grown at 10 per cent a year for decades, and its business model is the same one it had during those years, one of steady incremental growth through the old-fashioned method of making a better widget than its competitors. The stock market takes one look at its figures and reacts with a colossal, neck-ricking yawn. There is no glamorous upside here and no reason to believe in any growth beyond the kind that Goodwidget has proved it can achieve. Thus, although Goodwidget actually sells more widgets and makes more money than eWidget – it made £500 million last year – because it seems to have less potential for growth, its shares are, in terms of their earnings, cheaper. The shares are priced at ten times their earnings, giving the company a market capitalisation of £5 billion. Goodwidget, despite earning more than twice as much as eWidget, is worth only half as much on the stock market. All money is not created equal. The money earned by Goodwidget is worth much less than the money earned by eWidget. This is one of those points of stock-market logic which seems surreal, nonsensical and wholly counterintuitive to civilians, but which to market participants is as familiar as beans on toast. (An example: when AOL took over Time Warner, the old media company supplied 70 per cent of the profit-stream, but ended up with 45 per cent of the merged firm, because AOL’s market cap was so much bigger. How successfully did that play out? Well, at the time of the merger, the new combined company’s market capitalisation was $350 billion. Today it’s $28.8 billion. That’s $321.2 billion in value gone with the wind. I say again, for anti-capitalists, merger = fiesta.)

Now let’s consider what happens if eWidget takes over Goodwidget. They bid £5 billion for the old-school company, and their offer is accepted. (In practice, by the way, they would offer more than that, since the whole point of takeovers is that the buyer sees more value in the target company than the market does: he sees a way of making more money than is already being made. But let’s keep this example simple.) The new company is worth £10 billion plus £5 billion, yes? No – and this, from the stock market’s point of view, is the beautiful part. Goodwidget’s £500 million of earnings are now added to the total revenue of eWidget, so the merged firm is earning £700 million a year. Remember that eWidget is valued at 50 times its earnings (so that £700 million of earnings implies a market capitalisation of £35 billion), which means that eWidget shares are about to more than treble in price. That in turn completely justifies the confidence of the shareholders who bought a piece of this exciting, sexy, go-go 21st-century widget-maker. The successful takeover has magically sent the share-price rocketing; the company has grown. It isn’t what’s known as ‘organic’ growth, of course, the kind which comes from selling more of your stuff to more people, but so what? Although most takeovers and mergers end by destroying value, the market loves them anyway.