When an exchange of common stock is involved in an acquisition or merger agreement, two different securities must be valued. In addition, a proper ratio of exchange must be found that reflects the respective values of the shares. Moreover, in most cases, the acquirer has to pay a significant premium (between 15 and 25 percent is the common range) over the objective value of the shares of the acquired company. This premium, of course, will affect the actual ratio of exchange of shares agreed on. While in the end, a numerical solution is applied, the underlying values and the premium will be the result of extensive negotiation and a certain amount of “horse trading” (Capron, 1999).
As the two stocks are valued, any differences in the quality and breadth of trading in the securities markets can be an important factor. If, for example, a large, well-established company acquires a new and fast-growing company, the market's assessment of the value of the acquirer's stock is likely to be more reliable than that of the candidate, whose stock may be thinly traded and unproven. But even if both companies had comparable market exposure, the inherent difference in the nature and performance of the two companies may exhibit itself in, among other indicators, a pronounced difference in price/earnings ratios. In effect, this means the performance of one company is valued less highly in the marketplace than that of the other. This difference will influence valuation of the stocks and the final price negotiated.
We will demonstrate just a few of the key calculations needed to arrive at the basis of exchange, using a simplified example. Let us assume that Assimilated Corp. and Kensington Corp have the following key dimensions and performance data at the time of their merger negotiations:
Key DataAssimilated Corp.Kensington
Current earnings$ 50,000,000 $10,000,000
Number of shares (outstanding)10 million 10 million
Earnings per share (EPS) $ 5 $ 1
Current market price (P) EUR 60 $ 15
Price/earnings ratio (P/E) 12 x 15 x
Negotiations between the management teams have reached a point where, after Candidate had rejected several offers, Acquirer now considers a price premium of about 20 percent over the current market value of Candidate's stock necessary to make a deal. This would call for an exchange ratio of $ 18/ $ 60, or 0.3 shares of Acquirer stock for each share of Candidate stock (meaning that 3 million new shares of Acquirer would be issued to the shareholders of Candidate's stock) (Chatterjee, 1986). The impact on Acquirer would be as follows, at the combined current levels of earnings (abstracting from possible synergy effects or benefits):
Assimilated Corp (after the merger)
Combined earnings (of the two companies)$ 60,000,000
Number of shares (10 mil. old + 3 miI. new)$13 million
New earnings per share (new EPS combined) $ 4.62
Old earnings per share (pre-merger EPS) $ 5.00
Immediate dilution (difference between EPS)$ 0.38
Under these conditions, Acquirer would suffer an immediate dilution of $ 0.38 per share from the combination (decline in ...