My most recent blogs have dealt with acquisition transactions from various perspectives. Most recently, “What’s a good price?”, looked at the issue of pricing multiples—and how they are meaningless out of context.
This week’s blog will address how a buyer can really know what to pay for a target bank. In other words, “How do you price an acquisition transaction?”
Where do you begin?
Let’s start with the basics.
1. No dilutive deals.
The board isn’t going to do anything in the way of an acquisition at any price if it hurts shareholder value for its current shareholders. (At least, the board shouldn’t.)
Normally, this translates into the purchasing bank not engaging in an acquisition transaction at such a price that its post-acquisition earnings per share will be lower than its pre-acquisition earnings per share.
In the distant past—decades ago—we would assist clients in acquisition transactions that were “dilutive to earnings per share” for the first couple of years.
Today, whether the transaction is accretive to the buyer’s earnings per share serves as the litmus test. If the transaction fails that initial test, a deal rarely occurs.
2. Don’t trade down.
Because of dilution concerns to earnings per share, a buyer will not give up more in stock or cash as transaction currency than it receives in offsetting earnings stream from the seller.
Keep in mind, this is not simply the seller’s earnings stream from current operations. It is the sustainable, post-transaction earnings stream that the seller brings to the buyer.
The difference between these two earnings streams is, for one, the (hopefully) significant reduction in non-interest expense as a result of the transaction, which boosts post-transaction operating earnings.
In addition to cost-savings, there may also be revenue enhancements. For example, what if the buyer has a large trust department or wealth management business, whereas the seller has none? The buyer should be able to run more of that business through the seller’s distribution network, thereby increasing earnings post-transaction.
Once the buyer determines the post-transaction earnings stream it is acquiring from the seller, then it can determine how much to pay for the earnings stream. Let’s take a closer look at this.
Going by the numbers … and judgment
Let’s say the buyer is paying in its stock, which generally means that it is a public bank holding company with some share liquidity. Then the purchase price can be determined using a pretty simple dilution formula—dividing the buyer’s projected earnings per share into the post-transaction earnings stream.
That will give the buyer the maximum number of shares, and the right purchase price, that it can pay for the transaction. That is, the number of shares times the market price equals the transaction purchase price.
That particular process may also yield a transaction that is significantly outside the norm. For example, if the market norm is 150% of book, a dilution analysis may indicate the buyer could pay 250% of book. A disciplined buyer will not pay that, however, because every subsequent target would expect the same premium.
The concept of dilution to the buyer’s earnings per share remains the same if the transaction consideration is cash.
The buyer has to come up with that cash from somewhere, be it borrowings, liquidating assets, or raising equity. Each of those sourcing alternatives has a cost associated with it. As such, the buyer needs to receive from the selling community bank an earnings stream sufficient to cover the cost of obtaining the cash.
Remember what’s paramount
The concept is simple. Our consulting firm’s merger analysis model, like most models, is based on the dilution analysis. Our model also utilizes a discounted cash flow analysis, as well as comparable transaction analysis.
But the reality is earnings dilution is the key.
The buyer is not going to do anything that gives up so much in cash or stock that it dilutes its own shareholders’ earnings per share.
For this reason, there needs to be a dose of conservatism tossed into the dilution model. That is, cost savings may be elusive, and revenue enhancements definitely are. As a result, when the buyer contemplates anticipated and realistic cost savings associated with the transaction, the transaction model may only incorporate 60% or so of those savings to ensure post-transaction earnings are not overstated.
Remember, as I mentioned in the previous blog, it is only once the purchase price is determined that it is translated into all our favorite metrics: price to book, price to earnings, price to assets, and price to core deposits.