Key Rule 1

Question 1

5 most important concepts to understand

Answer 1

• why would you buy/ merge another company.
• how does a marger model work
• how do you finance the purchase
• what happens immediately after you buy the other company
• what happens in the long term, why success or not

Question 2

Why would a company buy another company?

Answer 2

If it believes it will earn more from the acquisition than it spends to complete the acquisition.

E.g. - acquire for £500 mil, over next 10 years earn 1-1.2 billion
- roughly 15% internal rate of return if you assume 100 mil in additional earnings each year

Question 3

What is EPS?

Answer 3

Earning Per Share= Net Income - preferred dividends / weighted Shares Outstanding
- essentially the profit per share.
- may go up, or down, or be same depending on the price buyer pays, purchase method and seller’s pre-tax method
- weighted to account for changes in number of shares over time like stock splits
- preferred dividends = dividends paid to preferred shareholders, so not received by common shareholders

Question 4

In a merger model, usually you focus on:

Answer 4

EPS accretion/ dilution
- accretion = buyer’s EPS goes up
- dilution = buyer’s EPS goes down
This allows to figure out whether the deal will increase or decrease EPS.

Question 5

Two common reasons for buying a company

Answer 5

• financial reasons
• fuzzy reasons

Question 6

Financial reasons for acquisitions

Answer 6

• two mature firms merge to outcompete other firms
• expand into new geographical regions
• company may be undervalued
• might be motivated to gain the seller’s customers, could up-charge them, or cross sell their own products, etc.

Question 7

Fuzzy reasons for acquisitions

Answer 7

Essentially irrational reasons:
- massive acquisitions may be driven by ego and ‘destiny’
- seller has particular important tech, patent or IP
- seller proposes a threat
- seller has amazing employees buyer is willing to pay premium for - common with tech start-ups
- may not be good ROI or higher EPS, but buyer thinks intangible benefits will materialise in the very long-term

Question 8

Difference between merger and acquisition

Answer 8

Merger - buyer and seller around the same size
Acquisition - buyer is significantly bigger, usually 2/3x bigger by market cap/ revenue
- mechanically work the same
- transaction structures and purchase methods may differ

Question 9

EPS formula components explained

Answer 9

• Net Income: The total profit of the company after all expenses, taxes, and costs have been deducted from total revenue.
• Dividends on Preferred Stock: The portion of net income that is paid out to preferred shareholders. Preferred dividends are subtracted because EPS is focused on the earnings available to common shareholders.
• Weighted Average Shares Outstanding: The average number of shares of common stock that are outstanding during the reporting period, weighted by the time they were outstanding. This accounts for any changes in the number of shares during the period (e.g., due to stock splits, buybacks, or issuance of new shares).