What is Bootstrap Effect?

Bootstrap Effect or Bootstrap Earnings Effect refers to the short-term boost in the earnings of the acquirer company when it merges with the target company even though there is no economic benefit from such a combination.

Let’s take an example of Bootstrap Effect

There are two companies: company A and company B. Company A is trading at a higher Price to Earnings than company B, which trades at a lower Price to Earnings ratio. Now, if company A enters into a share-swap deal with company B, company A will have to pay for the market value of the shares of company B using its shares. Given the above situation, the earnings per share of company A post-merger will shoot up. Remember, after the merger, there is no company B.

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How to Identify Bootstrap Effect?

That was a lot of theory. Let’s just not be overwhelmed by the textual definition and dive more to put this concept under the belt. So why did the earnings per shareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company’s performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more of the company A shoot up?

If company A acquires company B through stocks, fewer combined shares will be shares outstandingShares OutstandingOutstanding shares are the stocks available with the company’s shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner’s equity in the liability side of the company’s balance sheet.read more post-merger. Since earnings remain the same but there are fewer shares of stock, the earnings per share ratio increases favorably. However, investors may not understand the reason behind the increase in earnings per share. Instead of knowing the underlying reason behind the sudden surge, investors may believe the earnings per share increased because of the synergySynergySynergy is a strategy where individuals or entities combine their efforts and resources to accomplish more collectively than they could individually.read more created through the merger, increasing the value of the post-merger stock.

Companies may enjoy this temporary boost in stock price, but the bootstrap effect generally becomes apparent in some years. To sustain the earnings per share ratio at an artificially surged level, the company would have to continue to play the merge-and-expand strategy by aggressively acquiring companies at the same rate. Once a merger-and-expansion spree comes to a halt, the earnings per share will decrease, and the stock price will follow suit.

Bootstrap Effect Example #1

Let’s take an example to understand it further:

  • Acquirer needs to pay: $3,000,000.0Acquirer’s share price: $100Number of shares acquirer needs to issue: $3,000,000.0 / $100 = 30,000 sharesSo, as a result of the merger, there will be a total of 130,000 shares (including 100,000 old shares and 30,000 new shares).The post-merger earnings of the merged entity will be $850,000 (including $600,000 of the acquirer and $250,000 of target).Hence, the post-merger earnings per share will be 6.5 as per the following calculation:Post-merger EPS = $850,000 / 130,000 = 6.5

It can be seen that the post-merger earnings per share of the acquirer are greater than the acquirer’s earning per share before the merger, which is mainly due to the effect of reduction in the total number of shares of the post-merger entity, which is 130,000 (instead of 200,000) and increase in acquirer’s post-merger earnings due to addition of the earnings of the target.

This short-run increase in earnings per share is due to the sheer play of mathematics and not because of any economic growth mergerMergerMerger refers to a strategic process whereby two or more companies mutually form a new single legal venture. For example, in 2015, ketchup maker H.J. Heinz Co and Kraft Foods Group Inc merged their business to become Kraft Heinz Company, a leading global food and beverage firm.read more.

Bootstrap Effect Example #2

Let’s take another bootstrap earnings example:

As per the table is shown above, we will calculate the following:

  • of shares to be issued by the acquirerPost-merger EPSPost-merger P/EPost-merger Price

No. of shares to be issued by the acquirer:

  • = Market value of Equity of Target / Share Price of Acquirer= $3,500,000.0 / $100.0= 35,000.0 shares

Post-merger EPS:

  • = Total earnings of the Acquirer post-merger / Total number of shares of Acquirer post-merger= ($300,000.0 + $125,000.0) / (100,000.0 + 35,000.0)= 3.1

Post-merger P/E:

Assuming the market is efficient and hence pre and the post-merger share price of Acquirer will remain the same.

  • = Weighted average EPS of Acquirer + Weighted average EPS of Target= $300,000.0 / ($300,000.0 + $125,000.0)) x 33.3 + $125,000.0 / ($300,000.0 + $125,000.0)) x 28.0 = 31.8

Post-merger Share Price of Acquirer:

Assuming market is not efficient, hence the share price pre and post-merger will not be the same.

  • = Acquirer’s pre-merger P-E ratio x Acquirer’s post-merger EPS = 33.3 x 3.1 = 105

which is higher than the acquirer’s pre-merger share price due to the bootstrap effect.

Summary

The following events identify the bootstrap effect:

  • The shares of the acquirer trade at a higher P/E ratio than shares of the target.The acquirer’s EPS increases after the merger without any operational contribution.

When there are no economically viable gains from a business combinationA Business CombinationA business combination is a type of transaction in which one organization acquires the other organization and therefore assumes control of the other organization’s business activities and employees. In simple terms, it is a consolidation of two or more businesses to achieve a common goal by eliminating competition.read more, such a surge in share price does not sustain for a long time as investors recognize that the increase in the acquirer’s EPS is purely due to the bootstrap effect, and hence, adjust the acquirer’s P-E downwards in the long run.

However, there have been instances (e.g. 1990’s dotcom bubbleDotcom BubbleThe Dotcom Bubble was an economic bubble that affected the prices of stocks related to the technology industry during the late 1990s and early 2000s in the United States. The event was triggered by the hype over the new Internet industry, media attention, and investors’ speculation of profits by dot-com companies.read more) where many high P-E companies bootstrapped their earnings to exhibit continuous EPS growth by successively merging with low P-E companies. Hence, investors must be cautious as companies may use such strategies to create this P-E bubble and maintain it through a merger spree. But, in the end, fundamentals always triumph. So, value investors will continue to be the winners.

Bootstrap Effect Video

This has been a guide to Bootstrap Effect in Mergers and Acquisitions? Here we discuss ways to identify Bootstrap Effect along with bootstrap earnings examples. You may learn more about M&A from the following articles –

  • Bootstrapping Yield CurveStatutory MergerBear Hug