Looking for the Bootstrap Effect?
What does bootstrap effect mean in simple terms?
Want a real-life example?
In this article, I will break down the meaning of Bootstrap Effect so you know all there is to know about it!
Keep reading as I have gathered exactly the information that you need!
Let me explain to you what is the bootstrap effect and how it works!
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What Is The Bootstrap Effect
The bootstrap effect refers to a type of merger where the post-merger earnings per share is artificially increased although the merger itself does not produce true value for the shareholders.
The reason why the earnings per share is increased following the merger is purely as a result of the combined earnings of the acquirer and target divided by fewer total shares outstanding.
I know that this does not sound clear at the moment.
Be sure to keep reading as I will go over a concrete example so you can see how the bootstrap effect works.
Bootstrap Effect Example
Let’s look at an example of how the bootstrap effect works to better understand the concept.
Let’s take a Company A (the acquirer) with the following characteristics:
- Current share price: $50
- Earnings per share: $3
- Price to earnings ratio: 16.67
- Shares outstanding: 50,000
- Earnings: $150,000
- Market capitalization: $2,500,000
Company B (the target) has the following characteristics:
- Current share price: $15
- Earnings per share: $1.25
- Price to earnings ratio: 12
- Shares outstanding: 50,000
- Earnings: $62,500
- Market capitalization: $750,000
Now, Company A will use its shares to buy all the shares of Company B (Company A will have to purchase 50,000 shares at $15 per share).
Company A will issue 1,000 shares at $50 per share to make the purchase.
Following the merger, here is the combined impact on the total shares outstanding of Company A:
- Current share price: $50
- Shares outstanding: 51,000
- Market capitalization: $2,550,000
Now let’s look at the impact on the combined earnings per share.
Let’s add Company B’s earnings to that of Company A and divide that by the total number of shares after the transaction ($150,000 + $62,500 / 51,000).
The earrings per share will therefore come out to $4.16.
As you can see in this example, all we did was combine the two company’s earnings and divide by the total outstanding shares following the merger.
Even though the merger did not create more value for the shareholders, on paper, the earnings per share of Company A goes up from $3 to $4.16.
When Does The Bootstrap Effect Work
For the bootstrap effect to work, it’s important that the acquiring company’s price-to-earnings ratio (P/E Ratio) be higher than the target company and that the transaction is done through a stock swap.
For the post-merger earnings per share to go up, you’ll need to have a situation where the total combined revenue of the companies is divided by fewer shares in total.
For example, imagine Company A has:
- Stock price of $150
- Total shares of 200,000
- Earnings $600,000
- P/E is 50
- EPS is $3
Company B has:
- Stock price of $75
- Total shares of 150,000
- Earnings of $300,000
- P/E is 37.5
- EPS is $2
If Company A buys Company B, the transaction will look like this:
- Company A must issue 75,000 shares to buy all of the Company B stocks ($75 X 150,000 / $150)
- Post-merger number of shares outstanding in Company A will be 275,000
- Combined earnings will be $900,000
- Combined EPS will be $3.27 ($900,000 / 275000)
As you can see, the bootstrap effect worked as the total combined shares after the merger is less than prior to the merger (275,000 instead of 350,000).
Since the total earnings get divided by fewer shares, the earnings per share figure actually goes up from $3.00 to $3.27 for Company A.
Why Use The Bootstrap Earnings Effect
The bootstrap earnings effect is a financial practice in corporate finance where a company attempts to increase its earnings per share by merging with another company having a lower price-to-earnings ratio.
In essence, the EPS bootstrapping effect has no economic benefit for the acquiring company or the target, however, it does boost the acquirer’s earnings per share in the short term.
Typically, the market does recognize that a particular merger is producing a “bootstrap effect” and the stock price will eventually be priced accordingly.
However, in situations where the market does not recognize this accounting trick, then the acquirer’s stock price may actually get a boost.
The market will assume that a higher P/E ratio means that the company is doing better than before and so it will price the company’s stock accordingly.
Long Term Impact of Bootstrap Effect
Typically, the bootstrap effect will produce a short-term and temporary impacts on the acquiring company’s earnings per share.
In other words, following the merger and for a short period of time, the acquiring company can report an increase in its earnings per share.
However, the EPS impact will fade away over time.
The only way a company can sustain an increase in its earnings per share is to continually acquire companies having a lower P/E ratio through a sware swap.
Bootstrap Effect Risk
The bootstrap effect is an accounting trick allowing a company to artificially show higher earnings per share even though there was no increase in the company’s revenues.
This is done by merging with another company having a lower PE ratio and using the company’s shares to make the acquisition.
It’s important that you are aware of companies looking to bootstrap their earnings to show a growing EPS over time.
For example, in the late 1990s and 2000s, prior to the dotcom bubble, many companies were taking advantage of their high PE ratios to bootstrap their earnings by acquiring smaller PE companies.
In general, the markets will detect that a company has attempted an earnings bootstrap and will adjust the acquiring company’s PE ratio downwards in the long run.
However, it’s important for investors to look at a company’s overall financial position and assess its business holistically to avoid falling into an EPS bootstrap trick.
Bootstrap Effects Takeaways
So there you have it folks!
What Does Bootstrap Effect Mean
In essence, the bootstrap effect or bootstrap acquisition refers to the impact of a merger where the acquiring company’s earnings is mathematically increased even though the merger did not produce more economic benefit for the shareholders.
For the bootstrap effect to produce a short-run increase in earnings per share, an acquiring company must purchase a target having a lower price to earnings ratio and purchase the target’s shares in a share for share exchange.
The objective is to divide the combined revenues of the acquirer and target by fewer shares outstanding thereby producing higher earnings per share result.
Now that you know what is bootstrap effect, when it happens, why companies use it, and how it works, good luck with your research!
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