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Bootstrap Effect
Bootstrap effect refers to merger that does not provide true economic benefits to the acquirer
company but there is an increase in the earnings per share of shareholders as the stocks are exchanged
in the merger and after the merger the shares combined are few and the earnings are same as the
combined earnings of both the company’s pre-merger, so it results in the increase in the earnings per
share.

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 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 as compared to 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 own 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.

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 share of the company A shoot up?

If company A acquires company B through stocks, there will be fewer combined shares outstanding
post-merger. Since earnings remain the same but there are fewer shares of stock, the earnings per
share ratio increases favorably. Investors may not understand the reason behind the increase in
earnings per share. Instead of getting to know the underlying reason behind the sudden surge,
investors may believe the earnings per share increased because of the synergy created through the
merger, resulting in the increase in 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. In order 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:

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Now, given the above scenario, in order to acquire the target company, the acquirer will have to
issue new shares in exchange for the shares of the target company as per the following calculation:

• Acquirer needs to pay: $3,000,000.0

• Acquirer’s share price: $100
• Number of shares acquirer needs to issue: $3,000,000.0 / $100 = 30,000 shares
• So, 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 clearly be seen that the post-merger earnings per share of the acquirer is greater than the
acquirer’s earning per share before merger which is mainly due to effect of reduction in 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 or any kind of synergy created by the merger.

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 acquirer

• Post-merger EPS
• Post-merger P/E
• Post-merger Price
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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 bootstrap effect is identified by the following events:

• 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 combination, such surge in share price
do 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 in the past (e.g. 1990’s dotcom bubble) 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 may try to maintain it through merger spree. But, in the end,
fundamentals always triumph. So, value investors will continue to be the winners.