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ECO438-FAC413
HW 1: Scenario Analysis

The Conglomerate Con Game: A Monkey Business?

Consider a scenario of two companies – India Electronics Pvt. Ltd., an electronics firm, and
Juicy Juice Pvt. Ltd., which makes various kinds of juices. Each has 200,000 shares outstanding
on the market. It’s 2018, and both companies have earnings of INR 1 million a year, or INR 5 per
share. Neither business is actually growing, and with or without merger activity, earnings will just
continue along at the same level.

The two firms sell at different prices, however. Since India Electronics is in the electronics
industry, the market awards it a PE multiple1 of 20 which, multiplied by its INR 5 earnings per
share, gives it a market price of INR 100. Juicy Juice, in a less hip business, has its earnings
multiplied at only 10 times and, consequently, its INR 5 per share earnings command a market
price of only INR 50.

The board of India Electronics has made a decision that it’s going to emerge as a
conglomerate. It offers to absorb Juicy Juice by a stock swap at the rate of 2 for 3. This means,
the holders of Juicy Juice would get two shares of India Electronics – which have a market value
of INR 200 – for every three shares of Juicy Juice – with a total market value of INR 150. This
seems to be a great proposal, and the merger is approved cheerfully.

The budding conglomerate is named Synergy Pvt. Ltd., which now has 333,333 shares2
outstanding and total earnings of INR 2 million to put against them, or INR 6 per share. Thus, by
2019 when the merger has been completed, earnings have risen by 20%, from INR 5 to INR 6, and
this growth seems to justify India Electronics’ former PE multiple of 20. Consequently, the shares
of Synergy rise from INR 100 to INR 120, and all go home rich and happy. In addition, the

1
The price-earnings multiple or PE multiple (also known as the P/E ratio or PER) is the ratio of a company's share price to the company's earnings per
share. = , where the is earnings per share. For ex., if the share price is Rs. 100 and company's EPS for the year is Rs. 20, the
its PE multiple is 5.
2
There are 200,000 original shares of India Electronics plus an extra 133,333, which get printed up to exchange for Juicy’s 200,000 shares according to the
terms of the merger.
 2

shareholders of Juicy who were bought out need not pay any taxes on their profits until they sell
their shares of the combined company.

After one year, Synergy finds a company called Iron Tools Pvt. Ltd. which earns INR 10 per
share or INR 1 million with 100,000 shares outstanding. Iron Tools is in the relatively risky
specialized hardware business, so its shares command a PE multiple of 10 and sell at INR 100.
Synergy offers to absorb Iron Tools on a share-for share exchange basis. The shareholders of Iron
Tools are delighted to exchange their INR 100 shares for the conglomerate’s INR 120 shares. By
the end of 2020, the combined company has earnings of INR 3 million, shares outstanding of
433,333 and EPS of INR 6.92.

Company Earnings # shares EPS (INR) PE multiple Price

level outstanding (INR)
(INR)
Before India 1,000,000 200,000 5.00 20 100
merger 2018 Electronics
Juicy Juice 1,000,000 200,000 5.00 10 50
After first Synergy (India 2,000,000 333,333 6.00 20 120
merger 2019 Electronics +
Juicy Juiced)
Iron Tools 1,000,000 100,000 10.00 10 100
After second Synergy (India 3,000,000 433,333 6.92 20 138.125
merger 2020 Electronics +
Juicy Juiced +
Iron Tools)

An investor who browses through the Economic Times will find record of the Synergy
conglomerate as follows:

EPS (INR)
2018 2019 2020

Synergy Pvt. Ltd. 5.00 6.00 6.92

Clearly, Synergy is a growth stock, and its record of extraordinary performance appears to
have earned it a high and possibly an even increasing multiple of earnings. What has happened
here? Give your evaluation and analysis of this scenario in detail with solid logical arguments.