Conservation of Value  47
The common element of both these acquisitions was radical performance 
improvement, not marginal change. But sometimes we have seen acquisitions 
justified by what could only be called magic.
Assume, for example, that Company A is worth $100 and Company B is 
worth $50, based on their respective expected cash flows. Company A buys 
Company B for $50, issuing its own shares. For simplicity, assume that the 
combined cash flows are not expected to increase. What is the new Company 
AB worth?
Immediately after the acquisition, the two companies are the same as they 
were before, with the same expected cash flows, and the original sharehold-
ers of the two companies still own the shares of the combined company. So 
Company AB should be worth $150, and the original A shareholders’ shares 
of AB should be worth $100, while the original B shareholders’ shares of AB 
should be worth $50.
As simple as this seems, some executives and financial professionals will 
still see some extra value in the transaction. Assume that Company A is ex-
pected to earn $5 next year, so its P/E is 20 times. Company B is expected to 
earn $3 next year, so its P/E is 16.7 times. What then will be the P/E of Com-
pany AB? A straightforward approach suggests that the value of Company 
AB should remain $150. Its earnings will be $8, so its P/E will be about 18.8, 
between A’s and B’s P/Es. But here’s where the magic happens. Many execu-
tives and bankers believe that once A buys B, the stock market will apply A’s 
P/E of 20 to B’s earnings. In other words, B’s earnings are worth more once 
they are owned by A. By this thinking, the value of Company AB would be 
$160, a $10 increase in the combined value.
There are even terms for this: multiple expansion in the United States and 
rerating in the United Kingdom. The notion is that the multiple of Company 
B’s earnings expands to the level of Company A’s because the market doesn’t 
recognize that perhaps the new earnings added to A are not as valuable. This 
must be so, because B’s earnings will now be all mixed up with A’s, and the 
market won’t be able to tell the difference.
Another version of the multiple-expansion illusion works the other way 
around. Now suppose Company B purchases Company A. We’ve heard the 
argument that since a company with a lower price-to-earnings (P/E) ratio is 
buying a higher-P/E company, it must be getting into higher-growth busi-
nesses. Higher growth is generally good, so another theory postulates that 
because B is accelerating its growth, its P/E will increase.
If multiple expansion were true, all acquisitions would create value be-
cause the P/E on the lower-P/E company’s earnings would rise to that of the 
company with the higher P/E, regardless of which was the buyer or seller. But 
no data exist that support this fallacy. Multiple expansion may sound great, 
but it is an entirely unsound way of justifying an acquisition that doesn’t have 
tangible benefits.