Sly: I think Treit raised a very valid point that is not well understood by many, that's all. That's why people get confused and may get engaged in emotional arguments that have little to do with the topic itself. The confusion starts with the term marginal return as used by Treit. What the heck is that? My understanding is that term is similar to the term "marginal tax rate" used in US tax law: if you are in a higher tax bracket, say 25%, and have an annual taxable income of $60,000, you donot pay 25% x 60,000= $15,000. You pay much less (about $11,000) b/c you pay the lower tax rates first on the full ranges allowed for them (10% on the first $8,700, then 15% on the range b/w 8,700-35.350 and 25% on the amount above $35,350. So "marginal" means the tax on the additional dollars, not on the whole amount. Makes sense?
Ok, the question for us now is: when is marginal return for the equity financing portion of capex accretive with these additional funds raised at a certain price or PE ratio.? I'll bet that while the explanation may seem simple, not too many people have a correct answer to that, probably not even Solomon despite his financial background.
I'll try to provide below a general answer illustrated by a simple example to clarify that question. Say Company is expected to earn in 2013 a certain earnings per share= eps= E/S (E= Net total Inc, S= # shares outstanding before any additional issuances). In order for a share issuance to be accretive, the additional funds raised by selling "s" new shares must earn by itself an additional net income "e" such that the new eps is equal to the one before the issuance. So "accretive marginal return" means:
eps = (E+e)/(S+s) = E/S ................ (1)
Note that as eps increases year after year by g% (=eps growth rate), not only E must increase to g x E but the marginal earning e must also increase to at least g x e (assuming the share counts remain unchanged) in order for the original marginal funds to stay accretive. Meanwhile the new shares stays in the denominator forever, so the marginal future return (g x e) must grow even more to match a growth rate of g (say 30%) b/c it's divided by a larger denominator ( S+s) than if it were based on S alone.
Example (hypothetical): In 2013, SIAF expects to earn $100m on originally 100m shares, meaning eps =$1. During the year, due to unexpected cash needs and poor stock performance, the company decides to raise $15m additional funds by selling shares at a very poor P/E , say = 0.5, or at a pps of $.50. That means it must sell 30m shares for $15m. Company says the 30% dilution is justified b/c it allows it to grow the eps by 50%. Is it correct? Is the dilution accretive?
Answer: in order for the 30% dilution to be accretive, Condition (1) must be satisfied:
eps = ($100m+e)/ (100m+30m) = $1
This means: e = $30m, or the additional $15m funds raised by selling 30m shares must generate by itself an additional earning of $30m to be accretive ( $130m / 130m = $1). That means the $15m "marginal funds" must return $30m "marginal earnings". This however implies a ROI of 200% (equal to the inverse of the P/E the money was raised at), twice as high as the ROI earned by the original 100m shares. One can see from this example that it's almost impossible to have an accretive dilution at a P/E < 1. That's why in an earlier exchange with me, Treit has suggested that dilution be only done at a P/E of at least 2, better at 2.5 b/c that a P/E of 2.5 (pps at $2.5 on expected annual earnings of $1) implies a ROI = 40%, a more realistic expectation of return on the "marginal funds" portion. Only then one can expect dilution to be accretive, at least for the first year. The question remains if it will be accretive in the following years or not.
On a side note, in a more normal world, any businessman can only dream of an acquisition that generates a ROI of 40% b/c that means a payback of his original investment in 2.5 years. A payback time of 5 to 10 years is far more common and considered a good deal in most cases in my own experience. I will leave it to your judgement as to whether a 30% dilution would be justified by an expected eps growth of 50% as Mgmt claims.
Hope that clarifies the question to some extent.
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