Accretion / dilution was one of the most difficult finance concepts for me to understand when I was starting out. Ironically, it’s one of the simplest. I think the jargon can make it intimidating at first.
This article will introduce the concept of accretion / dilution - how to calulate it and when / why it’s used in financial analysis.
Accretion / dilution means:
How much will some per-share financial metric change as a result of a transaction?
That’s it. Generally, it’s used to evaluate the projected change in EPS (Earnings Per Share) resulting from a merger or acquisition. But it’s not exclusive to EPS - the concept can be applied to any per-share financial metric. For example, when evaluating MLP mergers, you might look at the projected accretion / dilution for LP distributions. Why per-share metrics only? We’ll discuss below.
EPS Accretion / (Dilution) = (Pro Forma EPS - Standalone EPS) / Standalone EPS
Here’s a quick example:
Standalone FY 2020E EPS: 1.00
Pro Forma FY 2020E EPS: 1.25
EPS Accretion / (Dilution) = (1.25 - 1.00) / 1.00
EPS Accretion / (Dilution) = 0.25 / 1.00
So, the proposed transaction is 25% accretive, and we’re projecting a 0.25 increase in FY2020E EPS
Since the PF EPS is greater than the standalone EPS, the deal is accretive. If the PF EPS is lower than the standalone EPS, the deal would be dilutive. Here’s an example:
Standalone FY 2020E EPS: 1.00
Pro Forma FY 2020E EPS: 0.98
EPS Accretion / (Dilution) = (0.98 - 1.00) / 1.00
EPS Accretion / (Dilution) = -0.02 / 1.00
So, the proposed transaction is 2% dilutive
Remember, accretive is positive and dilutive is negative.
Finance jargon can be overwhelming at first, but you’ll see the same elements pop up over and over. Here’s a quick review:
- FY 2020E - FY is the abbreviation for fiscal year. A company’s fiscal year can be different from the standard calendar year (1/1 - 12/31). Furthermore, the E after 2020 just means “Estimated” since we’re working with estimated financials for fiscal year 2020.
- Pro Forma - That’s Latin for “as if.” You often see it abbreviated as “PF.” When evaluating a potential transaction, the financial forecasts are Pro Forma, as if the transaction had occurred.
We’ve shown how to calculate EPS accretion / dilution above. Below are some of the factors that influence EPS accretion / dilution in an acquisition:
- Target company earnings
- Cost to realize synergies (synergies aren’t free!)
- Acquisition offer (how much was paid, and what form: cash vs. stock)
- Deal financing (as applicable)
We’ve put together an EPS accretion / dilution template that you can use to explore these concepts and the scenarios below.
This is one of the hypotheticals that always used to trip me up. Ignoring synergies, in an all-stock deal, how do you know if the deal is accretive?
It depends on two factors:
- Target P/E multiple (using the offer price per share)
- Acquiror P/E multiple
If company A (20x P/E multiple) purchases company B (10x P/E multiple) in an all-stock transaction, the deal will be accretive. The more expensive stock is buying the less expensive stock.
Here’s another way to think about it:
- 20x P/E multiple means 5% Earnings / Share yield
- 10x P/E multiple means 10% Earnings / Share yield
- If you issue a 5% bond to purchase a 10% bond, the interest income from the 10% bond will more than outweigh the 5% interest expense you owe.
- In this case, company A is the 5% bond (since company A is issuing shares as merger consideration), and company B is the 10% bond (its shares trade at a higher earnings yield).
In an all-cash deal, the acquiror pays the target’s shareholders 100% cash (no stock). The acquiror has to get that cash from somewhere. They have a few options:
- Excess balance sheet cash (e.g., Apple)
- Raise debt
- Raise equity (and pay target’s shareholders with cash proceeds)
For simplicity, we’re going to assume option 2 (Raise debt). In this case, understanding the accretion / dilution is simple: is the acquired earnings yield > the tax-effected interest rate from the acquisition debt?
Here’s an example:
Company A is buying company B for 25.00 per share. Company B has projected EPS of 2.50 and 100 shares. Company A finances the transaction with debt issued at 5%.
Company B has a 10x P/E multiple, or 10% earnings yield.
Company A is issuing debt at 5% pretax (~3.5% post-tax).
The transaction is clearly accretive. Company A will receive extra net income equal to:
162.5 = 25.00 offer price x 100 shares x (10% earnings yield - 3.5% post-tax interest rate)
To calculate the exact accretion we need to know Company A’s share count and EPS. Assuming Company A has 200 shares and projected EPS of 3.00, the deal is quite accretive:
162.5 extra net income / 200 shares = 0.8125 extra EPS
0.8125 / 3.00 = 27% accretive
Use the attached template to explore how the different variables impact accretion / dilution.
Play around with the following assumptions:
- % Premium
- Consideration mix (% Stock / % Cash)
- Interest rate on acquisition debt
- Target & acquiror projected EPS
This is the more complicated part of the story. Let’s start with another question: When evaluating a potential acquisition, what metrics / analyses are most important?
Everything below is a good answer:
- Valuation of target company / asset (are you paying less than the value you’re receiving?)
- PF leverage / capital structure
- PF combined financials / earnings
There are other aspects we’re leaving out that are also important - and that’s partly why evaluating acquisitions is so difficult. A merger or acquisition is a complex problem, and you need to examine it from different angles, which can sometimes tell contradictory stories.
Let’s go back through the list of relevant analyses above.
- Valuation of target company - this is arguably the hardest piece. Valuation is a notoriously tricky beast with lots of variables and hidden assumptions. Skilled finance professionals can make a DCF tell any story they wish. While other valuation methodologies (e.g., public comparables and precedent transactions) are a bit less numerically subjective, there’s still ample wiggle room: Which public comparables do we select? Which, if any, prior deals are relevant?
- PF leverage / capital structure - this is the simplest piece. In most cases, leverage / capital structure is a constraint. The financing tail generally does not wag the acquisition dog. Below are a couple examples:
- The acquiror doesn’t want its credit rating downgraded, so it can only raise $Xmm in debt and must fund the rest of the transaction with equity.
- The acquiror’s outstanding debt has covenants that prevent the acquiror from raising additional debt. The acquiror must use equity.
- PF combined financials - what is the projected financial profile of the company? What synergies is the acquiror predicting, and what is the cost to realize those synergies?
There’s a lot to look at. And that’s one of the main reasons why people like EPS accretion / dilution.
Remember: EPS = Net Income / Fully Diluted Shares Outstanding
- Net Income includes the effect of any capital structure change (interest expense), synergies, cost to realize synergies, and the earnings of the acquired company.
- Diluted shares outstanding incude any stock offered as merger consideration.
Thus, EPS accretion / dilution can serve as an all-in-one snapshot of a transaction’s financial impact.
If you believe that:
- Management’s financial projections (including synergies) are materially accurate and
- The PF company will trade at the exact same P/E multiple as before
Then, any accretive deal will leave shareholders better off (the stock will trade at a higher price).
That’s an oversimplification, but it is the basic logic behind EPS accretion / dilution. Let’s examine these assumptions and some of the ways things can go wrong:
- Projected financials - Even when management has the best intentions, projections are always somewhat wrong. The macroeconomic environment can change, a business unit can unexpectedly decline, or maybe the acquiror just does a bad job forecasting the target’s (or their own) financials.
- P/E Multiple - While many stocks trade on P/E multiples, many also trade on EV / EBITDA, or a blend of the two. Some trade based on revenue. And some trade purely on hype. If a company’s stock price trades on EV / EBITDA, then EPS is not as relevant. Likewise, for a material transaction, it’s rare that the trading multiple would remain constant. The market will react; the multiple will change.
- Accretive, but overpay - It’s very possible for one company to acquire another company in an accretive deal, and overpay. EPS accretion is usually a necessary, but never sufficient, condition for a good deal.
- Bad strategy - A company acquires another company for the financial rationale (the deal’s accretive), but the acquisition is a poor strategic bet.
So EPS accretion can serve as a financial snapshot, but you shouldn’t rely on it as your sole guide.
As you’ve probably gathered, accretion / dilution is most important for public companies. Private companies rarely need to worry about per-share metrics, such as EPS. They often have heavily concentrated ownership and owners who are directly represented on the board of directors.
Public companies face a different set of conditions:
- Diffuse shareholder ownership
- Agency problems (most shareholders not directly represented on the board)
- Public quarterly financial results
- Constant performance measuring stick: company stock price
When undergoing a material merger / acquisition, management teams of public companies face a lot of extra stress navigating these conditions.
- They must communicate to shareholders why the deal is a good use of shareholder capital (vs. returning capital to shareholders & organic initiatives)
- They must sell the public markets on the deal (equity research analysts, major investors, and press)
Even if the management team and the board are convinced a deal is good, they will face severe displeasure if the stock price tanks following a deal announcement. These days, a poorly received acquisition and lackluster earnings are an invitation for activist investors (a.k.a. an extremely persistent migraine).
For these reasons, EPS accretion is often an essential metric for communicating a deal to the public markets. It’s an easy data point that management can refer to in order to show shareholders why a deal makes sense - why it leaves them better off. We’ll make more money for each of your shares, so your shares will be more valuable.