By Victor Paquet (Mergersight Operations) and Carlo Lepoardi & Tommaso Arona (Boston University partners)
An accretion/dilution analysis is a calculation that determines whether or not a merge/acquisition is going to be financially beneficial for the acquirer. We do this by looking at the EPS (Earnings per Share) of the acquirer as a standalone institution, and then comparing it to the EPS Pro Forma.
Pro Forma is the term used to describe the company after a hypothetical merge or acquisition with the target company. If EPS increases, then the deal is considered accretive, and thus financially beneficial. While if EPS decreases Pro Forma, then the deal is considered to be dilutive, and thus would reduce shareholder value.
Why engage in a dilutive deal?
Theoretically, you would only want to make a deal happen if it is accretive; however, long-term synergies may be a reason why an acquirer may choose to make an initially dilutive deal.
Synergies is the concept that by combining entities, you will produce additional business value. Synergies can be split up into two main categories: revenue and cost synergies.
Revenue synergies occur when if by combining entities the acquirer is able to expand in new markets, offer complementary product (cross-selling), or able to increase its prices due to it purchasing a competitor (increased pricing power), thus increasing revenue.
Cost synergies derive from cutting down employee count (you do not need two CEOs or two IT departments) or vertically integrating (eliminating double marginalization).
Other reasons to consider a dilutive deal: entire industry experiencing major external threats, preventing other companies from acquiring the target, or arguing that because the model uses historical data, estimates, and one-year financials that net income is expected to grow.
Steps of the analysis
1) Firstly, identify the proportion of equity and debt that would finance this hypothetical transaction, and take note of the tax rate and debt-related interest rate.
2) Then, calculate the acquirer’s market capitalization (= share price * shares outstanding) and add the proportion of the target’s market cap being funded by equity (market cap * % of Equity), to find the Pro Forma market capitalization.
3) To calculate the amount of shares issued by the acquirer to purchase the target, divide the proportion of the target’s market capitalization which is funded by equity by the acquirer’s stock price. Furthermore, by summing the number of shares issued by the acquirer and their current shares outstanding you can calculate the number of shares outstanding in the Pro Forma company.
4) Next, solve for the acquirer’s EPS by dividing the earnings by the number of shares outstanding, both values deriving from prior to the merge. We will be using this EPS calculation to compare it to the Pro Forma EPS calculation in order to determine whether the deal is accretive or dilutive.
5) To calculate the Pro Forma EPS calculation, we need to take into consideration interest expenses and synergies when summing the earnings generated from the acquirer and target. Interest expense can be calculated by multiplying the amount of debt used to finance this transaction by the interest rate, and then multiply that derived number by (1-Tax rate) to account for the debt shield. To find the value of your post-tax synergies, subtract the cost of realizing those synergies from the expected yielded synergy value, and then similarly multiply that number by (1-Tax rate) to arrive at a post-tax synergy. Ultimately, adding the acquirer’s earnings, the target’s earnings, anticipated post-tax synergies, and subtracting interest expense to find the Pro Forma earnings. From there divide the Pro Forma earnings by the Pro Forma shares outstanding calculated in step 3, to arrive at a Pro Forma EPS calculation.
6) Lastly, compare the acquirer’s EPS with the Pro Forma EPS. If the acquirer’s EPS > Pro Forma EPS, then the deal is dilutive. Vice versa, if the acquirer’s EPS < Pro Forma EPS, then the deal is accretive. Express the accretion/dilution in percentage terms to show the change from before and after the hypothetical transaction.
Explaining/walking through an accretion/dilution analysis is a question that may pop up during an interview with any M&A related firms, predominantly in investment banks and private equity. They might ask you to do a paper model, solving for whether a deal is accretive or dilutive on the spot, or solving for other elements of the deal based on the outcome (i.e What would the post-tax synergies need to be to make this deal accretive?).
Furthermore, there is plenty of opportunity for the interviewer to dive deeper into caveats and limitations, so expect follow up questions.
Another method to determine whether a deal is accretive or dilutive is by considering the cost of financing. Specifically, comparing the deal’s Weighted Average Cost of Capital (See 2023.09.22 M&A technical for WACC explanation) to the target’s Earnings Yield. This is a more theoretical approach that says that the inverse of a company’s P/E multiple (or 1/(Price per share/Earnings per share – expressed as a %)) is equal to the target’s Earnings Yield. This is because in theory an investor’s appetite, or how much an investor is willing to pay for a company’s stock that generates an X amount of earnings (think P/E multiple), should correlate to the amount that that investor expects to yield in return (think cost of equity). Essentially, we are comparing how expensive it costs to acquire a business with the incremental earning we are getting from that business. If WACC > Earnings Yield, then the deal is considered to be dilutive. Vice versa, if WACC < Earning Yield, then the deal is considered to be accretive.
Bonus: Key Observations and Tricks
If your deal is 100% funded by equity, there is a quicker way to determine whether a deal is going to be accretive or dilutive. This involves comparing the P/E multiple of the acquirer to the target. As a P/E multiple reflects how “expensive” a stock is (think about it as how much people are willing to pay for every additional earning generated), if the acquirer acquires a company with a relatively higher P/E multiple utilizing their own “cheaper” stock, then the acquisition will be dilutive. Vice versa, if the acquirer’s P/E multiple > target’s P/E multiple, then the acquisition will be accretive.
While the pro forma enterprise value is always going to be equal to the sum of the target and acquirer’s enterprise value, this is not true for the combined market capitalization value if debt or cash is used to finance the transaction.
Important to keep in mind that P/E multiples, market capitalization, and net income are easily manipulated via treasury stocks (repurchased stock) and raising of additional debt to accrue more interest expense. These manipulations could be the difference between whether a deal is considered accretive or dilutive.
Accretion/Dilution analysis really only requires the acquiring company to be public. This is because private companies are typically valued based on multiples rather than their share price and EPS (fundamental metrics to this model). However, you only really need the equity value and the earnings of the target company to compute this analysis.