Accretion/Dilution: What Is It And Does it Matter?
This guest post is written by Mike Gasparro of AxialMarket. You can also view the post on AxialMarket’s blog.
In this blog posting, we explore the concept of accretion/dilution. What is it? How is it calculated? Why and how is it relevant for strategic buyers and what does it mean for sellers negotiating with strategic buyers.
The accretion/dilution concept refers to the impact an acquisition has on the buying firm’s Earnings Per Share (“EPS”). An acquisition is accretive when the combined EPS (known as pro forma EPS) is greater than the buyer’s standalone EPS. An acquisition isdilutive when pro forma EPS is less than the standalone EPS.
For example, suppose analysts expect 3M’s EPS to be $6.12 in 2011. If they were to acquire Company ABC, pro forma EPS in 2011 is now expected to be $6.18 — $0.06 higher than if 3M had not acquired Company ABC. In this case, the deal is $0.06 accretive to 2011 EPS. On the other hand, if after acquiring Company ABC, 3M’s pro forma 2011 EPS is expected to be less than the original $6.12, the transaction is dilutive.
The calculations can get complicated as there are a number of variables which are interrelated. A qualified investment banker/M&A advisor can quickly help with the intricacies and the necessary calculations.
Here are the basics:
- Estimate the Net Income of the Combined Firm – Although simple in theory, the calculation is more complicated than just adding both firms’ net incomes. The combined net income should take into consideration expected synergies. Typical synergies include additional revenue from cross-selling products/services, economies of scale in sourcing and/or elimination of redundant functions. Additionally, the net income has to be adjusted for other transaction related items such as changes in interest expense due to debt being issued, changes in depreciation or amortization deductions due to write-ups or downs in assets, changes in tax rates, etc.
- Calculate the New Share Count - If the strategic buyer is going to finance a portion of the purchase price with stock, they will be issuing new shares which should be added to the current share count.
- Divide the Estimated Net Income of the Combined Firm by the New Share Count – Compare this new pro forma EPS to the buyer’s original standalone EPS to determine whether the transaction is accretive or dilutive.
Accretion/dilution is relevant to a strategic buyer as it can be regarded as a proxy for whether the acquisition creates or destroys value for shareholders. EPS serves as an indicator of a company’s profitability. If a transaction is going to decrease the company’s profitability (i.e. it is dilutive), the value of the buyer should theoretically decrease following the transaction.
However, there are significant limitations to this analysis. First, accretion/dilution is looking at the transaction over a fixed period of time. Strategic buyers generally intend to own an acquired business indefinitely. Additionally, EPS is impacted by numerous accounting decisions (which can be manipulated) and does not necessarily reflect the economic reality or the combined company’s ability to generate cash flow.
We recently participated in a seminar hosted by Investment Dealers’ Digest , “Corporate Development and Strategic Buyers: How to Make M&A Pay for You in Today’s Market.” During the seminar, strategic buyers discussed whether they would acquire a company that was dilutive to earnings. The results were similar to what we have found with our AxialMarket Members: some strategic buyers will not do a dilutive transaction; others require the transaction to be accretive after a certain period time; still others are not concerned with this issue and focus on strategic fit.
As a seller, it’s important for you to be aware of the concept of accretion/dilution, understand the basics, and realize that it can potentially impact decisions made by strategic buyers. However, it’s not the be-all end-all for all buyers. As we discussed in “5 Major Differences Between Strategic and Financial Buyers,” strategic buyers focus heavily on synergies and integration capabilities. So while accretion/dilution may be a factor for some potential strategic buyers, there are many other issues which will influence their decision.
(Image courtesy of Ricardo Carmona)
I made a long comment before on the valuation by earning multiples, I don't want to sound like a DCF junkie but I'll make a point again in making a comparison to what would happen to value in the DCF analysis.
I think Accretion / Dilution is definitely not even close to be a indication of value creation (or destruction) because it leaves out the principle of risk-adjusted and time-weighted (discounted) returns necessary to measure value creation or destruction.
So, for instance, lets say (to cite your example) 3M buys company ABC and earnings get around 1% accretive, but bought a Colombian company, so the risk of those pro-forma earnings also carry a lot more risk, and for that 1% increment in EPS 3M paid a 15x multiple, there would be clearly value destruction.
Sorry if I didn't get your point, as I stated before I'm a first year undergrad in Colombia and I don't have the knowledge of you wall st guys.
Sebasm611
15 Jul 10 at 17:57
Agree 100% Sebasm, that anything financial must be risk-weighted. Generally when analysts look at EPS though, they're looking forward. You'd rarely use EPS from last year. So if we talk about 2011 EPS, it's a forecast that “should” take risk into account. But as I mentioned in my last response, while it helps to work towards targets in a strategic sense, it's futile to rely on forecasts.
The one thing to keep in mind in private equity is that good returns come from selling an investment for more than you paid. That increase in price doesn't always means there's an increase in value. Buffett may say that “price is what you pay, value is what you get”, but he's talking about long-term investing. In private equity, “price is what you pay, and price is what you get.” Value helps, but it's far from the decider of returns.
The Private Equiteer
17 Jul 10 at 04:35
I think that Sebasm is right here and makes an excellent point. I'm not a big fan of accretion/dilution mostly for the reasons listed in the post (too short of a time frame, accounting manipulations, etc), but Sebasm has pointed out an additional flaw that I have not seen addressed in all of the articles I've on the subject: accretion/dilution is all about the flows to the shareholders and has nothing to say about the rate at which those flows (whether cash or accounting) will be discounted.
The closest accretion/dilution comes to taking into account changes in the cost of capital is through projected changes in interest expenses, but as far as I can tell it doesn't have any way to factor the changes in the cost of equity capital. I'm also not aware that analyst EPS estimates factor cost of capital at all – they may forecast “risk” of some sort through probability weighting multiple scenarios, but this is not the same as Beta-based costs of capital under the CAPM. Additionally, relying on the availability or accuracy of analyst EPS estimates isn't really relevant to the question, since Sebasm is essential asking about the change to the *value* per share, not the earnings. To the extent that the target's business differs from that of the acquirer, it could have a significant change on the beta used to determine the acquirer's cost of capital. Put in less theoretical terms, it could significantly change the peer set against which the acquirer is compared. One example is the United Online acquisition of FTD (http://paidcontent.org/article/419-united-onlin...). Yahoo Finance may still be categorizing UNTD as an ISP, but they get 60% of their business from selling flowers.
Sebasm: I'm doubly impressed with the question coming from a first-year undergrad. I couldn't find your other comment, but feel free to reach out if you want to discuss any other related topics. With my full name I'm pretty easy to find on the internet.
Jordan Elpern-Waxman
26 Jul 10 at 02:58