What is the meaning of accretion and dilution?
Corporate executives often talk about accretion and dilution when explaining their capital
allocation strategies to investors: “We identify and pursue accretive M&A opportunities”.
Or when an actual merger or acquisition is announced: “the transaction is expected
to be dilutive this year, and accretive thereafter”.
What these executives refer to is the effect on a financial metric called Earnings Per
Share, or EPS, which is simply the Net Income generated by a company divided by the number
of its outstanding shares.
Here’s a numerical example of EPS accretion: the EPS forecast for the stand-alone company
XYZ is $2.50 this year, $2.70 next year, and $3 two years from now.
XYZ company is considering to buy ABC corporation.
As a result of the transaction, the EPS is expected to go up by 2 cents this year, 3
cents next year, and 4 cents two years from now.
This makes the expected EPS of the combined company after doing the deal higher than the
expected EPS without doing the deal, which is called accretion.
Here’s a numerical example of EPS dilution: the EPS forecast for the stand-alone company
XYZ is the same $2.50 this year, $2.70 next year, and $3 two years from now.
XYZ company is considering to buy DEF corporation.
As a result of the transaction, the EPS is expected to be lowered by 4 cents this year,
3 cents next year, and 2 cents two years from now.
This makes the expected EPS of the combined company after doing the deal lower than the
expected EPS without doing the deal, which is called dilution.
So which of the two companies should XYZ buy?
Naïve EPS-focused executives and investors would say ABC, as the ABC deal is expected
to be accretive to EPS.
The better answer is: it depends!
Let’s take a look at the business life cycle of acquisition targets ABC and DEF.
Companies start off as embryonic or emerging, then go through growth, maturity, and ultimately
aging and decline.
Maybe ABC is a mature company that currently generates a good level of net income, but
is getting close to its peak and has very few growth prospects.
DEF on the other hand could be an embryonic company that has not generated any net income
yet, but is about to launch a product that has the potential of generating billions of
dollars in the future.
Which of these companies would you like to buy?
Once again, the answer is “it depends”, as for example we don’t know the acquisition
price or the expected returns on the investment.
But certainly we shouldn’t just look at accretion or dilution of EPS to decide!
Merger and acquisition specialists often build huge financial models
for accretion and dilution analysis.
EPS is net income divided by the number of shares, and both the numerator as well as
the denominator in that equation could move as a result of doing a deal.
If the acquiring company issues new shares to finance the acquisition, increasing the
share count by 5%, but in return is expected to be able to increase its net income by 10%,
then the deal is labeled accretive as it increases EPS.
If the share count increases by 10%, and net income by just 5%, then the deal is labeled
dilutive as it decreases EPS.
Here’s a practical observation for you: in our debt-loaded economy, acquisitions are
often financed with cash on hand and/or proceeds from debt financing.
In that case, the number of shares in the denominator doesn’t change, and accretion
– dilution analysis is really about trying to estimate the effect of the M&A transaction
on net income.
Here are some important factors to consider.
Being able to add the existing or potential Net Income of the acquired company to your
numbers, realizing cost synergies for example by integrating back-office functions, or realizing
revenue synergies through more valuable complementary product portfolios,
would all generate additional net income, and drive accretion.
Having to absorb the expenses for amortization of Intangible Assets created in the deal,
facing acquisition-related charges such as legal, regulatory, restructuring and integration
costs, and paying interest on the incremental debt,
would all decrease net income, and drive dilution.
Each M&A deal has specific characteristics, sometimes the sum of these items is a net
positive, sometimes a net negative.
Bonus tip: why are so many companies keen on using “non-GAAP EPS”
rather than “GAAP EPS”?
Chances of a deal being labeled accretive are much higher if you focus on non-GAAP EPS
rather than on GAAP EPS!
In non-GAAP EPS, a lot of companies filter out several of the main expense lines related
to acquisitions: the amortization of acquisition-related intangibles,
restructuring, and various acquisition-related charges.
Accretion and dilution.
Does the proposed deal increase or decrease the post-transaction earnings per share?
An interesting datapoint, but definitely not the only one in mergers and acquisitions!
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