Accretion/Dilution: What Is It And Does it Matter?

In this article, 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 is dilutive 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 Axial 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. 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.