Accretion and dilution

When a listed company announces an acquisition, one of the first questions investors ask is whether it is accretive or dilutive to earnings per share (EPS). An accretive deal raises the buyer's EPS; a dilutive one lowers it. Superday interviewers like this topic because it combines accounting, financing and valuation in a few lines of arithmetic.

The core calculation

Compare pro forma EPS with the buyer's standalone EPS. The percentage difference is the accretion or dilution. Analysts usually look at the first full year after completion, using forecast earnings.

How the deal is paid for

• Cash on hand: no new shares, but the buyer loses the interest it was earning on that cash, after tax
• New debt: no new shares, but net income falls by the interest, after tax, because interest is deductible
• New shares: no interest cost, but the share count rises, spreading earnings over more shares

Each route has a cost. Cash usually has the lowest cost, because the interest a company earns on deposits is typically below what it pays on new debt. Debt costs more. Shares are often the most expensive in EPS terms, because the buyer is effectively paying with its own earnings.

Rules of thumb

You can often tell the answer without full calculations by comparing the cost of each funding route with the earnings bought. The target's earnings yield on the price paid is its net income ÷ purchase price, the inverse of the purchase P/E.

• All shares: the buyer's cost is its own earnings yield (1 ÷ its P/E), so the deal is accretive if the buyer's P/E is higher than the P/E it pays
• All debt: the cost is the after-tax interest rate, so the deal is accretive if the target's earnings yield on the price paid is higher
• All cash: the cost is the after-tax interest rate lost on the cash, with the same comparison

In the example, the target's earnings yield is £30m ÷ £400m = 7.5%. The after-tax cost of debt is 4.5%, which is lower, so the debt deal is accretive. The buyer's earnings yield is 1 ÷ 20 = 5%, also lower than 7.5%, so the share deal is accretive too, but by less. For mixed funding, compare 7.5% with the weighted average of the costs.

Breakeven synergies

If a deal is dilutive, a natural follow-up is how much in synergies would make it break even. Work out the net income needed to hold EPS flat, compare it with pro forma net income, and gross the gap up for tax.

Suppose the buyer instead pays £600m in shares for a target earning £20m, 30x earnings, while its own shares trade at 20x. It issues 75m new shares, so it needs 40p × 575m = £230m of net income to keep EPS at 40p. Without synergies it has £220m. The £10m gap is after tax, so it needs about £13.3m of pre-tax synergies, £10m ÷ 75%, to break even.

What else changes the answer

• Synergies add to pro forma net income after tax, and can turn a dilutive deal accretive
• Purchase price allocation: intangible assets recognised under IFRS 3, such as customer relationships, are amortised and reduce earnings, while goodwill is not amortised under IFRS
• Transaction fees and integration costs reduce earnings in the first year
• Refinancing: the target's existing debt may be repaid and replaced at a different rate
• Timing: a deal that completes part way through the year only adds part of the target's earnings

Accretive does not mean good

A cheap debt-funded deal can be highly accretive and still destroy value, if the buyer overpays or takes on too much risk. EPS ignores the cost of equity and the extra risk that leverage brings. A better test is whether the value of the target plus synergies exceeds the price paid, and whether the return on the investment beats the cost of capital. Mentioning this nuance is one of the easiest ways to impress in an interview.