Owners and managers of companies are periodically pitched merger and acquisition (M&A) deal proposals. As such, investment bankers, private equity shops, and related companies provide ideas to decision-makers on acquiring another company, merging with a competitor, or being acquired by a financial group or operating company.
Analyzing whether a specific M&A deal is a valuable one with long-term growth prospects is a complex undertaking that covers tremendous amounts of information and forecasting. An accretion/dilution analysis helps decision-makers in the M&A process determine whether or not they should proceed with a proposed deal.
- An accretion/dilution analysis is a simple test used to evaluate the merit of a proposed merger or acquisition deal.
- The accretion/dilution analysis determines if the post-transaction earnings per share (EPS) is increased or decreased.
- The managers in a prospective M&A deal need to consider many factors, such as the negotiation process, the global impact, and the compatibility of the companies.
- The process of an accretion/dilution analysis begins with estimating pro-forma net income to eventually arrive at pro-forma earnings per share (EPS).
- An increase in pro-forma EPS is regarded as an accretion, while a decrease is regarded as a dilution.
What Is an Accretion/Dilution Analysis?
An accretion/dilution analysis is a simple test, although there is some grunt work required. It is an analysis that answers the question: "Does the proposed deal increase or decrease the post-transaction earnings per share (EPS)?" This determines the justification for the deal in the first place.
For companies faced with M&A opportunities, many factors need to be considered, including the global impact of the arrangement, the likelihood of a quick and painless negotiation process, and the compatibility of the merging or acquiring companies. The dealmakers—the front-line workers who spearhead the deals—must address all of these factors in order to successfully broker M&As.
Steps Involved in an Accretion/Dilution Analysis
- Estimate a pro forma net income for the combined entities.
- Include conservative estimates of net income, taking into account prospective operational and financial synergies that are likely to result after the deal is finished. Some groups incorporate the last 12 months (LTM) as well as one- or two-year projections. Others include projected net income only. Regarding prospective synergies, the new company may anticipate higher revenues due to cross-selling of a wider array of product and service offerings, as well as lower costs due to the elimination of redundant functions and manufacturing facilities.
- Aside from variables that affect the pro-forma net income due to anticipated synergies, the analyst should also account for transaction-related adjustments that may occur, such as a higher interest expense if this is a leveraged buyout with debt being used to fund the deal, lower interest income if cash is used to make the purchase, and additional considerations on post-transaction amortization of intangible assets.
- Calculate the combined company's new share count.
- Tabulate the prospective acquirer's share count. Factor new shares that would be issued to make the purchase if it's a stock deal.
- Check the accuracy of your numbers.
- Check your numbers before presenting them. Are you incorporating some professional skepticism on prospective synergies, or is the entire garden laden with beautiful roses?
- Divide pro-forma net income by pro-forma shares to arrive at a pro-forma EPS.
- Is the pro-forma EPS higher than the original EPS? An increase in EPS is regarded as accretion, while a decrease is regarded as dilution. Many on Wall Street typically frown at dilutive transactions. If a deal has a reasonable likelihood of turning accretive from year two and onwards, a proposed business combination may be more palatable.
When pro-forma EPS is neither larger nor smaller than before, then the accretion/dilution analysis is said to breakeven. In this case, other factors would determine whether the M&A deal should proceed.
The Bottom Line
An accretion/dilution analysis is often seen as a proxy for whether or not a contemplated deal creates or destroys shareholder value. For instance, if the combined entity has better manufacturing capabilities and more diverse offerings, it may take more than a couple of years to fully integrate both operations to leverage and realize efficiencies, and for marketing to convey the message.
An accretion/dilution analysis is not a composite of the complete picture, nor does it contemplate how a newly-combined entity operates, adjusts, or takes advantage of opportunities years down the road.