Accretive vs. Dilutive Mergers: An Overview

A merger and acquisition (M&A) deal is said to be accretive if the acquiring firm's earnings per share (EPS) increase after the deal goes through. If the resulting deal causes the acquiring firm's EPS to decline, the deal is considered to be dilutive. Investors should be careful with this analysis. Not every accretive deal is necessarily good, and not every dilutive deal is bad.

Dilution and accretion are scientific terms that refer to the concentration of a chemical or element. When used in conjunction with stock ownership, a financial event is accretive whenever it causes an appreciation in EPS. Conversely, an event is dilutive whenever the resulting action causes EPS to drop.

Key Takeaways

  • Mergers and acquisitions involve combining two or more corporate entities through a transaction.
  • An accretive acquisition will increase the acquiring company's earnings per share.
  • A dilutive acquisition will decrease the acquirer's earnings per share.

Accretive Acquisition

An accretive acquisition will increase the acquiring company's earnings per share (EPS). Accretive acquisitions tend to be favorable for the company's market price because the price paid by the acquiring firm is lower than the boost that the new acquisition is expected to provide to the acquiring company's EPS.

As a general rule, an accretive merger or acquisition occurs when the price-earnings (P/E) ratio of the acquiring firm is greater than that of the target firm.

An accretive acquisition is similar to the practice of bootstrapping, wherein an acquirer purposely buys a company with a low price-earnings ratio through a stock swap transaction in order to boost the post-acquisition earnings per share of the newly formed combined business and encourage a rise in the price of its shares.

But while bootstrapping is often frowned upon as an accounting practice that games the system and lowers overall earnings quality, an accretive acquisition plays to the combined synergies of a merger in a positive way.

Dilutive Acquisition

A dilutive acquisition is a takeover transaction that decreases the acquirer's EPS through lower (or negative) earnings contribution or if additional shares are issued to pay for the acquisition. A dilutive acquisition can decrease shareholder value temporarily, but if the deal has strategic value, it can potentially lead to a sufficient increase in EPS in later years.

In general, if the standalone earnings capacity of the target firm is not as strong as the acquirer's, the combination will be EPS-dilutive to the acquirer. This may be true in the first one or two years post-transaction closing, but as revenues and cost synergies take hold through scale economies, the acquisition should become accretive to earnings.

The market tends to punish the share price of the acquirer if the benefits are not immediately clear. A lower EPS, after all, at the same trading multiple will reduce the stock price. (Conversely, an announcement of an EPS-accretive deal in Year 1 will quickly reward shareholders with a higher stock price.)

EPS is calculated as net income, minus paid dividends to preferred shareholders, divided by the average number of outstanding shares.

EPS and M&A Deals

Normally, the primary goal of a merger model is to find out if the acquiring company can increase its EPS after the deal goes through. Ostensibly, a deal with accretive consequences should create additional value for the firm's shareholders—a result that many consider to be the primary duty of a corporation's directors.

There are many reasons why EPS might go up after an M&A deal. The synergy between the two firms might result in increased economies of scale or scope. The target company's capital or research and development tools may lead to future gains in productivity or revenue generation. In any case, the financial analysts are looking for a sum value that is greater than the individual components.

As a rule of thumb, analysts look to each company's P/E ratio. If the target company has a smaller P/E ratio, the merger should be accretive.

However, a momentary increase in EPS does not necessarily mean that the deal will be a long-term success. Successfully executing a merger is a complex and risky effort. There may be future unintended consequences that end up damaging the new company's valuation.