What is an 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, where 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.
BREAKING DOWN Accretive Acquisition
An accretive acquisition increases synergies between the acquired and the acquirer. A synergy occurs when the combination of two organizations produce a combined value that is greater than the sum of the separate parts. So, value in an accretive acquisition is generated because the buyer of a smaller company is able to add the acquired business's pro-forma EBITDA/earnings ratio to its own EBITDA/earnings ratio, where EBITDA is earnings before interest, taxes, depreciation and amortization. If the acquisition is done correctly, the purchasing company has a higher enterprise value (EV)/EBITDA multiple, and the addition of the acquired company increases the total value of the combined entity.
An Example of an Accretive Acquisition
There are many cases where an established company seeks to add value to its shareholders through a strategic acquisition. Unlike an acquisition that is conducted due to research and development or product acquisition purposes, as was the case with Facebook's purchase of Oculus Rift, an accretive acquisition immediately increases the value of the acquiring company's stock.
If, for example, a large, public technology company wants to increase its EPS immediately, thus increasing its share price, it would look to acquire a smaller technology company with a higher EPS. If the larger company had an EPS of $2 and calculated that, if it acquired a smaller company with an EPS of $2.50, it would realize a combined pro-forma EPS of $2.15, the gross value of the acquisition would be 15 percent. If the cost of acquiring the company is 10 cents per share, is $0.10, the net benefit is positive.
Potential Drawbacks of an Accretive Acquisition
However, since pro-forma financial statements and 12- to 24-month forecasts are used to derive the potential accretive value of the acquisition, synergies are not guaranteed. In fact, the only way to realize the added value of combining the firms is to integrate both companies effectively and efficiently, so there are no lost benefits. Often, the combination of the firms fails and the resulting entity realizes an EPS that falls short of expectations, causing the firm to lose overall value.