Latepost Acquisition Accounting I: Accretive (Dilutive) Deals Tin Dismiss Hold Upwardly Bad (Good) Deals

Analysts, investors as well as journalists who follow stocks receive got an obsessive focus on earnings per share, what it is instantly as well as what it volition endure inwards the future, every bit tin endure seen inwards the earnings annunciation game every that takes upward then much of Wall Street’s fourth dimension as well as resources. Not surprisingly, acquiring firms, considering novel deals, seat their accountants to move on what they believe is a cardinal question, “Will the earnings per portion for the companionship (acquirer) instruct upward or downward afterward the acquisition?” Influenza A virus subtype H5N1 bargain that volition number inwards higher earnings per share, post-deal, is classified every bit accretive, whereas ane that volition elbow grease a drib inwards earnings per portion is viewed every bit dilutive. 

Is it ameliorate to receive got an accretive or a dilutive deal? If yous asked that inquiry of most investors, analysts or fifty-fifty CFOs, the answer, yous would endure told, is obvious. An accretive bargain is ameliorate than a dilutive deal, amongst the logical follow through that if your earnings per portion increase, your stock toll volition follow. But is that true? To run across why it is not, permit us interruption downward the mechanics of what volition spill out to earnings per share, afterward an acquisition or merger. The internet income of the ii firms volition endure cumulated as well as divided yesteryear the number of shares outstanding inwards the combined firm, afterward the merger. Mathematically, hither are the ii factors that volition decide whether a bargain is accretive or dilutive:

1. What are the relative PE ratios of the acquiring/target firms? In a portion swap, where the acquiring firm’s shares are swapped for the target trace of piece of job solid shares, the combined company’s earnings per portion volition increment (be accretive) only if the PE ratio of the acquiring trace of piece of job solid is greater than the PE ratio for the target firm. It volition endure dilutive, if the contrary is true. 
2. How volition the bargain endure financed? If a bargain is funded amongst cash on mitt or yesteryear issuing novel debt, the bargain volition endure accretive, if the companionship existence acquired is profitable as well as is generating a high plenty expected income to comprehend the lost involvement income (if cash is used) or the expected involvement expenses (if debt is used). 

If yous are interested, you tin download a elementary spreadsheet that plant out whether a bargain volition endure accretive or dilutive to the acquiring company.

Reviewing these ii weather instruct inwards clear why it is absurd to mean value that accretive deals are ever skillful as well as that dilutive deals are bad. The Achilles heel inwards this reasoning is inwards the supposition that the PE ratio volition remain fixed afterward the deal; if that were true, higher EPS volition ever interpret into higher price, making accretive deals skillful for acquiring companionship stockholders. But it is not, as well as yous tin run across the rationale yesteryear looking at all of the scenarios listed above:

1. If yous are buying a companionship amongst a lower PE ratio than yours, at that spot is unremarkably a skillful ground why that companionship has the lower PE. It could endure that the trace of piece of job solid is riskier than average, has lower or no growth or is inwards a concern amongst sub-standard returns. If whatever or all of these reasons hold, acquiring this companionship volition convey those problems into the combined companionship as well as elbow grease the PE ratio for the combined companionship to fall. If that drib exceeds the increment inwards EPS, the stock toll of the combined companionship volition too fall, all the same the accretive nature of the deal. 
2. If yous are funding a bargain amongst cash, the bargain volition almost ever endure accretive because the income yous are generating from cash (especially at today’s depression involvement rates) volition mostly endure lower than the equity earnings yous volition instruct from the companionship that yous are acquiring. But is that value enhancing? Not really. Replacing an investment that generates 1% riskless today amongst a risky investment that generates a 4% furnish volition brand investors inwards the companionship worse off, non better. 
3. If yous are financing the bargain amongst debt, the bargain volition endure accretive if the equity earnings that yous generate from the acquired companionship exceeds the involvement expense. But hither again, that is non a sufficient status for value creation. You are contractually committed to brand the involvement expense, piece the income yous anticipate is “risky”. The basic tenets of the risk/reward merchandise off volition require a much higher risky equity furnish than the involvement charge per unit of measurement on the debt yous receive got on for the bargain to endure value creating. 

Using the same type of reasoning, yous tin run across that it is possible for a dilutive bargain to endure value creating: the target trace of piece of job solid may receive got higher growth/higher lineament growth/lower run a peril than yous create as well as acquiring it may force upward the combined firm’s PE and/or at that spot may endure plenty growth inwards the trace of piece of job solid that fifty-fifty though the electrical flow earnings don’t comprehend your involvement expenses/foregone involvement income, the futurity earnings volition comfortably. It is so alone possible for an accretive bargain to endure value destroying as well as a dilutive bargain to endure value increasing.

There are CFOs who volition listen this declaration as well as say that it is “academic”. The marketplace (and the equity inquiry community) assist close earnings per share, they volition argue, as well as it is non sophisticated plenty to brand the adjustments to PE for run a peril as well as fundamentals. The proof, though, is non inwards what CFOs believe or what equity inquiry analysts say matters, but inwards how the marketplace reacts to accretive as well as dilutive deals. Influenza A virus subtype H5N1 McKinsey written report of accretive as well as dilutive deals uncovered the next marketplace reactions to these deals:

Note that at to the lowest degree inwards this curt sample period, at that spot is no show that markets vantage accretive deals as well as punish dilutive deals. Thus, Leo Apotheker’s defense, offered ii days afterward HP bought Autonomy, that “Autonomy volition be, on Day 1, accretive to HP” would receive got rung hollow, fifty-fifty without the create goodness of hindsight. I, for one, mean value that it is fourth dimension that nosotros consigned this dilutive/accretive analysis to where it belongs: the dustbin. It is non only genuinely useless inwards assessing the lineament of deals, but worse, it allows companies to justify (at to the lowest degree to themselves) around really bad deals.


The Acquisition Series
HP's bargain from hell: The mark-it-up as well as write-it-down ii step
Acquisition Archives: Winners as well as Losers
Acquisition Hubris: Over confident CEOs as well as Compliant Boards
Acquisition Advice: Big bargain or skillful deal?
Acquisition Accounting I: Accretive (Dilutive) Deals tin endure bad (good) deals
Acquisition Accounting II: Goodwill, to a greater extent than plug than asset

Acquisition Alchemy: Creating value from deals

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