Analysts, investors and journalists who follow stocks have an obsessive focus on earnings per share, what it is now and what it will be in the future, as can be seen in the earnings announcement game every that takes up so much of Wall Street’s time and resources. Not surprisingly, acquiring firms, considering new deals, put their accountants to work on what they believe is a central question, “Will the earnings per share for the company (acquirer) go up or down after the acquisition?” A deal that will result in higher earnings per share, post-deal, is classified as accretive, whereas one that will cause a drop in earnings per share is viewed as dilutive.
Is it better to have an accretive or a dilutive deal? If you asked that question of most investors, analysts or even CFOs, the answer, you would be told, is obvious. An accretive deal is better than a dilutive deal, with the logical follow through that if your earnings per share increase, your stock price will follow. But is that true? To see why it is not, let us break down the mechanics of what will happen to earnings per share, after an acquisition or merger. The net income of the two firms will be cumulated and divided by the number of shares outstanding in the combined firm, after the merger. Mathematically, here are the two factors that will determine whether a deal is accretive or dilutive:
- What are the relative PE ratios of the acquiring/target firms? In a share swap, where the acquiring firm’s shares are swapped for the target firm shares, the combined company’s earnings per share will increase (be accretive) only if the PE ratio of the acquiring firm is greater than the PE ratio for the target firm. It will be dilutive, if the reverse is true.
- How will the deal be financed? If a deal is funded with cash on hand or by issuing new debt, the deal will be accretive, if the company being acquired is profitable and is generating a high enough expected income to cover the lost interest income (if cash is used) or the expected interest expenses (if debt is used).
If you are interested, you can download a simple spreadsheet that works out whether a deal will be accretive or dilutive to the acquiring company.
Reviewing these two conditions make it clear why it is absurd to think that accretive deals are always good and that dilutive deals are bad. The Achilles heel in this reasoning is in the assumption that the PE ratio will stay fixed after the deal; if that were true, higher EPS will always translate into higher price, making accretive deals good for acquiring company stockholders. But it is not, and you can see the rationale by looking at all of the scenarios listed above:
- If you are buying a company with a lower PE ratio than yours, there is usually a good reason why that company has the lower PE. It could be that the firm is riskier than average, has lower or no growth or is in a business with sub-standard returns. If any or all of these reasons hold, acquiring this company will bring those problems into the combined company and cause the PE ratio for the combined company to fall. If that drop exceeds the increase in EPS, the stock price of the combined company will also fall, notwithstanding the accretive nature of the deal.
- If you are funding a deal with cash, the deal will almost always be accretive because the income you are generating from cash (especially at today’s low interest rates) will generally be lower than the equity earnings you will get from the company that you are acquiring. But is that value enhancing? Not really. Replacing an investment that generates 1% riskless today with a risky investment that generates a 4% return will make investors in the company worse off, not better.
- If you are financing the deal with debt, the deal will be accretive if the equity earnings that you generate from the acquired company exceeds the interest expense. But here again, that is not a sufficient condition for value creation. You are contractually committed to make the interest expense, while the income you anticipate is “risky”. The basic tenets of the risk/reward trade off will require a much higher risky equity return than the interest rate on the debt you take on for the deal to be value creating.
Using the same type of reasoning, you can see that it is possible for a dilutive deal to be value creating: the target firm may have higher growth/higher quality growth/lower risk than you do and acquiring it may push up the combined firm’s PE and/or there may be enough growth in the firm that even though the current earnings don’t cover your interest expenses/foregone interest income, the future earnings will comfortably. It is therefore entirely possible for an accretive deal to be value destroying and a dilutive deal to be value increasing.
There are CFOs who will hear this argument and say that it is “academic”. The market (and the equity research community) care about earnings per share, they will argue, and it is not sophisticated enough to make the adjustments to PE for risk and fundamentals. The proof, though, is not in what CFOs believe or what equity research analysts say matters, but in how the market reacts to accretive and dilutive deals. A McKinsey study of accretive and dilutive deals uncovered the following market reactions to these deals.
I disagree with many of the premises of your post. I will contend that accretive is always better than dilutive, provided you're looking at the proper timeframe. I think you are looking at too narrow a time frame in drawing your conclusions.
I think one of the main reasons you took the opposite position is your assertion that the risk you're taking on does not justify the accretive nature of the acquisition. Risk of what? Earnings on the acquired equity declining? If that is what happens, then the deal wasn't truly an accretive deal, it was only accretive at the beginning, but ultimately dilutive, and thus a bad deal.
On the flipside, your reasoning for why a dilutive deal could be value-creating is that "the target firm may have higher growth than your firm". If this is the case, in the LONG RUN, the deal will prove to be accretive, even if it is not immediately so. I would argue that makes it an accretive deal.
Besides, what's the point in only looking at the immediate impacts of an acquisition. They are supposed to be made with a long-term horizon, so I think it is only fair to categorize them as "accretive" or "dilutive" based on their long term impacts on the acquiring company, not the immediate impacts.
You have to learn how to understand academics. They come from a world of theories and exactness. Aswath is a 'groundbreaking' academic because he occasionally speaks out against silly beliefs like the belief that acquisitions that are immediately accretive to earnings are usually a good thing. This is a big step for an academic, but he doesn't quite make the leap to the common sense side.
Academics analyze accounting numbers, good analysts analyze businesses.
Yeah a couple key things wrong with this post (which isn't a half bad intro to merger theory, but not at all how it works in practice).
P/E multiple arb a la 60s conglomerates used to exist because people only looked at acc/dil in the next couple years (because there were no spreadsheets). Over time, the slower growth of earnings reduces acquired EPS. Depending on how much you paid, this means a deal can become dilutive in years 3-5 (moreso back when goodwill was amortized, less so now). Generally this is offset by synergies as they fade in, but if there is a huge growth differential or no synergies it may not be.
Think of accretion dilution as a method to figure out, given a set of growth/margin assumptions, what you can pay. Often, those assumptions are completely wrong, and you get Autonomy. But like any other financial analysis or model, garbage in garbage out.
You are right on everything being accretive when you buy it with cash that earns zero interest or really cheap debt. However, this should make you want to go out and buy stuff. This explains the deals where established companies overpay for growing ones is that growth opportunities are limited by extraneous factors. By acquiring, even at a lower expected return on asset investment than the standalone buyer generates, the company is able to generate more absolute returns. As long as those returns are higher than the cost of capital (i.e. currently ~0 for IG firms, it is good for the equityholders. If management decides the additional return to equity is more valuable than the risk of the deal (and the risk associated with the higher leverage), then they should still do it.
However, the ideal financial deal is one where the company trades at a lower P/E than you and the merger can reduce the discount. For instance, discount is due to worries about buyer entering the space or standalone viability, discount instantly gone, value created.
How can you argue with him - He wrote the f'in book.
uhm OP is pretty much spot on I dont really know wtf u guys are on about.
He's talking about an acquisition being accretive or dilutive in terms of GAAP accounting and P/E ratios. I'm not sure if you've ever researched a stock before, but EPS is a completely BS number and so is the P/E ratio. Academics care about these things, good investors care about whether the acquisition adds value to the company regardless of its impact on EPS or the P/E ratio.
Aswath is right, leveredarb hit it on the head.
I feel like the arguments against his post reinforce what he said. That you guys got in such a tizzy and were so ready to flame his post that you pulled out all of your deep finance knowledge... and reinforced his points.
@MFFL - exactly. He's saying where $1.00 EPS plus $0.50 acquired EPS would be termed "accretive" there are many ways where it is not. If the acquired company is not generating a sufficient return on capital (value destruction), if the acquired company adds significant risk (New firm cost of capital), if the acquired company trades at a low valuation (see prior two points) and the New Company trades at a lower multiple, thereby Old EPS* Old multiple > New EPS * New multiple.
@meabric - isn't this what he said? That any deal done with cash costing 1% looks accretive, but infact may not be? See my above points and your own about whether deals don't provide returns above their true cost.
@notamonkey - huh? So where he is saying that simple GAAP $1 + $0.50 may not really be accretive as you would think, and then you say "haha, he is talking about EPS and using GAAP which are soooo flawed", aren't you espousing the point? You hit it on the head "good investors care about whether it adds value". His whole point was that Accretive deals don't necessarily add value. They add to one financial metric, usually looked at 1 year from the announcement of the deal, and investors generally take EPS growth to mean it was a good deal.
I feel like I'm taking crazy pills
Nobody is disagreeing about that. What I'm saying is that ceteris paribus you should do more deals (with cash at least) under ZIRP.
His conclusion is what I don't agree with. He wants acc/dil to go into the "dustbin." In that case, most of the other tools of modern finance would need to go with it, they are all flawed. Every model is a (inherently wrong) approximation that is used because the reduction in complexity is worth the loss of accuracy.
My claim is that over a reasonable timeframe (3-5 years, which you are projecting for DCF purposes anyway), acc/dil is a pretty decent metric. Certainly, the desire to avoid dilutive deals creates a brightline in some auction processes that prevents "gross" overpayment (although it also is used to justify "slight" overpayment). In this case I am using overpayment in a financial fairness given imperfect information sense and not the retrospective sense. The value of accretion-dilution is in the process, not as an indicator of market response, which is why Aswath doesn't value it and practitioners do.
Finally, while I agree EPS and P/E are BS, some things empirically trade on those ratios, and that is the way it is. Announcing buybacks and spins creates value more often than not, despite what EMH says.
If we are going to go on a tirade against idiotic financial metrics we should start with ROIC.
I'm not at all trying to flame him. I didn't even know who he was until you guys starting talking about him and I googled him. I respect his credentials (which are certainly more impressive than my own), and I'm glad he posted. But I still think any acquisition that boosts earnings per share in the long run is a positive thing. I would imagine he even agrees with that, with our main difference being I use the term accretive to describe all the impacts of an acquisition over the entire timeframe of the investment, not just the immediate knee jerk reaction on EPS.
my parents are worth more than yours.
/end of discussion
@notamonkey - huh?
@meabric Good points. I would say though that under ZIRP, you can GET AWAY WITH more deals, not that you SHOULD do more. I can't speak for OP but I think he's saying Accretion does not equal Value Creating, and therefore needs to be looked at more skeptically.
I think that is exactly what he is saying. For your standard merger model you are usually looking at accretion/dilution for 1 and 2 years out. Just because a deal looks accretive in your merger model the next two years does not necessarily mean the target is creating value. As he says, the target could add significant risk to the combined company which would in turn cause poor performance for the new company. Or the company is slowing down in growth and is generating poor returns. This could make the combined company dilutive for every year past year 2. In other words, there could be negative reasons as to why the target has a low P/E that does not show up on an excel sheet calculation. Same idea for a dilutive deal. Of course a target that has high growth (and therefore a high P/E ratio) will make the combined company look dilutive for the next couple of years. Does that mean it is not a value adding transaction? Absolutely not. It is a growing company at a young stage with presumably many years of value creation to come.
You think a CEO is going to look at some merger math and say, "Oh great! The next two years are accretive, let's do the deal!"? Definitely not. There is way more going on behind the numbers and no one should ever take them at face value. I think that is the point he is trying to get across.
I love the balls
No matter how far out the analysis is done, I think the point that not all accretive deals are value enhancing for shareholders remains accurate (though Damodaran doesn't appear to have addressed this issue in his post). Under ZIRP the cost that you should compare the increase in profits from an acquisition to is not the 0.01% interest rate on the cash you're giving up, it's the return the shareholders could get from investing that cash in other ways - even if a company has no organic opportunities to invest the capital in, buybacks and dividends are almost always an available alternative to acquisitions.
A no-growth company in a fully mature industry could buy a slow growth, almost mature company and both increase EPS and expand the multiple on the combined entity, and the investment would still not necessarily be the best thing for shareholders. Of course, it's extremely difficult to judge what the appropriate opportunity cost to charge an acquisition with is (and impossible to do so objectively), and a great portion of deals will always fall in a grey area where knowledgeable, reasonable people can disagree over whether they were value-creating or not. I just think it's important to keep in mind that you need to evaluate other factors than just the impact on a company's financial performance of a transaction.
Molestiae in officia facere itaque recusandae. Autem consequatur ea autem dolores aut ipsum. Inventore error non consequatur nisi.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...