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Here’s how I think about it. You have to assume an all stock deal for this to hold true (although it will be true in many cases that include debt financing). The problem with this question is that people tend to memorize it without understanding the why. Let’s look at a quick example.
Company A (buyer) has a P/E multiple of 15x and Company B (target) has a P/E multiple of 10x.
In order to determine accretion/dilution, we need to focus on the cost of acquisition and the “yield” received by the buyer.
Cost of Acquisition = %Cash x AT Cost of Cash + %Debt x AT Cost of Debt + %Stock x AT Cost of Stock
In all-stock transactions, the Cost of Acquisition = Cost of Stock and the Cost of Stock is the inverse of the P/E multiple (this is just one way of doing it and it’s the same as Buyer NI / Buyer Equity Value).
Now, we compare the following:
Cost of Acquisition > Yield of Seller = Dilutive
Cost of Acquisition Yield of Seller = Accretive
For the above example, the cost of acquisition for Company A is 1/15 or 6.67% and the “yield” of the seller is 1/10 or 10%, making this deal accretive.
It costs the buyer 6.67% of it’s share price to acquire a company that yields 10%.
why is Ke = 1/(P/E)? What is the intuition?
Ke is the Cost of Equity as it pertains to WACC, slightly different that the Cost of Stock in the Cost of Acquisition formula.
It’s different because you are looking at the Cost of Equity in terms of its impact on the company’s EPS, not the company’s overall discount rate.
Exactly how I think about it, think of their cost of equity as your return vs your cost
So to quantify the level of dillution, it would be what? 10% - 6.67% ?
Here's the simple way I think about it. How much of your earnings do you have to spend compared to the amount of earnings you're buying?
Very simple example:
Company A has EPS of $1.00, trades at 15.0x P/E
Company B also has EPS of $1.00 but trades at a P/E of 1.0x
Company A buys Company B for $1 million in an all-stock deal
How much of Company A's earnings does $1 million of stock value represent? At a P/E or 15.0x the answer is $67k. i.e. Company A generates $1 million of stock value for every $67k of earnings.
Make sense so far?
Now how much of Company B's earnings does it take to generate $1 million of stock value? At a P/E of 1.0x the answer is $1 million. It takes Company B $1 million of earnings to create $1 million of stock value.
So back to my original question of how much of your earnings do you have to spend relative to the earnings you're buying? In this example Company A is spending $67k of earnings to buy $1 million of earnings.
Deal's accretive.
These answers are all way too complicated... Basically in an all stock deal, If I am acquiring a company with a lower P/E than my own it will be accretive. You are essentially paying less for each dollar of earnings
I get that what does paying less for the same earnings have to do with being accretive?
Think about it more like earnings yield than P/E multiple and it's a lot easier to comprehend. E/P is a company's earnings yield. If a company acquires another that has a higher earnings yield (i.e. if the target has a lower P/E), that is accretive.
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