Accretive

The term "accretive" can describe a process or situation where something gradually grows or accumulates over time. It happens through the addition of new materials or components. You may have heard its counterpart (opposite), the term “dilutive.”

In the financial world, this term is applied to several financial concepts to reflect an increase in something. 

For example, you purchase a zero-coupon bond at a discount. Your bond is now an accretive asset or growing asset while you hold it to maturity.

1. Imagine this bond is traded at $50 while its par value is $100. 
2. We know paying $50 for this instrument will generate a 100% return. 
3. The payment of $100 received at maturity is an accreted value.

If, for instance, it is a coupon-paying bond with the same terms as above, accrued interests received would also enhance its accretive value. 

In a corporate finance deal, accretion value is one of the most important steps to determine the attractiveness of the deal you are looking to conduct. 

In M&A (mergers and acquisitions) transactions, an accretion/dilution analysis is at the core of giving a deal the green light to proceed.

Let’s understand why it is so important.

What is Accretive Analysis?

Accretion analysis measures the contribution of a transaction to a potential acquirer’s earnings considering a predetermined financing structure. It is focused on comparing the pro forma acquirer’s EPS (earnings per share) and his EPS on a standalone basis.

Generally, this analysis is a fundamental screening tool for prospective acquirers and bankers willing to make deals. Usually, acquirers only engage in accretive transactions over a reasonably projected period. 

Since these deals don’t create value for shareholders and may even be valued as destructive, there are a few cases when they would make sense.

For instance, a target is unprofitable but for a short period. The first one or two years are needed to put the company back on track to see positive numbers.

High-growth profile companies with booming sales or technologies are good examples (e.g., Slack and Spotify).

In contrast, accretion deals can be unsuccessful as well. For example, sometimes accretive mergers fail because:

• The leverage is too high.
• A newly acquired business contains many risks.
• A mismatch exists between investors and management regarding the level of upsides that a target can bring to the table.

In a perfect world, buyers would like to see accretion from the get-go of the deal closing. It is like an ROI (return on investment). You always want it to be immediate because it gives you instant benefits.

Most deals are long-term-oriented projects meant to create shareholder value over time. However, investors and markets are always forward-looking and focus on future EPS (earnings per share) changes. 

This is why accretion analysis captures the target’s expected performance, envisioned synergies, and other mutually beneficial improvements that yield higher growth.

Interview Hints for Conducting An Accretion Analysis

In corporate finance, there are three possible ways of financing a deal. It can be a share, cash, or mixed deal. A share deal is when the purchase price is entirely paid with shares, while a cash deal is fully paid with money. 

A mixed deal is a combination of the two previous. It can be any ratio of 20%/80%, 50%/50%, or any other.

You can use two rules of thumb to determine whether a deal is accretive. These shortcuts are handy in interviews. 

Generally, interviews for M&A (mergers and acquisitions) positions may contain short mental exercises demanding the analysis of the attractiveness of a deal from the three possible ways of financing a deal WSO has mentioned.

1. 100% Stock Transaction

This transaction is typical when an acquirer takes over a target with a lower P/E (price-to-earnings) ratio. A lower target’s P/E makes this deal always accretion for the buyer. Compare their earnings or earnings yield.

If the P/E ratio of the buyer is ten versus the P/E of 5 of the target, the earnings yield will be 10% and 20%, respectively. Therefore, earnings yield is calculated by 1/(P/E). 

(1/10)*100 = 10% vs (1/5)*100 = 20%

In our example, the buyer gives up a stock that generates a 10% earnings yield to receive a stock that produces a 20% earnings yield. It is by far an accretion deal. Conversely, purchasing a target with a higher P/E ratio in a full stock transaction will not be accretive.

However, such a deal can become accretion by considering synergies and enabling the buyer to improve its financial performance. 

In contrast, transaction-related expenses like D&A (depreciation & amortization) will reduce the accretion effect.

2. 100% Cash Transaction

This transaction, as its name implies, is entirely financed in cash. The buyer pays real money to the shareholders of the target. Cash can have two sources:

• Debt
• Balance sheet cash (cash owned by a company)

To gauge whether a deal is accretive, you need to compare the earnings yield of the target with the cost of cash used for financing. 

Let’s take the same 20% earnings yield of the previous example.

The ingredient we still need is the cost of debt if we use leverage for the acquisition. Let’s assume it is 10%. We cannot directly compare these two figures because we must use the net cost of debt.

Assuming the tax rate of 20%, the net cost of debt is 8%:

10% * (1 - 20%)

Net cost of debt is necessary because interests are tax deductible. Therefore, we pay less taxes. 

Comparing 20% versus 8% is sensible, and this deal is accretive. We buy something that yields 20% with a cost of 8%.

You should apply the same logic when you use the company’s cash. The company’s cash is not free. And so, in this case, we speak about the opportunity cost. 

For instance, the buyer spends money on the acquisition instead of investing in treasury bonds and receiving financial interest.

Therefore, the net cost of cash will be computed similarly to the net cost of debt.

3. Example of Mixed Financing (Cash & Equity)

Suppose Company A has a P/E ratio of 4x and Company B has a P/E ratio of 10x. The cost of debt of A is 10%, cost of cash interest is 4%. The tax rate is 50%. 

We assume that Company A purchases Company B with equity, debt, and cash. The repartition, or proportion, is 25%, 50%, and 25%, respectively. 

It is impossible to determine whether this transaction is accretive using the above-mentioned tips.

Company A’s implied cost of equity (or earnings yield) that the company gives up to the target is 25%:

¼ = 25%, where 4 is P/E

Applying the same principle, the earnings yield of Company B is 12.5%. Company A’s cost of debt is 5%. 

We take the “gross” cost of debt of 10% multiplied by the tax rate of 50%.

The cost of cash is identically calculated:

4% * 50% = 2%

Now, we should multiply the cost of each financing source by its weight. 

• We multiply 25% (cost of equity) by 25% (its weight) = 6.25%
• We multiply 5% (cost of debt) by 50% (its weight) = 2.5%
• We multiply 2% (cost of cash) by 25% (its weight) = 0.5%

Finally, sum these figures up to get the total cost of the deal:

6.25% + 2.5% + 0.5% = 9.25%

This deal is accretive because the assets we buy with a cost of 9.25% don’t exceed its earnings yield of 12.5%. 

Researched and authored by Illia Shliapuhin | LinkedIn

Reviewed and Edited by Shahrukh Azim Butt | LinkedIn 

Free Resources 

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Activist Shareholder
• Call Report
• Going Concern
• Media for Equity
• Perpetuity