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Accretion/Dilution Analysis – Part I: EPS, Earnings Yield and All-Stock Transactions

Accretion/Dilution is an important concept in corporate finance which is associated with mergers & acquisitions (is a transaction accretive or dilutive post-merger) – however, accretion/dilution analysis is conducted whenever an analyst looks at pro-forma earnings (or cash flow for energy and mining companies) after the evaluation of various corporate actions (a recapitalization, a project).

The concept is also important for sales and trading, as corporate and financial clients care about the effects of risk management solutions (hedging) on accretion as it pertains to earnings or cash flow.

As such, being able to convey a strong understanding of accretion/dilution is key in investment banking interviews (especially in the M&A team).

For the purposes of this article, we focus on earnings accretion/dilution in the form of Earnings Per Share, or EPS.

The Relationship between EPS, the Earnings Yield and the P/E Ratio

EPS combined with the share price effectively produces an earnings yield on a stock (EPS/Share Price). By itself, this provides a very crude valuation metric or investment criteria – the higher your return on investment via the earnings yield, the more attractive the stock. The inverse of the earnings yield is the widely used price/earnings ratio (P/E ratio).

However, like with the price earnings, the earnings yield cannot be looked at in isolation to determine whether the stock is a good investment, because the future cash flows from a company are much less certain compared to the contracted interest on a bond (which is fixed) or the rent from real estate.

In an efficient market, a lower earnings yield or a higher price/earnings can be explained by better growth prospects, a more stable business, or adjustments for non-recurring factors – for instance, a company that had a one-time legal charge for the year that will not be present on a go-forward basis will likely trade at a lower earnings yield or higher price/earnings because investors need to factor in the future economic value of the firm.

From a valuation standpoint, should EPS increase organically and without a broad change in market sentiment where the P/E multiple assigned increases or decreases (which bankers or equity research like to refer to as multiple expansion or contraction), the price of the stock and accordingly the value of an equity investment should increase.

EPS Accretion and Dilution in Mergers & Acquisitions in an All-Stock Deal

From a purely accounting level, the purchase of another company using shares of the acquirer company will result in EPS accretion if the earnings yield of the target is higher than that of the acquirer, or the target P/E is lower than that of the acquirer.

A simplifying explanation is that the consideration the acquirer is giving up is equity that returns less per dollar of investment for equity that returns more per dollar of investment.

How accretive the deal is will depend on the difference in earnings yield and size between the target and the acquirer.

The EPS Accretion/Dilution and Share Price Movements Post-Merger

Companies and investment bankers will usually structure a deal so that there is EPS accretion immediately. However, the share price of the acquirer post announcement often falls even when this is the case, if the market perceives the EPS accretion to be widely a result of financial engineering/corporate finance wizardry as opposed to realizable synergies.

For example, if a company that trades at a P/E of 10 purchases a company with a P/E of 5, this is accretive from on an EPS basis. However, absent any reason (synergies) for the market to re-rate the combined company at the acquirer’s multiple, the P/E should theoretically end up being the weighted average of the two less the premium paid and may take an additional conglomerate discount (the more separate operating businesses, the less simple the company is to analyze, leading to investors further discounting the stock).

Related Reading for Accretion/Dilution

Mergers & AcquisitionsBid Pricing Strategy: Part II · Bid Pricing Strategy: Part I · Deal Protection in Mergers & Acquisitions · Investment Banking Bake-Off or Beauty Contest · Acquisition Finance: Equity Consideration · Acquisition Finance: Bullet Debt · Acquisition Finance: Bank Debt · M&A Process Walkthrough · Types of M&A Sell Side Processes · Investment Banking Teaser · Accretion/Dilution Analysis – Part IV: Synergies and Source of Funds for M&A · Accretion/Dilution Analysis – Part III: Using Debt for Acquisitions · Accretion/Dilution Analysis – Part II: Accretion/Dilution Math and Breakeven Premium · Accretion/Dilution Analysis – Part I: EPS, Earnings Yield and All-Stock Transactions · Purchasing a Company via Cash or Stock ·
Corporate FinanceHow to Answer “What Two Companies Do You Think Should Merge?” · A Comparison of Spin-Outs versus Carve-Out IPOs: Part I · Dividend Policy and Return of Capital · Accretion/Dilution Analysis – Part IV: Synergies and Source of Funds for M&A · Accretion/Dilution Analysis – Part III: Using Debt for Acquisitions · Accretion/Dilution Analysis – Part II: Accretion/Dilution Math and Breakeven Premium · Accretion/Dilution Analysis – Part I: EPS, Earnings Yield and All-Stock Transactions · Purchasing a Company via Cash or Stock · WACC and Optimal Capital Structure Reviews · Reasons for Mergers & Acquisitions · Early Bond Redemption Analysis · Hedging Interest Rate Risk ·
Matt
ex investment banking associate
https://www.linkedin.com/in/matt-walker-ssh/

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