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EPS Accretion/Dilution Analysis

 

Accretion/dilution analysis helps evaluate the effect of a proposed transaction on shareholder value  by checking whether EPS for buying shareholders will increase or decrease after the transaction. Generally, shareholders do not prefer dilutive transactions; however, if the deal may generate enough value to become accretive in a reasonable time, a proposed transaction is justified.

The purpose of an accretion/dilution analysis is to estimate the impact of an acquisition to the acquirer’s future earnings per share (EPS) and compare the new EPS (“pro forma EPS”) with what the company’s EPS would be without the transaction.

The steps involved in accretion/dilution analysis are:

  1. Estimate a pro forma net income for the combined entities.
  2. Include conservative estimates of net income, taking into account prospective operational and financial synergies that are likely to result from the transaction. Some groups incorporate the last 12 months (LTM) as well as one- or two-year projections. Others include projected net income only. Regarding prospective synergies, the new company may anticipate higher revenues due to cross-selling of a wider array of products and services, as well as lower costs due to the elimination of redundant functions and manufacturing facilities.
  3. Aside from variables that affect the pro forma net income due to anticipated synergies, we also account for transaction-related adjustments that may occur, such as higher interest expense if debt is used to fund the transaction; lower interest income, if cash is used to make the purchase; and additional considerations on post-transaction intangible asset amortizations
  4. Compute the prospective acquirer's share count. Factor new shares that would be issued to make the purchase – if it is a stock deal.
  5. Divide pro forma net income by pro forma shares to arrive at a pro forma EPS.

An increase to EPS is regarded as accretion, while a decrease is regarded as dilution.

A real-life accretion/dilution analysis may be much more complex if the deal is structured as cash-and-stock-for-stock, if preferred shares and dilutive instruments are involved, if debt and transaction fees are substantial, and so on. Generally, if the buying company has a higher P/E multiple than that of the target, the deal is likely to be accretive. The reverse is true for a dilutive transaction. In addition to this, a pre-acquisition purchase price allocation is required for a transaction that might have a material level of intangible assets. The value of intangible assets will impact amortization, and in turn, the EPS of the company.