A merger and acquisition (M&A) deal is said to be accretive if the acquiring firm’s earnings per share (EPS) increases after the deal goes through. If the resulting deal causes the acquiring firm’s EPS to decline, the deal is considered to be dilutive. Investors should be careful with this analysis; not every accretive deal is necessarily good, and not every dilutive deal is bad.
Dilution and Accretion
Dilution and accretion are scientific terms that refer to the concentration of a chemical or element. When used in conjunction with stock ownership, a financial event is accretive whenever it causes an appreciation in EPS. Conversely, an event is dilutive whenever the resulting action causes EPS to drop.
EPS is calculated as net income less paid dividends to preferred shareholders, divided by the average number of outstanding shares.
EPS and M&A Deals
Normally, the primary goal of a merger model is to find out if the acquiring company can increase its EPS after the deal goes through. Ostensibly, a deal with accretive consequences should create additional value for the firm’s shareholders – a result that many consider to be the primary duty of a corporation’s directors.
There are many reasons why EPS might go up after an M&A deal. The synergy between the two firms might result in increased economies of scale or scope. The target company’s capital or research and development tools may lead to future gains in productivity or revenue generation. In any case, the financial analysts are looking for a sum value that is greater than the individual components.
As a rule of thumb, analysts look to each company’s P/E ratio. If the target company has a smaller P/E ratio, the merger should be accretive.
However, a momentary increase in EPS does not necessarily mean that the deal will be a long-term success. Successfully executing a merger is a complex and risky effort. There may be future unintended consequences that end up damaging the new company’s valuation.