Accretion Dilution Model is one of the most popular models frequently used by Investment Banks when they analyze whether or not the M&A deal should happen. Basically, the model gives analysts an overview of how the M&A would affect the firm’s EPS (Earnings Per Share). Why is understanding the model important? Because one to several questions about a company’s EPS can come up in any of your investment banking interviews. But it’s more important since you would have to perform the model a bunch of times if you become an analyst/an associate at Investment Banks.
1. Definition of Accretion Dilution Models
The birth of the Accretion Dilution Model derives from stakeholders’ demand, specifically, from investors and company’s owners, who care a lot and are apprehensive about the company’s EPS. The model is performed by comparing the firm’s pre-acquisition EPS with its post-acquisition EPS to come to the conclusion of whether or not it would take steps to get closer to the M&A deal.
The usage of the model is applied as the following story: Prior to the acquisition, a company has its standalone EPS. The company is considering acquiring another company (acquisition), hence, it has a new EPS which is called the combined EPS or pro forma EPS. By virtue of the model calculation, the combined EPS (pro forma) will fall into one of the three scenarios:
- If the combined EPS is greater than the acquirer’s standalone EPS, then the M&A is ACCRETIVE.
- Otherwise, if the combined EPS is lower than the company pre-acquisition EPS, then the M&A deal is DILUTIVE.
- Finally, if EPS stays unchanged or changes relatively slightly, the acquisition is BREAKEVEN or NEUTRAL since it has no impact on the firm’s EPS.
Now that you know what is called an accretive or a dilutive acquisition, so:
Is an accretive acquisition better than a dilutive one?
Not really, the acquisition can happen or not depending on various factors. The company is willing to take over another company if the acquired one presents long-term growth prospects regardless of dilutive EPS after acquisition. Accretion Dilution Model is just an efficient analysis contributing to consideration of acquisition or merger. In fact, many models would be applied to arrive at the finalized agreement.
2. What does Accretion Dilution Figure Out?
Specifically, it looks to give an answer for the question: How does the proposed M&A deal impact on the firm post-acquisition EPS, increase or decrease or unchange? The outcome of the model would help investors, owners rethink their decision in the first place before proceeding with the deal.
As said, the core purpose of the Accretion Dilution Model is to figure out whether or not a company should make an acquisition if it views EPS as an only proxy to assess. Thus, there is a prevailing perception that:
- A dilutive EPS following the acquisition is hardly a good deal to proceed with.
- While an accretive pro forma EPS would be a better choice.
- Investors and company’s owners might accept dilutive EPS in the first years after acquisition to wait for the turnaround in the next several years when the EPS becomes accretive.
Here exists a few limitations when using Accretion Dilution Model to assess the potential of an acquisition:
- The model solely focuses on EPS of the firm. EPS acts as a proxy for a firm’s value decrease or increase. Despite an important gauge of the firm’s performance, there are a number of different metrics and multiples that can be used to asset a deal rather than just EPS. The firm’s value is projected from cash flow, cost of working capital and return while EPS seems more crucial in the stock exchange markets. The decrease in EPS drags the Stock Price down given a fixed P/E multiple. Investors might feel a little wary if the EPS becomes diluted far away from its initial level right before the acquisition or merger.
3. How to Perform Accretion Dilution Model?
As said, the model is simply performed based on the logic basic that analysts derive the value of pre-acquisition and post-acquisition EPS of the firm, then compare the two to assess if the deal is accretive and dilutive.
For the sake of simplicity, we don’t take the premium offered into account. The step-by-step guide to perform Accretion Dilution Model is presented with a quick example like below:
Step 1: Determine the acquirer’s EPS, the target company’s EPS.
Numbers of acquirer’s EPS and target’s EPS are projected numbers. Technically, it’s necessary to project those numbers in several years ahead, for example, 5-10 years.
The value of EPS can be derived by dividing the net income by outstanding shares of each firm.
- Take the Net Income/Net Earnings and the outstanding shares of each firm and put them in a table (these datas can be taken from the financial statements – In fact, analysts project the net income of each firm within 5-10 years so let’s obtain these datas from the projection file)
- Deriving the value of EPS
Let’s say, we have the value of net income of Acquirer and Target, which are $30,000 and $15,000 respectively. The number of outstanding shares are 5,000 shares for Acquirer and 3,000 shares for Target Company. Then, the EPS of Acquirer is derived by dividing $30,000 by $5,000, equal to 6, which is the EPS of Acquirer. Similarly, the Target Company’s EPS is 5.
Acquirer trades their stocks, say, at $25 per share, while the target company lists their price at $30 per share. We calculate the P/E by taking the value of share price divided by the EPS. It’s unnecessary to present the P/E here, but for the completeness purpose, let’s calculate it.
Step 2: Determine the number of additional shares the acquirer should issue to purchase the target company.
The target’s firm value is calculated by multiplying the share price by the number of outstanding shares. To purchase the target company, Acquirer has to issue additional stocks whose value is relative to the value of the target’s firm value.
To calculate the number of additional stocks issued by the Acquirer, you take the share price of the imminently-acquired company multiplied by its number of outstanding shares, then divide by the share price of the acquirer. In this example, we have the value of the target company is $90,000. To acquire this company, the acquirer issues 3,600 additional shares to purchase 3,000 shares of the target company. ($90,000/$25=3,600 shares issued additionally).
Step 3: Calculate the Pro forma Net Income and the volume of outstanding shares, and identify the combined EPS (Pro forma EPS)
For the sake of simplicity, we project that the Pro forma income would be the sum of Acquirer and Target (unrealistic in the real world). The Pro forma Net Income is $45,000.
The Pro forma number of outstanding share is equal to the initial number of acquirer’s outstanding share plus additional shares newly issued by the acquirer, which is 8,600 outstanding shares (5,000 + 3,600)
Dividing the Pro forma Net Income by the Pro forma number of outstanding shares gives the value of the combined EPS (Pro forma EPS). It is $5.23.
Step 4: Assess the Pro forma EPS if it is accretive or dilutive
First, we calculate the difference between the Pro forma EPS and the initial acquirer’s EPS (Pro forma EPS – Initial acquirer’s EPS). If it is negative, the deal is dilutive, and vice versa. Here, the residue is ($0.77).
Then we identify the percentage change if the deal is proceeded. Taking the difference above divided by initial EPS of the acquirer is the percentage change, which is -13% in this case.
The comprehensive guide above just provides steps to perform Accretion/Dilution Model at a basic level for you to understand the logic of it. In the real world, the model requires a number spreadsheets, in which analysts present projected numbers of net incomes, share prices, etc. Another unrealistic thing here is no share price premium or share issuance discount are put in the calculation. In several first years following the acquisition, the EPS can be dilutive, but then when the synergies kick in, revenue is likely to soar up due to a vast array of new products and services, redundant costs are eliminated and the functions are merged to maximize the efficiency, the EPS will become accretive.
Accretion Dilution Model acts as a proxy to assess if the deal would create or destroy the shareholder value. Wall Street widely advocates accretive acquisition deals while frowning on deals that make the company dilutive.
To arrive at a more overview picture of the deal, it’s required to perform the Accretion Dilution Model based on forecast numbers in 5 -10 years. Accretion Dilution Model, however, is not a complete analysis to consider the acquisition. There is still the likelihood of turning accretive afterwards due to the synergies (both cost synergies and revenue synergies).
When two firms merge with each other, overlapping functions, redundant costs would be removed, inefficient plants, manufacturers would be closed down. This is called Cost synergies.
In the best case scenario, if the cost synergies go along with the revenue synergies, which boost the revenues by providing more goods and service as the result of the acquisition, the deals create value for shareholders. In this case, the business combination is palatable.
Though it’s not too tricky, questions tied to the Accretion Dilution Model often come up in Investment Banking, Private Equity interviews to test out the knowledge and the comprehension of a candidate. That’s why you have to grasp key takeaways of the model to process flexibly in interviews.