How an Investment Banker Builds an Accretion Dilution Model, Part 1
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This article is part one of a two-part series. Click here for part two.
One of the core models investment banking analysts and associates have to build when analyzing an acquisition is the accretion/dilution model. The underlying purpose of such an analysis is to assess the impact of an acquisition on the acquirer's earnings per share (EPS).
Why is this important? Well, we'll get to that in a second, but first let's talk about the basic mechanics involved in performing such an analysis. First, some definitions:
An acquisition is accretive when the combined (pro forma) EPS is greater than the acquirer's standalone EPS. For example, suppose analysts expect Procter & Gamble's EPS to be $3.05 next year. You are a banker charged with the task of modeling the impact to Procter & Gamble's EPS if they were to acquire Colgate-Palmolive. So you build your model and determine that the pro forma EPS next year would actually be $3.10 - $0.05 higher than had the acquisition not taken place. In other words, the deal would be $0.05 accretive next year.
An acquisition is dilutive if the opposite is determined: that pro forma EPS would be lower than $3.05 A deal is considered breakeven when there is virtually no impact to the EPS.
- Accretion: When pro forma EPS > Acquirer's EPS
- Dilution: When pro forma EPS < Acquirer's EPS
- Breakeven: No impact on Acquirer's EPS
Click here to see how accretion/dilution is integrated into M&A pitchbooks prepared by Goldman Sachs and Lazard.
Now that we got definitions out of the way, let’s dive into the mechanics of a very basic accretion/dilution analysis:
Exercise 1. Calculate accretion/dilution:
We can back into combined net income by multiplying EPS by shares outstanding for both acquirer and target and get $10,000 + $5,000, or $15,000 (note 1). Acquirer shares trade at $25, while target shares trade at $60 Since no premium is being offered to target shareholders (unlikely in the real world), target shareholders will accept 2.4 acquirer shares in exchange for each target share. Thus, acquirer must issue 2,400 shares to purchase 1,000 target shares. Now we can complete the analysis:
Notice this deal is dilutive. In fact, a 100% stock deal will always be dilutive when target’s PE ratio is higher than acquirer's (note 2) . Conversely, the deal will always be accretive when acquirer’s PE ratio is higher than target’s. Why? PE ratio indicates how expensive a company’s earnings are.
Imagine a simple scenario: Acquirer Co., which expects to generate EPS of $1 next year, has shares trading at $5 in the stock market, implying a PE ratio of 5.0x. Acquirer Co. is considering acquiring Target Co. with EPS of $1 next year but whose shares trade at $10 in the stock market, implying a PE ratio of 10.0x. In a 100% stock deal, Acquirer Co. must issue 2 shares in order to acquire one target share. Since one Acquirer Co share equates to owning $1 of the company's net income and acquirer must issue 2 of these shares in order to acquire $1 of target's net income, then of course the incremental benefit of target net income will not be sufficient to offset the share dilution required to make the deal happen.
Does M&A create shareholder value?
An acquisition creates shareholder value (increases the value of shareholder stock) by acquiring a business whose fundamental value is higher than the purchase price. If the acquisition is strategic and cost savings (cost synergies) from the elimination of redundant personnel, overlapping R&D efforts, closing down manufacturing plants, and increased revenues (revenue synergies) from cross-selling opportunities, etc. can be captured, the acquisition creates shareholder value as long as the fundamental value of the target plus the present value of the synergies is greater than the purchase price.
This implies that, for example, when an acquirer purchases target at a 30% premium (note 3) to target market value, it must believe that the fundamental value of the business, plus expected synergies is higher than the 30%-above-market purchase price. If the acquirer is wrong, it has destroyed shareholder value. Between 1980 and 2001, acquisitions resulted in an average of a 1-3% decline in acquirer share price, translating into $218 billion in value transferred from acquirers to sellers (note 4) , and implying that acquirers, on average overpay. Why do acquirers overpay? Part of it is that many CEOs want to be Gordon Gecco and will squander shareholders’ money to prove it. Sadly, I am only half-kidding. There are of course other reasons, but we will leave that discussion for another day.
Does accretion/dilution tell you anything about shareholder value
So how does this tie with accretion/dilution? First, it should be noted that the prevailing perception is that Wall Street generally frowns upon deals that are EPS dilutive. It is widely believed that analysts and investors may tolerate dilution in the first year, as long as they can be reasonably assured that the deal will turn accretive in year 2 post-acquisition (note 5).
Why does accretion/dilution matter? Well the short answer is that EPS accretion/dilution is essentially regarded as a proxy for value creation/destruction. The basic reasoning is that given a fixed PE ratio, if EPS is expected to decline as a result of the deal, price (value) should decline as well. Of course using EPS as a proxy for value carries some substantial limitations, especially when observed over only a short period such as 2 years, as is typically done in accretion/dilution analysis.
Fundamental value is driven from expected operating cash flows, returns on capital and the cost of capital - not EPS or accounting profits. With that qualification notwithstanding, accretion/dilution, by virtue of the prevailing perceptions, represents an important facet of an overall M&A analysis. It is often presented in fairness opinions and deal books, in addition to DCF valuation, comparables valuation, etc. (see standard deal book presentation below).
Presentation of Accretion Dilution Analysis
Accretion/dilution analysis is sometimes derived using a “quick and dirty” analysis (this is essentially an extension of the simple example we illustrated above), or as part of an integrated pro forma M&A model, where the pro forma balance sheet, income statement, and cash flow statement are all projected.
- Note 1. Assume shares outstanding used for EPS calculations do not change during the year.
- Note 2. Where PE ratio is based on the offer price and assuming no synergies, or adjustments other than issuance of new acquirer shares. In a complete accretion/dilution analysis, these assumptions need to be relaxed.
- Note 3. On average, acquirers pay 30% above target’s preannouncement market price according to McKinsey & Company.
- Note 4. S.B. Moeller, F. P. Schlingemann, and R.M. Stulz, “Do Shareholders of Acquiring Firms Gain from Acquisitions?” (NBER Working working paper no. W9523, Ohio State University, 2003.
- Note 5. McKinsey & Company’s empirical analysis of 117 transactions greater than $3 billion between 1999 and 2000 determined that the market prices are actually neutral to EPS accretion/dilution. Source: Valuation, fourth edition, Koller, Goedhart & Wessels.
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