Accretion and dilution: how to tell if a deal lifts earnings per share

A deal is accretive if the buyer's earnings per share go up after it, and dilutive if they go down. Merger model interviews come down to working that out quickly.

The logic

The buyer gains the target's earnings and gives something up to pay for them:

• Cash: the interest it was earning on the cash, after tax.
• Debt: the interest on the new debt, after tax.
• Shares: a larger share count.

If what it gains is more than what it gives up, per share, the deal is accretive.

The shortcut

Compare yields.

• The target's earnings yield is its net income divided by the price paid, the inverse of the P/E paid.
• The cost of each funding source: after-tax interest rate for cash and debt; the buyer's own earnings yield (1 / its P/E) for shares.

If the target's yield is higher than the weighted cost of funding, the deal is accretive.

All-stock rule of thumb: a buyer with a higher P/E than the price paid for the target gets accretion.

Worked example

A buyer earns 100 with 50 shares (EPS 2.00) and trades at 40, a P/E of 20. It buys a target earning 20 for 200, a P/E of 10.

• All stock: it issues 200 / 40 = 5 shares. EPS = 120 / 55 = 2.18. Accretive.
• All debt at 6%, tax 25%: after-tax interest = 200 × 6% × 0.75 = 9. EPS = (100 + 20 − 9) / 50 = 2.22. Accretive.

Debt is cheaper here: its after-tax cost is 4.5% against a share cost of 5% (1/20), and the target yields 10%.

What a full model adds

• Synergies, and the costs of achieving them.
• Amortisation of intangibles created in the deal.
• Fees and financing costs.
• The effect on the balance sheet and credit ratios.

Questions to expect

• Why might a company do a dilutive deal? Strategic value, synergies that arrive later, or growth that the first-year figure ignores.
• Is accretion the same as value creation? No. A deal can be accretive and still destroy value if the buyer overpays.
• Which is usually cheapest: cash, debt or shares? Cash, then debt, then shares, though it depends on rates and the buyer's P/E.