4.5.3. Accretion/Dilution Analysis
An accretion/dilution analysis helps determine what effect a proposed acquisition will have on the acquiring company’s post-acquisition EPS. A deal is considered accretive when the EPS for the combined entity is greater than the EPS of the acquiring company before the merger or acquisition. The acquisition would be dilutive if EPS is lower. If EPS remains unchanged, the deal is a breakeven prospect. The accretion/dilution analysis is important because company management and investors generally frown on deals that are dilutive after one or two years. (You’ll see the phrase pro forma a lot in the next few pages. With regard to financial projections, this phrase is simply a reminder that the numbers are future estimates based on an assumption that things will go as expected. For example, no attempt is made to account for the possibility that a major disaster will disrupt the company’s operations.)
The following are the basic steps to follow in performing an accretion/dilution analysis for a proposed acquisition:
Step 1: Estimate the pro forma net income for the combined entities, including realistically expected synergies. One way to estimate pro forma net income is to estimate combined operating income based on historical data; add expected synergies; subtract interest expense; and subtract taxes. If the firm will need to borrow money for the transaction, the interest expense will have to be increased accordingly.
pro forma net income = combined operating income + synergies – interest expense – taxes
Step 2: Determine the new share count for the combined entity, including any new shares issued as part of a stock deal. Remember that if it is a cash deal, no new shares will be issued. If it is a part cash and part stock deal, this will have to be figured into the number of issued shares.
new share count = new shares created + buyer’s fully diluted shares outstanding