Walk me through an accretion/dilution analysis

When one company buys another, the first question the buyer's shareholders ask is simple: did this make us better off?

The usual way to answer that is earnings per share. If earnings per share goes up after the deal, it is accretive. If it goes down, it is dilutive.

This is the standard technical question in mergers and acquisitions interviews. It gets asked two ways — sometimes they want the full calculation, sometimes they want a ten-second shortcut. Prepare for both.

There is also a judgment question underneath it, which catches people out. Accretive does not mean good.

First, what is earnings per share?

If this is new to you, start here.

Earnings per share, or EPS, is a company's profit divided by the number of shares.

EPS = net income ÷ number of shares

If a company earns $100 million and has 50 million shares, EPS is $2.00.

It matters because it tells each shareholder what their single share earned. Investors watch it closely, and a company's share price often moves on whether EPS beat expectations.

So when a company buys another one, everyone wants to know what happens to EPS.

Why a deal can go either way

Buying a company adds profit. That pushes EPS up.

But paying for it costs something. That pushes EPS down. How much depends on how you pay:

• Pay with cash — you lose the interest you were earning on that cash
• Pay with debt — you now owe interest on the loan
• Pay with your own shares — you have created more shares, so the same profit is split more ways

Whether EPS rises or falls comes down to whether the profit you gained is bigger than the cost of getting it.

The full calculation

Step 1: Build the combined profit

Start with the two companies' profits and adjust:

Acquirer's net income Plus target's net income Plus synergies, after tax. Synergies are savings from combining — one head office instead of two, for example. These are pre-tax savings, so multiply by (1 − tax rate). Minus interest on new debt, after tax. If you borrowed to fund the deal, you now pay interest. Interest is tax deductible, so again multiply by (1 − tax rate). Minus interest income lost on cash used, after tax. If you spent $500 million of cash that was earning 3 percent, you have lost $15 million of income a year. This line gets forgotten constantly. Minus extra depreciation and amortisation, after tax. When you buy a company, its assets get revalued to what they are really worth today. Higher asset values mean higher depreciation, which reduces profit.

Tax everything at the acquirer's tax rate, because that is the rate the combined company pays.

Step 2: Build the combined share count

Acquirer's existing shares Plus new shares issued, if any part of the deal is paid in stock.

New shares = (value of the stock portion) ÷ (acquirer's share price)

If you are paying $600 million in stock and your shares are worth $30 each, you issue 20 million new shares.

Step 3: Divide and compare

New EPS = combined profit ÷ combined shares

Compare it to the acquirer's EPS before the deal. Higher means accretive. Lower means dilutive.

The shortcut (this is often what they want)

For an all-stock deal, there is a much faster way. It relies on understanding one idea.

Earnings yield

A P/E ratio is share price divided by earnings per share. If a share costs $40 and earns $2, the P/E is 20.

Now flip it upside down. Earnings yield is earnings divided by price — in this case $2 ÷ $40, which is 5 percent.

That tells you: for every dollar of share price, the company produces 5 cents of earnings.

The rule

In an all-stock deal, compare the two P/E ratios:

• If the acquirer's P/E is higher than the P/E being paid for the target, the deal is accretive
• If it is lower, the deal is dilutive

Why? A high-P/E company has a low earnings yield. That means its shares are an expensive currency — each share buys a lot. When it uses those expensive shares to buy earnings that are cheaper per dollar, EPS goes up.

The everyday version: a high-multiple company buying a low-multiple company creates accretion.

One warning

You must use the P/E based on the price you are actually paying, including the premium. Not the target's share price before the deal was announced.

Buyers almost always pay 20 to 40 percent above the market price to persuade shareholders to sell. Ignore that and you will get borderline deals wrong.

The general version

For deals mixing cash, debt and stock, compare the cost of each funding source against what you are buying:

• Cost of cash = the after-tax interest income you give up
• Cost of debt = the after-tax interest rate you pay
• Cost of stock = the acquirer's earnings yield (1 ÷ P/E)

Weight those by how much of the deal each funds. Compare to the target's earnings yield at the purchase price.

If what you are buying yields more than what you are paying, the deal is accretive.

Breakeven synergies

Often the more useful number than accretion itself.

Breakeven synergies are the level of savings needed to make the deal exactly neutral — EPS neither rises nor falls.

If a deal needs $200 million of annual synergies to break even, and management is promising $220 million, that is very tight. If they are promising $600 million, there is real room.

Mentioning this shows you understand what the analysis is actually for.

The judgment point: accretive is not the same as good

This is what separates a strong answer from a mechanical one.

A deal can be accretive and still destroy value. You can massively overpay for a business and still see EPS rise, simply because you funded it cheaply. The shareholders are worse off, but the EPS number looks fine.

A deal can be dilutive and still be excellent. Buying a fast-growing business might reduce EPS in year one and transform the company over five years.

EPS is an accounting outcome over one year. Value is about the cash a business generates over its life. They are different questions.

Saying this out loud is often what makes the interviewer nod.

Saying it out loud

"A deal is accretive if the buyer's earnings per share goes up, and dilutive if it goes down.

To work it out, you build combined net income — both companies' profits, plus after-tax synergies, less after-tax interest on new debt, less the interest income given up on any cash used, less extra depreciation from writing up the target's assets. Everything taxed at the acquirer's rate.

Then you build the combined share count, adding any new shares issued to pay for the deal. Divide, and compare to standalone EPS.

For an all-stock deal there is a shortcut: compare P/E ratios. If the acquirer trades at a higher multiple than the one being paid for the target, it is accretive.

It is worth adding that accretive is not the same as a good deal. You can overpay and still be accretive if you fund it cheaply."

What the interviewer is really checking

Can you list the adjustments cleanly?

This build is expected knowledge. Stalling halfway through suggests you have not practised it.

Do you understand what each funding source costs?

Cash is usually cheapest in EPS terms because forgone interest income is small. Stock is usually the most expensive. Interviewers often change the funding mix mid-question to see whether you are calculating or reciting.

Do you use the offer price?

The shortcut only works against the P/E implied by what you are actually paying. Candidates who use the target's unaffected price get the sign wrong on close calls.

Do you know the difference between accretion and value?

The best answers volunteer that accretion is an EPS outcome, not a valuation conclusion. That distinction is the whole judgment test.

Do you know the small lines?

Forgone interest income on cash. The tax effect on synergies. Extra depreciation from asset write-ups. These are what get dropped under pressure.

Common mistakes

Using the target's price before the deal was announced.

Use the multiple implied by the offer price, premium included.

Forgetting the interest income lost on cash.

Cash spent on the deal stops earning interest. That reduces combined profit, and it is the most commonly dropped line.

Forgetting to tax-effect things.

Synergies and incremental interest both flow through pre-tax. Multiply by one minus the tax rate.

Ignoring extra depreciation from asset write-ups.

Buying a company means revaluing its assets, which raises depreciation and lowers profit. Note that goodwill itself is not amortised for US public companies — it is tested for impairment. Mixing those up is a giveaway.

Using the target's tax rate.

The combined company pays the acquirer's rate.

Saying accretive means the deal is good.

The most punished error here, because it is a judgment failure rather than an arithmetic one.

Forgetting fees.

Advisory fees are generally expensed. Financing fees are capitalised and spread over the life of the debt. Mentioning the treatment earns credit even if they tell you not to model it.