11. Accretion and Dilution

Overview

Every merger is either accretive or dilutive. In this lesson, we learn what these terms mean and how to quickly perform accretion / dilution analysis in our case study.

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Summary

  1. Lesson Goal (00:04)

    The goal of this lesson is to analyze if the proposed transaction is a good deal, using the concepts of accretion and dilution.

  2. Evaluating the Potential Merger (00:14)

    We cannot evaluate a potential merger using a single number, instead we must consider various different aspects of the proposed transaction. Some factors that will affect our evaluation of the deal include the increase in profitability, the impact of dilution, the increase in debt exposure, and the reduced cash position.

  3. Understanding Accretion and Dilution (00:57)

    Accretion/dilution analysis is commonly completed when a public company is making an acquisition. Accretion is the earnings growth that occurs due to business expansion. A merger or acquisition will increase revenue through combining the two companies and through synergies. Dilution is the reduction in ownership percentage that occurs when new shares are issued. In our example, new shares are issued to TrouserTown shareholders, reducing the percentage of the business owned by ShirtShop shareholders. This dilutes the shareholding of ShirtShop shareholders.

  4. Analyzing Earnings Per Share (01:55)

    In order to understand the balance between accretion and dilution, we use the Earnings Per Share metric. This divides Net Income by the total number of shares. In our example, Net Income is found in our combined Income Statement. The total number of shares in the combined company is found by adding the initial number of shares in the acquirer, and the number of new shares issued in the transaction.

    We calculate the standalone Earnings Per Share projections for the acquirer pre-transaction, and calculate the Earnings Per Share projections for the combined company. This allows us to analyze how beneficial the transaction will be. In our case, we see that Earnings Per Share will be considerably higher if the merger takes place. This indicates that the deal is highly accretive.

Transcript

In the previous lesson we combined the income statements of Shirt Shop and Trouser Town. Now we need to figure out if this represents a good deal for both companies. As you can imagine, there is no single number that will return a verdict of yes or no and so, instead we're going to have to look at a number of different metrics and piece together a picture that points to a positive or negative view of the deal. The components of the deal we will look at are as follows.

Increased profitability, the impact of dilution, especially with regard to share issue, increase in debt exposure as debt is used as part of the deal and of course, a decrease in cash position.

If you look at this list, you can see that the first bullet relates to synergies and the next three relate to how the transaction is funded. Let's begin by focusing on the first two bullets in this lesson by introducing a concept called accretion/dilution analysis. This analysis is commonly completed when a public company is making an acquisition. Accretion is defined as the earnings growth due to business expansion. If we look at the income statement of the acquirer before the acquisition, we can see that there's a net profit of just under 50 million. But now in our merger model, we can see that the net income is going to jump to 94.9 million in 2017 and as a result it looks as if this deal is highly accretive, however, this needs to be balanced with dilution whereby the percentage ownership of the company reduces as part of the transaction. In this particular transaction, dilution will occur because we have over six million shares issued to Trouser Town shareholders. To balance these two concepts of accretion and dilution, we've a single metric called earnings per share and earnings per share is simply the net income divided by the number of shares. Let's quickly calculate this for the combined entity.

I'll start by including the acquirer's total shares which I can find in that tab and I'll copy across.

Next are the shares issued in the transaction, so I'll scroll to the very top.

And find that number here and again I'll copy across.

I clearly need to anchor before copying.

I can now calculate total diluted shares which is simply the sum.

Now I'm going to calculate the standalone earnings per share for Shirt Shop before the transaction and this will simply equal to the net income of Shirt Shop divided by the number of shares.

And again I can copy across and this tells me that pre-transaction, the projections are for an earnings per share of between four and 4.27.

The combined earnings per share, on the other hand, are going to be the net income divided by total diluted shares.

And as we can see, these are much greater than the standalone version proving that the deal is going to be very accretive.

We might want to calculate the difference between standalone and combined and I'll do that in two ways. Starting with simply the absolute value and then also including the percentage difference.

And as you can see based on these calculations, earnings per share grow 22.6% the next year after we complete our transaction.