When entering into an accretive acquisition, it’s important to look at the numbers to determine if the merger or acquisition you’re involved in is going to work out financially for your company. Knowledge of how to calculate earnings per share (commonly abbreviated as EPS) and how that plays into the merger of two companies is paramount; it can make the difference between a financially successful transaction or a failure. But first, we have to look at what defines an accretive acquisition.
It’s All About Accretive Acquisition
Simply put, an accretive acquisition is a type of transaction that increases the acquiring company’s EPS. In most instances, an accretive acquisition happens when the price-earnings ratio (commonly abbreviated as P/E) of the target company is less than the P/E of the acquiring company. The endgame is most often to increase the synergy, leading to a single company whose value is greater than the value of the two separate companies combined.
What Is Pro Forma Earnings Per Share?
Pro forma earnings per share (or pro forma EPS) is a formula that projects the earnings per share that an acquiring company will have after a merger and acquisition (commonly abbreviated as M&A). The term “pro forma” is Latin for “as a matter of form” or “for the sake of form.” It’s most commonly used in financial modeling and accounting.
Standard EPS has a much simpler formula; its quotient is calculated by taking a firm’s net income (the numerator) and dividing that by the weighted shares that are outstanding (the denominator). To accurately calculate pro forma EPS is a complex undertaking. It follows the standard EPS formula, but adds a few items, including the target firm’s net income (along with other items, depending on the transaction) to the numerator; and to the denominator, it adds any new shares that are issued due to the acquisition.
The pro forma EPS formula looks like this:
Pro Forma EPS = (Acquirer’s Net Income + Target’s Net Income +/- “Incremental Adjustments” ) / (Acquirer’s shares outstanding + New Shares Issued)
Defining Incremental Adjustments
In the pro forma EPS formula, there are some obvious items. For example, the net income of both companies (acquiring and target) as well as the number of shares, which are the acquirer’s outstanding shares as well as the number of new shares issued as a result of the merger and acquisition. Several of those “incremental adjustment” items are tax-related, including incremental post-tax adjustments, after-tax synergies (referring to gains in assets), tax-related depreciation and after-tax interest expenses, among others. Of course, every transaction is different and some (or all) of these incremental adjustments may (or may not be) present.
What Does This All Mean?
Pro forma EPS is a valuable tool, used by the acquiring company in an M&A for financial projections. It is used to project the numbers when it comes to either acquiring or merging with the target company, and whether the transaction will have a positive or negative effect on the acquiring company’s EPS. Of course, this is only one (of potentially many) factors that determine whether an M&A is the proper course for both of the companies involved.
What Is a Good EPS?
Finally, one thing you must understand is the concept of accretion/dilution. In layman’s terms, accretion/dilution is a formula that allows you to assess the changes in EPS due to a merger or acquisition. Similar to calculating pro forma EPS, accretion/dilution is a formula:
EPS Accretion / (Dilution) = (Pro Forma EPS – Standalone EPS) / Standalone EPS
The goal for any successful M&A is to have the pro forma EPS greater than the standalone EPS, which would make the deal accretive. However, if the pro forma EPS is lower than the standalone EPS, the result is a dilutive deal, and obviously not the goal of the merger or acquisition in the first place.
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Chris Capelle is a technology expert, writer and instructor. For over 25 years, he has worked in the publishing, advertising and consumer products industries.