What is Accretive Acquisition?
An accretive acquisition is an acquisition that increases the acquiring company’s earnings per share (EPS). These acquisitions benefit the company’s market price because the price paid by the acquiring firm is lower than the financial boost that the new acquisition is expected to provide to the acquiring company’s EPS. As a general rule, an accretive merger or acquisition occurs when the price-to-earnings (P/E) ratio of the acquiring firm is greater than that of the target firm.
How an Accretive Acquisition Works
An accretive acquisition increases the synergy between the two companies and creates a combination where the combined value is greater than the sum of its parts. So value in an accretive acquisition is generated because the buyer of a smaller company is able to add the acquired business’s pro-forma EBITDA/earnings ratio to its own EBITDA/earnings ratio. (EBITDA is “earnings before interest, taxes, depreciation, and amoritization.”) If the acquisition is done correctly, the purchasing company has a higher enterprise value (EV)/EBITDA multiple, and the addition of the acquired company increases the total value of the combined entity.
Example of an Accretive Acquisition
As an example, if a large, public packaged goods company wants to increase its EPS immediately, thus increasing its share price, it would look to acquire a smaller packaged goods company with a higher EPS. If the larger company had an EPS of $2 and calculated that if it acquired a smaller company with an EPS of $2.50, it would realize a combined pro-forma EPS of $2.15, the gross value of the acquisition would be 15%. If the cost of acquiring the company is 10 cents per share, the net benefit is positive to the tune of five cents per share.
If the opposite is found—that the acquiring cost is more than the accretive value—then it is determined to be dilutive.
Accretion: When pro-forma EPS > Acquirer’s EPS
Dilution: When pro-forma EPS < Acquirer’s EPS
Criticism of Accretive Acquisitions
However, since pro-forma financial statements and 12- to 24-month forecasts are used to derive the potential accretive value of the acquisition, synergies are not guaranteed. In fact, the only way to realize the added value of combining the firms is to integrate both companies effectively and efficiently, so there are no lost benefits. Often, the combination of the firms fails and the resulting entity realizes an EPS that falls short of expectations, causing the firm to lose overall value.
Not all accretive acquisitions end up positive in the long term. While there may be an immediate spike in the EPS, the pro-forma EPS still has to be realized over the next 1 to 2 years.
Consider the example of Company A, with a current EPS of $1.00. Company A acquires Company B resulting in a combined pro-forma EPS of $1.40. In this case, the acquisition is 40% accretive. But to maintain a good financial position, it is often necessary to cut costs and restructure: for example now that Company A and Company B are merged, they may not need the same structures they currently have, and they can add benefit by cutting redundant costs such as duplicate sales teams or top executives and management.
The key to having an accretive acquisition is, therefore, less the accounting and numbers and more the ability to integrate both companies. Quite often, mergers that are seen as accretive will fail as the companies are not combatable to the synergy needed to merge and the accretive additions will only be a short-term stopgap in a poorly-laid out merger plan.
When Dilutive Deals Succeed
When Kellogg acquired Keebler Foods, many analysts were expecting a dilutive deal. Keebler had a higher P/E ratio than Kellogg so the deal was dilutive, cutting Kellogg by 20% EPS. But a year after the deal, Kellogg had rebounded with a 25% EPS return.
This is part of a trend studied by the Harvard Business Review where 100 US acquisitions between 1996 and 2000 were studied with price tags over $1 billion, and they found that dilutive deals outperformed accretive deals in the long run. In the year after the merger, nearly half of dilutive deals surpassed their average stock-price returns by 10%. On a third of accretive deals had done the same.
Harvard chalked it up to one word: discipline. The market’s suspicion of dilutive deals places more pressure on those executives to make wiser choices and make better due diligence, whereas the market’s ease on accretive deals give those executives a chance to rest on their laurels and underperform.
This emphasizes the need to do more than just a surface analysis of current pro-forma EPS of the acquirers and the acquired, and do the grunt work in coming months and years to make sure that the two merged companies synergize.