The accretion/dilution bogeyman
Price ratios remain the most widely used multiples in valuation, but they're also the most misused. Part of the reason for this is that there are widely held illusions about P/E ratios that color both acquisition valuations and equity research. In this article, I'll examine one of these illusions, centered on whether an acquisition will increase earnings per share (be accretive) or decrease earnings per share (be dilutive) for the acquiring company. Using the shorthand of dealmakers, the former are supposedly value-creating (and, therefore, good for acquiring company stockholders), whereas the latter are value-destroying and should be avoided.
To see the basis for the accretion/dilution illusion, consider a very simple example. Company A, with 1,000 shares outstanding, trading at $80 a share and earnings per share of $1 a share (P/E = 80) buys company B, with 8,000 shares outstanding, trading at $10 a share and earnings per share of $1 a share (P/E = 10). Whenever a high-P/E-ratio company acquires a lower-P/E-ratio company, as is the case here, the merger will be accretive. In this illustration, the earnings per share of company will increase substantially after the acquisition, irrespective of whether the acquisition is funded with cash or stock. In fact, if the acquisition is at a fair price (1,000 shares of company A are issued to finance the acquisition of 8,000 shares of company B), the earnings per share will be $4.50 a share after the transaction:
EPS after transaction = Net Income of Company A +
Net Income of Company B
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Shares in Company A +
Shares Issued by Company A to buy Company B
= (1,000 + 8,000)/(1,000 + 1,000) = $4.50
It's at this point that the illusion kicks in. In the most extreme case, the shares of company A will continue to trade at 80 times earnings (as they did before the acquisition), increasing the price per share to $340.
The reality is unlikely to even come close to this optimistic scenario. If company A paid a fair market value for B, the P/E ratio for the company can be computed as follows:
P/E after transaction = Market Cap of Company A +
Market Cap of Company B
------------------------------------
Net Income of Company A +
Net Income of Company B
= (80,000 + 80,000)/(1,000 + 8,000) = 17.78
If we assume that markets are sensible, the bottom line is that stockholders in company A won't gain from the increase in earnings per share, because the P/E ratio will drop proportionately (because it's a fair value acquisition). In other words, there were good reasons why company B traded at a low P/E ratio -- low growth, high risk, and low return on equity are three that come to mind -- and company A is now saddled with those same disadvantages. If it can change those parameters, it can gain in value, but that has nothing to do with accretive or dilutive earnings per share.
You may accuse me of being a believer in efficient markets at this point and argue that markets make mistakes. True, it is possible that the acquiring company, at least initially, may be able to fool investors, especially if it focuses on buying small, low-profile, high-risk companies that have low P/E ratios. But ultimately, the truth will prevail. As an investor, you have to ask yourself whether you want to risk riding the ignorance bandwagon as a high-P/E-ratio company grows by acquiring low-P/E-ratio companies, using the accretion argument. If you decide to take the risk, remember the disasters and disappointments waiting down the line for acquisitive companies with high P/E ratios in the late 1990s, such as Lucent (NYSE:LU), JDS Uniphase (NASDAQ:JDSU), Ariba (NASDAQ:ARBA), and Cisco (NASDAQ:CSCO).
The bottom line is that it makes no difference whether an acquisition is accretive or dilutive. Debating the effects on earnings per share is a distraction. What should really matter to investors is whether the price paid on an acquisition is less than the value received in exchange.
This article is the first of a two-part series.
Fool contributor Aswath Damodaran is a professor of finance at the Stern School of Business at New York University. Professor Damodaran has been voted Professor of the Year by the graduating MBA class five times during his career at NYU. You can visit his website for more information. Among his numerous books, Fools might be interested in Investment Fables and Investment Valuation . Professor Damodaran holds no financial position in any stocks mentioned. The Fool has a disclosure policy.
