Mergers, especially in the world of new media, are popping up like crocuses in spring. Companies interviewing MBAs for internships want to make sure that they know their M&A. Whether you're interviewing for a finance position in a high-tech firm or an investment bank that works with Internet stocks, you'd better be able to keep your mergers straight. Here's a quick way to determine if a merger is accretive or dilutive -- a commonly-asked question in MBA finance interviews.

A merger can be either accretive or dilutive. A merger is accretive when a firm with a higher price to earnings ratio (we'll call the company "Company 1," and label its P/E ratio "P/E1") acquires a firm of a lower P/E ratio (which we will label P/E2). Why do we call the merger accretive?

The company's new earnings will be E1 + E2. Let's call this Enew. Usually, the new company will maintain the P/E ratio of the acquiring firm. Post-acquisition, it will be valued as P/E1 x earnings.

However, the amount that Company 1 had to pay was only PE2 x E2. Hence it paid a lower price when compared to the additional valuation it received from the market due to the increased earnings. (Mathematically, this can be represented by P/E1 > P/E 2, P/E 1(E1 + E2)> P/E1(E1) + P/E2(E2)) Hence the word accretive. A simple way to memorize this is: "Accrete means to add. To add value." So if you pay less and receive more value, it is accretive. (Think of dilutive the other way -- as diluting, or thinning out, value.) ~ The reverse of this situation is a dilutive merger, and occurs when a company with a lower P/E ratio buys a firm with a higher P/E ratio. Here we use the term "buys" because the buying firm determines the final valuation multiple.

We'll look at a hypothetical example of a merger to make this clearer. Say Big Gun, a sporting goods store wants to buy a fast-growing chain called Ubershoe. Let's also say that Big Gun is valued at $500 million with earnings of $50 million, while Ubershoe is valued at $200 million with earnings of $10 million. Big Gun trades at a P/E ratio of 10/1; the combined company will also trade at this ratio. After the merger, the company will have earnings of $60 million, and will be valued at $600 million. This is a dilutive merger because previous to the deal, the combined valuation of the companies was $700 million.

Try this question?

Chipware is considering acquiring Buyusout.com. Chipware's P/E ratio is 55 times earnings, whereas Buyusout.com's P/E ratio is 30 times earnings. After Chipware acquires Buyusout.com, will Chipware's earnings per share rise, fall, or stay the same?

Chipware's earnings-per-share will rise, because of the following rule: when a higher P/E company buys a lower P/E company, the acquirer's earnings-per-share will rise. The deal is said to be "accretive," as opposed to "dilutive," to the acquirer's earnings.