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Article: Accretive and Dilutive Mergers

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Accretive and Dilutive Mergers

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.