EPS Accretion and Dilution

What is EPS?

Earnings per share (EPS) is designed to allow for comparison between businesses of different sizes. This shows the earnings for the period on a per share basis. It is used in many situations including the calculation of price earnings (PE) ratios and EPS accretion / dilution in M&A situations.

Understanding EPS Accretion / Dilution

EPS Formula

The EPS formula takes the earnings of a business and divides it by the number of shares outstanding.

Pro forma EPS = Pro forma net income / Shares outstanding

Calculating Earnings: Pro Forma Net Income

When calculating the impact of an M&A transaction on EPS, we need to use the combined or pro forma net income of the acquirer and target businesses post deal. This can be summarized using the formula:

Pro forma net income = Investor (acquirer) net income + Investee (target) net income +/- Transaction effects

Calculating Earnings: Transaction Effects

Any expected synergies due to the transaction will have to be included in the forecast income statement of the combined business and will need to be captured in the appropriate line item, most commonly SG&A expenses. The impact of synergies is to decrease SG&A costs, and therefore increase net income and EPS.

The company may also have issued additional debt or used balance sheet cash to fund the deal. These impact the interest expense/income lines of the income statement, thus affecting net income and EPS.

Calculating Number of Shares

The next item to be added to the EPS formula is the number of shares.

This is the number of the acquirer’s shares just after the acquisition is completed. It is assumed to be the same as WASO (weighted average shares outstanding). An M&A deal may cause the number of shares of the acquirer to increase if new shares are issued. This often happens where the target company’s shareholders exchange their old shares for new shares in the combined business, effectively becoming shareholders in the acquirer. The shares outstanding post deal can be calculated as:

Shares outstanding = Acquirer shares (diluted) + New shares issued

Accretion / dilution calculation

Once the pro forma EPS is calculated it can be compared to the acquirer’s standalone EPS as follows:

EPS accretion / (dilution) = Pro forma EPS / Acquirer standalone EPS – 1

This is often expressed as a percentage. A positive number indicates the deal is accretive as proforma EPS is higher than the acquirer’s standalone EPS. A negative number indicates the deal is dilutive because proforma EPS is lower than the acquirer’s standalone EPS.

M&A Models – EPS Accretion / Dilution

A simple M&A model (often referred to as an EPS accretion / dilution model) provides a quick and simplified view of a deal. They are quick to construct and provide a range of outputs including but not limited to:

• EPS accretion / dilution
• Ownership analysis
• Per share consideration (cash per share and stock exchange ratio)
• Sensitivity tables
• A simple synergies vs premium analysis
• A simple WACC vs ROIC analysis

The focus in this blog is the impact on EPS as a result of the transaction.

EPS Accretion / Dilution Example

Here we need to calculate the impact of an M&A transaction on the combined earnings per share. Initially we have the EPS, WASO and net income information for the acquirer and target as standalone entities:

In the model diagram above net income has been calculated as EPS multiplied by WASO for both the acquirer and target.

The model presents the actual year’s figures along with forecasted figures for the next three years of the acquirer and target.

The first step is to calculate the pro forma net income. This is shown in the model diagram below. This starts with the acquirer’s standalone net income, plus the target’s standalone net income, plus the post-tax synergies, less debt interest. The transaction effect figures are given to us and are hardcoded. Assume synergies savings post tax is 3.5 for all years and interest expense increases by 6.2 due to debt issuance for all years. In an M&A model, these would need to be calculated based on the assumptions and information in the model. This leads to the pro forma net income of 23.2 in the Actual Year column.

Next, we need the shares outstanding. This would be calculated and starts with the WASO of 15 from the acquirer in row 9, and adds on the number of shares issued to the target shareholders in exchange for their old shares. Let us assume 2.8 shares are issued. This gives the number of pro forma shares outstanding to be 17.8 which is assumed to stay flat across all years.

The pro forma EPS can now be calculated as pro forma net income divided by shares outstanding and gives a figure of 1.31 in the Actual Year column.

Finally, to calculate EPS accretion or dilution, we need to compare the pro forma EPS to the acquirer EPS. The acquirer’s EPS is seen in row 8 of the diagram, and is shown again in row 25, being EPS of 1.20 in the Actual Year column. The deal is accretive as pro forma EPS 1.31 is higher than the standalone EPS 1.20, producing EPS accretion of 8.8% in the Actual Year column.

It is important to check EPS accretion / dilution in future years because M&A deals will affect the future financial data. By copying the data across to the right for all years, we see how EPS will be impacted if the companies had merged and achieved these synergies and interest costs. In our example, EPS accretion has been achieved in all 3 of the forecast years and this suggests the acquisition should go ahead.