Accretion/Dilution and Fairness Opinions

An acquirer's CEO wants one number before signing: will this deal grow next year's earnings per share or shrink it? The banker who can answer that, then defend the price with a fairness opinion the board can rely on, runs the deal.

Earnings per share is net income divided by shares outstanding. When two companies combine, you build pro forma EPS, the combined entity's earnings divided by its new share count, and compare it to what the acquirer would have earned alone.

If pro forma EPS is higher than the acquirer's stand-alone EPS, the deal is accretive. If lower, it is dilutive. The word "pro forma" just means "as if the deal had already happened" for a full period.

$$\text{PF EPS} = \frac{NI_{A} + NI_{T} + S(1-t) - I_{\text{new}}(1-t)}{\text{Shares}_{A} + \text{Shares}_{\text{new}}}$$

Here $S$ is pre-tax synergies, $t$ is the tax rate, and $I_{\text{new}}$ is incremental interest. Compare the result to $NI_A / \text{Shares}_A$.

KEY: Accretion/dilution is an EPS test, not a value test. A deal can destroy value yet still be accretive, or create value yet be dilutive in year one.

Common mistakes

• Confusing accretion with value creation. Accretion is an EPS comparison only. A deal can be accretive and still overpay; the exam separates EPS impact from value.
• Flipping the P/E rule. A higher-P/E acquirer buying a lower-P/E target with stock is accretive. Reversing this is the most common error.
• Amortizing goodwill against EPS. Goodwill is not amortized; it is impairment-tested. The earnings drag comes from incremental interest and identifiable-intangible amortization, not goodwill.

Bottom line

• Accretion/dilution compares pro forma combined EPS to the acquirer's stand-alone EPS; higher is accretive, lower is dilutive
• Quick screen for stock deals: if the acquirer's P/E exceeds the target's, the all-stock deal is accretive before synergies; if lower, it is dilutive
• Pro forma net income equals combined net income plus after-tax synergies minus after-tax incremental interest on new acquisition debt
• Exchange ratio equals offer price per target share divided by acquirer share price; it sets new shares issued in a stock deal

Exam shortcut

P/E compass: higher-P/E acquirer + stock + lower-P/E target = accretive; lower-P/E acquirer = dilutive; equal = breakeven. Synergies and cheap cash push toward accretive. After-tax everything: add synergies as $S(1-t)$, subtract new interest as $I(1-t)$; breakeven synergy = after-tax shortfall ÷ $(1-t)$. Rule 5150 = disclose, don't ban: contingent fees, material relationships, independent verification, and fairness-committee approval all get disclosed in the proxy or prospectus.

The full lesson (about 2,656 words, 18 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.

Learning objectives

• C23
• C24

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