The M&A Model for Accretion/ Dilution

Author: Joris Kersten MSc (Kersten Corporate Finance)

Source used: Investment Banking: Valuation, leveraged buyouts and mergers & acquisitions. Second edition (2013). Joshua Rosenbaum & Joshua Pearl. Wiley Publishing company. 9781118472200.

Kersten Corporate Finance: M&A consultants + Valuators + once a year we provide a 6-day valuation training (next one: 15 - 21 March 2023 Vd Valk Hotel Uden Netherlands).

The M&A Model to calculate accretion/ dilution

The M&A model – Accretion/ Dilution: An Introduction

The M&A model consists essentially out of two standalone financial models, one for the acquirer and one for the target. These models are summed up in order to form “pro forma combined financial statements”.

As with a LBO model, historical financial data is entered into an “income statement (IS) tab” and “balance sheet (BS) tab” in Microsoft excel. And then assumptions like growth rates, margins, working capital assumptions etc. that drive income statements, cash flow statements and balance sheets are entered into “assumption tabs” in Microsoft excel.

And an offer price for the shares of the acquisition and acquisition structure (payment with equity vs debt, example 50%-50%) data are then entered into a “transaction summary tab” in excel.

After that the financing structure (how the debt part is built up), allocations of the purchase price premium (purchase price allocation (PPA)/ goodwill), assumptions around deal-related depreciation and amortization (because of asset write ups/ PPA) and estimated synergies are entered into a tab called “pro forma assumptions”.

Concerning the financing structure, a special tab is created in which for each debt instrument key terms are typed in. This tab is called “pro forma debt schedule”.

Once all the appropriate deal-related information is entered into the model, it should automatically update two tabs, 1 concerning the “pro forma credit statistics” and 1 concerning the “accretion or dilution” after the deal.

I will talk about accretion/ dilution later on in this blog, but first let’s take a look at some more basics of this so-called M&A model.

Build in flexibility with Microsoft excel

As with the LBO model, a M&A model is constructed with the flexibility to analyse a given proposed transaction under “multiple financing structures” and “operating scenarios”.

On the “transaction summary tab” in excel; basically the first tab, toggle cells allow the corporate finance consultant to switch amongst others between multiple financing structures and operating scenarios. Here for the “choose function” in excel is used, like I discussed in my blog on the LBO model.

This is just really handy, because it would be crazy to type in different operating scenarios and financing structures when your managing director or the client asks for this. It can now be done simply with building in a “toggle” with some choose functions. Excel is our best friend.

Financing structure and deal structure

An acquirer of a target company needs to choose among the available funds based on a variety of factors, think of cost of capital, flexibility on your balance sheet, rating agency considerations and speed and certainty to close the transaction.

Debt financing refers to the issuance of new debt or to use “revolver availability” to partially, or fully, fund a M&A transaction. Examples of debt instruments are: a revolving credit facility, term loans and bonds/ notes.

Equity financing refers to a company’s use of its own stock as an acquisition currency. An acquirer can either offer its own stock directly to the shareholders of the target. Or they can first issue shares and then use the cash proceeds to pay the shareholders of the target.

Equity financing offers the issuers with greater flexibility as there are no mandatory cash interest payments, repayments of principal and no covenants (as all the case with debt).

Goodwill, purchase price allocation (PPA) and deferred tax liability

In modelling a stock sale transaction “Goodwill” needs to be taken into account. When the purchase price exceeds the “net identifiable assets” of the target, this excess is first allocated to the target’s tangible and identifiable intangible assets. These are then written up to their “fair value” and we call this purchase price allocation (PPA).

These tangible and intangible asset write ups are then reflected in the acquirer’s pro forma balance sheet. And they are then depreciated and amortized over their useful lives which reduces after tax earnings.

This transaction related depreciation and amortization is not deductible for tax purposes. And from an accounting perspective, this discrepancy between book value and tax value is resolved through the creation of a deferred tax liability (DTL) on the balance sheet. For example called: “deferred income taxes”.

Goodwill is calculated as purchase price minus target’s net identifiable assets after allocations to the target’s tangible and intangible assets (PPA). Once calculated, goodwill is added to the asset side of the acquirer’s balance sheet and tested yearly for “impairment”.

Merger consequences analysis

Merger consequences analysis measures the impact on “earning per share” (EPS) in the form of “accretion/ dilution analysis”. And it also measures the credit statistics after the deal because of balance sheet effects.

This analysis enables strategic buyers to fine tune the deal for ultimate purchase price, deal structure and financing mix. Of course, for this key assumptions need to be made regarding purchase price, target company’s financials (operating scenarios), and deal structure and forms of financing.

A corporate finance consultant does this by first constructing standalone operating models (income statements, balance sheets and cash flow statements) in excel for both the target and the acquirer. As mentioned, these models are then combined into one pro forma financial model that incorporates all the transaction related adjustments.

Merger consequences analysis: Credit statistics

Acquirers of target companies are often guided by the desire to maintain key target ratios for the credit statistics in setting up their M&A financing structure.

Most widely used credit statistics are grouped into leverage ratios (e.g. debt to EBITDA and debt to total capitalization) and coverage ratios (e.g. EBITDA to interest expense).

Merger consequences analysis: Accretion/ Dilution

Accretion/ dilution analysis measures the effect of a transaction on a potential acquirer’s earnings, assuming a given financing structure. It centers on comparing the acquirer’s EPS pro forma (after the transaction) versus on a standalone basis (before the transaction).

If the “pro forma combined EPS” is lower than the acquirer’s standalone EPS, the transaction is said to be “dilutive”.

Conversely:

If the pro forma EPS is higher, the transaction is said to be accretive.

A rule of thumb for 100% stock transaction (100% paid with equity) is that when an acquirer purchases a target with a lower P/E ratio (Price/ Earnings), the acquisition is accretive. In this case, transactions where an acquirer purchases a higher P/E target are de facto dilutive.

The latter could be reversed do by “sizable synergies”.

Accretion/ dilution analysis is a key screening mechanism for strategic buyers. Acquirers do not pursue transactions that are dilutive over the foreseeable earning projection period.

For modelling purposes, key drivers for accretion/ dilution are purchase price, projected earnings for buyer and target (operating scenarios), expected synergies, form of financing, debt/ equity mix and the cost of debt.

The most accretive M&A deals have (relatively) low purchase prices, cheap forms of financing (more debt) and significant synergies.

Source used: Investment Banking: Valuation, leveraged buyouts and mergers & acquisitions. Second edition (2013). Joshua Rosenbaum & Joshua Pearl. Wiley Publishing company. 9781118472200.