Companies engage in mergers and acquisitions for various reasons, such as to eradicate or join forces with a valuable competitor, capitalize on a strategic advantage within a niche market, or combine people-power and resources to revolutionize an industry, among other business-minded intentions. Regardless of the actual reason a merger or acquisition is pursued, it is fairly evident that the primary endgame is to maximize a company’s value. Granted, there is no hard and fast way to calculate or define value, and true value is not necessarily just financial in nature.
For the most part, in order for a company to make a decision as to whether it is going to seek a particular merger or acquisition, it will have to conduct a careful analysis of the potential financial gain or loss. Of course, the extent and acceptability of the financial impact that the deal will have is highly dependent on whether there are shareholder interests at stake. One of the simplest ways to make this assessment is via an accretion or dilution analysis. This sounds far more complicated than it probably is because it really comes down to making a determination as to whether shareholder value will be enhanced or eroded.
Pro Forma Net Income
One of the easiest ways to make this analysis is by figuring out a pro forma net income for the newly formed entity, which obviously comprises the two entities prior to the merger. The net income should be as conservative as possible, although sophisticated analysts may be able to incorporate the influence of prospective synergies associated with the merger. For example, if there will be an increase in the number or volume of product lines due to the merger, there will likely be higher revenue. Of course, just as there may be synergies at play, there may also be transaction-associated financial detractors, such as interest payments related to debt financing.
Earnings Per Share
Once a thorough net income projection is calculated taking into consideration the possible financial positives and negatives associated with closing the deal, the analysts will need to know how many outstanding shares will exist subsequent to closing. In mergers and acquisitions, new shares may be issued, there may be a reduction in shares, or there may not be any change at all. The calculated pro forma net income divided by the total number of shares provides an estimate of the new entity’s earnings per share (EPS). If the new EPS is higher than before the merger, then there is accretion, whereas if it is lower, then there is dilution.
An Important Caveat
However, an important point to remember is that some of the financial benefits of a merger or acquisition will take some time to come to fruition. For example, if production capacity is going to increase over time, it may not be immediately clear how much that increase will translate dollar-wise. Thus, although evaluating the potential for accretion or dilution before a deal is actually pursued is a wise course of action, it cannot be the sole determinant for going forward.