The valuation of mergers and acquisitions (M&A) requires a specific focus on certain considerations. While some companies may be more acquisitive than others, it is typical for companies across all industries to regularly consider entering into M&A transactions. As a company’s in-house counsel, it is important to know how to evaluate the merits and drawbacks of potential M&A transactions. The valuation of a potential M&A deal will inform the approach taken to legal negotiations and impact how the legal documentation is drafted.

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An accretion/dilution analysis is a particularly useful tool for evaluating the impact of M&A transactions. It measures the impact of an acquisition on the earnings per share (EPS) of the acquiring company.

Overview of Accretion/Dilution Analysis

If the EPS of the newly combined company is higher than the EPS of the standalone acquiring company, then the M&A transaction is considered accretive. If the EPS of the newly combined company decreases as a result of the acquisition, then the M&A transaction is considered dilutive. A breakeven transaction is one in which the EPS is expected to remain unchanged following the acquisition.

In order to perform an accretion/dilution analysis of an M&A transaction, the following pieces of information are needed:

• Fully diluted share count for the target company and the acquiring company
• Purchase price, including the percentage of cash and stock
• Exchange ratio
• Last twelve-month (LTM) net income for the target company and the acquiring company
• Projected net income for the target company and the acquiring company

A lot of this information is readily available by searching through the annual 10-K reports or the quarterly 10-Q reports of public companies. Future financial projections of net income or EPS can be obtained from equity research reports or company management.

Calculating Pro Forma Net Income

The initial step for deriving pro forma net income is to add the net income for the target company with the net income for the acquiring company. A number of adjustments are then made to this combined value.

If the acquiring company will be raising new debt financing to fund the purchase price of the acquisition, then the interest expense on the new debt will need to be subtracted from the combined company net income value. If the acquiring company is using existing cash on its balance sheet, then the forgone interest income will need to be subtracted from the combined company net income value.

Strategic acquisitions typically will result in synergies for the newly combined company. The synergies value for purposes of the accretive/dilution analysis is estimated based on some percentage of revenue or EBITDA.

Intangible assets such as patents and trademarks are amortized on a company’s balance sheet according to each asset’s useful life. In the accretion/dilution analysis, amortization expenses will have a negative effect on the combined company net income value.

The value of tangible assets such as equipment will also be adjusted to fair market value. In the accretion/dilution analysis, depreciation expenses will have a negative effect on the combined company net income value.

A summary of the pro forma net income calculation is below:

Pro Forma Net Income

= Target Company’s Net Income + Acquiring Company’s Net Income

Subtract: After-Tax Interest Expense

Subtract: After-Tax Forgone Interest Income

Add: After-Tax Synergies

Subtract: After-Tax Amortization

Subtract: After-Tax Depreciation

Calculating Fully Diluted Share Count

After the pro forma net income has been calculated, the next step in the accretion/dilution analysis is to calculate the pro forma fully diluted share count.

The purchase price for the acquisition can be paid in cash, stock, or some combination of cash and stock. If the purchase price will be paid in all cash, there will be no change in the number of shares. Therefore, the acquiring company’s current number of fully diluted shares outstanding can be used. This number can be obtained from equity research reports or the company’s management.

If the purchase price will be paid in all stock, the exchange ratio is calculated by the formula:

If the purchase price will be paid using a combination of cash and stock, an extra step is involved after calculating the exchange ratio using the above formula. The exchange ratio will need to be multiplied by the percentage of purchase consideration to be paid in stock.

Once the exchange ratio has been calculated, the next step is to multiply the exchange ratio by the number of the target company’s fully diluted shares outstanding. The resulting value reflects the number of new shares to be issued.

Finally, the number of pro forma fully diluted shares is derived by adding the new shares to be issued with the current number of the acquiring company’s fully diluted shares.

Calculating Pro Forma EPS

The next step in the accretion/dilution analysis is plugging in the values for pro forma net income and the number of fully diluted shares that were calculated in the previous steps into the EPS formula. The formula for calculating EPS is:

Running the Sensitivity Analysis

In order to further refine the accretion/dilution analysis, a sensitivity analysis may be performed. The sensitivity analysis is usually created using Microsoft Excel’s Data Table functionality. Different combinations of variables may be changed the sensitivity analysis including the expected synergies, the acquisition premium, and the percentages of stock versus cash being used to fund the purchase price.