Takeaway: Just because a deal is “accretive” does not mean it is a good one.
When a company buys another entity, the press release heralding the deal often says that the deal is “accretive.” Many investors think this means that the deal is a good use of shareholder’s capital. But this is not necessarily the case.
What does “accretive” actually mean? Simply, that the company’s earnings per share (EPS) are higher after the deal than before.
Let’s walk through an example that shows an accretive deal may not be a good one:
Suppose a large steel company called SmartSteel has $2 of earnings per share and 10 million shares outstanding (and thus $20 million of net profits per year). The company also has $10 million of cash ($1 per share) sitting on its balance sheet, and SmartSteel is trying to figure out what to do with that capital.
Given today’s low-interest rate environment, SmartSteel is probably earning very little on that money given that interest rates on cash are almost zero. Let’s assume SmartSteel is getting 0.5% on its cash sitting in the bank. Therefore, SmartSteel is getting $50,000 per year in interest income from its cash or a $0.005 contribution to EPS.
SmartSteel’s management isn’t happy with that return, and the company’s investment bankers call and say the company should make an “accretive” acquisition. SmartSteel’s management decides to buy a small competitor called ExpensiveSteel.
A company will typically use a mixture of its own stock, cash, and debt to fund a deal. Let’s assume SmartSteel uses its $10 million of cash to buy ExpensiveSteel, which will add $200,000 to net income – 4x better than the return the company could have received from interest income. While SmartSteel is paying a high multiple of 50x earnings for ExpensiveSteel, the deal will add $0.02 of EPS versus just $0.005 of EPS if the company had just held cash.
Therefore, this deal is accretive to EPS by $0.015. SmartSteel’s new EPS is $2.015.
Good deal, right? Not really.
The return SmartSteel got on its capital – the cash here – was just 2% (net income of $200,000 used / $10 million of cash used). While it is too complex to get into in this post, there is a cost to capital. A simple enough explanation, for now, is that there is a cost to the company of issuing equity to investors, who demand an expected return given that investing in a company is risky. Historically, that cost has been ~9% for an average large firm, although an optimistic person could argue the cost is slightly lower – say 6-7% in today’s low-interest rate environment.
If the return of the deal is lower than the cost of capital, as it is here (the 2% return SmartSteel received vs. its, let’s say, 7% cost of capital), the deal actually destroys shareholder value.
What matters is the return the company is generating relative to its cost of capital. SmartSteel may have made an “accretive” acquisition to EPS, but the deal actually destroyed shareholder value.
Therefore, be alert when a company says a deal is “accretive”; that does not mean the deal is necessarily a good one.