Accretion

Accretion is the increase in a company's earnings per share (EPS) resulting from a financial transaction, most commonly a merger or acquisition. Think of it as a financial power-up. When one company buys another, investors and analysts immediately ask: “Is this deal accretive?” If the answer is yes, it means that for every share an investor owns, the new, combined company is expected to generate more profit than the acquiring company did on its own. This happens when the earnings gained from the target company are greater than the costs of the acquisition. These costs can include interest paid on new debt, or the “cost” of issuing new shares, which spreads the total earnings over a larger number of shares. A deal that lowers EPS is the opposite of accretive—it's called dilutive, and it's generally frowned upon by the market.

The concept is quite simple at its core: the benefit must outweigh the cost. When a company (let's call it AcquirerCo) buys another (TargetCo), the goal is for AcquirerCo's EPS to rise after the ink is dry. The math hinges on comparing what you gain versus what you give up:

• The Gain: AcquirerCo gets to add all of TargetCo's net income to its own.
• The Cost: This depends entirely on how AcquirerCo pays for the deal.
  1. Paying with Cash: The cost is the interest income AcquirerCo forgoes by spending its cash instead of investing it. This is an opportunity cost.
  2. Paying with Debt: The cost is the after-tax interest expense on the money borrowed to make the purchase.
  3. Paying with Stock: The cost is dilution. AcquirerCo issues new shares of its stock to pay TargetCo's shareholders. While no cash is spent, the company's total earnings must now be divided among more shares.

A deal is accretive if the extra earnings from TargetCo are greater than the costs incurred to buy it. This pushes the combined company's EPS above AcquirerCo's pre-deal EPS.

Let's imagine BigFish Inc. wants to buy SmallFry Co.

• BigFish Inc.:
  1. Annual Earnings: $100 million
  2. Shares Outstanding: 50 million
  3. EPS: $100m / 50m = $2.00 per share
• SmallFry Co.:
  1. Annual Earnings: $20 million
  2. Purchase Price: $250 million

Let's say BigFish's stock trades at $50 per share. To buy SmallFry for $250 million, BigFish must issue $250m / $50 = 5 million new shares.

• New Combined Earnings: $100m (BigFish) + $20m (SmallFry) = $120 million
• New Total Shares: 50m (BigFish's original) + 5m (newly issued) = 55 million
• New EPS: $120m / 55m = $2.18 per share

Since $2.18 is greater than BigFish's original $2.00 EPS, the deal is accretive.

Now, let's say BigFish borrows the full $250 million at a 4% interest rate.

• Annual Interest Expense: $250m x 4% = $10 million.
• After-Tax Cost: Assuming a 20% tax rate, the interest provides a tax shield. The actual cost is $10m x (1 - 0.20) = $8 million. This is the cost of debt.
• New Combined Earnings: $100m (BigFish) + $20m (SmallFry) - $8m (interest cost) = $112 million
• New Total Shares: 50 million (no new shares were issued)
• New EPS: $112m / 50m = $2.24 per share

In this case, the deal is even more accretive! This often happens when the acquirer's stock is expensive (has a high P/E ratio) and interest rates are low.

For value investors, who follow in the footsteps of legends like Warren Buffett, accretion is a useful metric, but one that must be handled with care. It can be a double-edged sword.

An accretive acquisition can be a clear sign of intelligent capital allocation. It shows that management is effectively using the company's resources—whether cash, debt capacity, or its own stock—to buy assets that immediately increase per-share profitability. A history of successfully completing accretive deals is often a hallmark of a world-class management team.

However, value investors are deeply skeptical of deals that are accretive only on paper. A short-term EPS boost can easily mask long-term value destruction. This can happen in several ways:

• Overpaying: Management, hungry for growth, might pay a ridiculous price for the target. The deal might still be accretive if interest rates are very low, but the company’s overall return on invested capital (ROIC) could plummet, destroying value over time.
• Ignoring Strategy: The acquired company might be a poor strategic fit. The promised synergies—cost savings and new revenue opportunities—may never happen, leading to a messy, inefficient, and less profitable combined entity.
• Accounting Tricks: Aggressive accounting related to goodwill and amortization can make a bad deal look good for the first year or two. The initial accretion can quickly turn into painful write-downs later on.

An accretive deal is a green light to start your analysis, not a checkered flag to finish it. It's a sign that a deal could be good, but you need to dig deeper. Always ask the critical questions:

1. Did the company pay a sensible price?
2. Does the acquisition make strategic sense and strengthen the company's competitive advantage?
3. How was the deal financed, and is the new level of debt sustainable?

True value creation comes from growing a business's long-term intrinsic business value, not just from playing with spreadsheets to engineer a higher EPS for the next quarter.