Thursday, January 22, 2015

Earnings Dilution - A Real or Imagined Problem?

A good deal is one that is expected to produce a positive net present value.  That is, it is worth more than it costs.  But what about a deal that has a positive net present value and results in earnings dilution next year?  Is this possible?  If so, is this still a good deal?  Are there any ways to avoid dilution?  In a share for share exchange, how can we tell the maximum number of shares that an acquirer could issue without causing dilution?

Can a deal with a positive net present value cause immediate dilution of earnings?  Absolutely.  If we issue enough shares to acquire a target and the shares are not offset by an appropriate increase in next year's earnings, dilution will occur.  By NPV terms, the deal is still a good one if the expected net present value is positive.  It is just that the value and cash flows appear later in time.  Nevertheless, the dilution in eps creates a very real perception that the firm is declining.  Shareholders without privy to the stream of expected cash flows or NPV calculations can assume that the acquiring firm is in a downward trend.  Hence, dilution creates a very real problem.

How to avoid it?  A first solution is not satisfying: don't acquire targets where dilution would occur.  This results in missing great opportunities if the deal is indeed a positive NPV.  A better approach is to structure the deal so that dilution does not occur.  This is done by issuing fewer shares and substituting cash or debt to complete the payment.  Deferred or contingent payouts can also help in this regard.  

How can we know if dilution will occur?

  1.  Estimate projected eps without the deal
  2.  Estimate projected total earnings with the deal
  3. Divide the projected total earnings by projected eps in step 1.  This tells you the maximum number of shares you can have outstanding without dilution
  4. From this maximum number of shares, subtract the current shares outstanding of the acquiring firm.  This tells you the maximum number of shares you could give the target without dilution.
  5. Divide the number in item 4 by the number of target shares currently outstanding.  This gives you the maximum exchange ratio without dilution.  
As an advanced concept, you could expand this maximum using free cash flow generated by the target in the first year after acquisition although you'd be giving away some value.  To do this:

6. Calculate how many shares of the acquiring firm you could acquire using the target's first year free cash flow.  Add this to the maximum number in item 4 and recalculate item 5.

All the best,


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