What is the difference between an accretive transaction and a dilutive transaction?

"Accretion" and "dilution" are chemical terms that refer to respective increases or decreases in the concentration of a substance or compound. The financial world adopted these references to describe the impact of a merger and acquisition (M&A) deal on earnings per share (EPS). When value is created and EPS increases after an M&A deal, it is said to be accretive. Conversely, the move is dilutive if value is destroyed and EPS drops.

There are other financial uses of the terms "accretive" and "dilutive"; indeed, "accretive" and "dilutive" could conceptually be applied to any economic transaction where value increases or decreases. The most common uses, however, refer to M&A transactions.

The notions of EPS accretion creating value or EPS dilution destroying value are generalizations. Circumstances may exist where one or the other isn't necessarily true, even though many investment professionals act as though these are fundamental investing laws.

Methods of valuation are important when determining EPS. The most common basis involves the price-to-earnings (P/E) ratio. Many assume that the acquiring company will have the same P/E ratio after an acquisition, so any EPS growth means that the overall value of the acquiring company has risen as part of the M&A deal.

Sometimes, EPS accretion comes with a down side: the newly acquired company will have a lower earnings growth rate than the acquiring company would have had as a standalone. It is very possible for the new company to have a lower P/E ratio because of the acquisition of the lower-rated target firm. This is particularly true if the acquisition was financed through the acquiring company's stock.

Often, too much emphasis is placed on EPS following an M&A deal. Ultimately, accretion can only show that the company being acquired has a lower P/E-rated stock. The opposite is true of a dilutive M&A deal.

Accretion and dilution are mathematical phenomena associated with M&A deals, and they can generally be used as part of the evaluation process. Ultimately, economies of scale, increased future cash flow and improved synergy determine successful mergers.