What is Accretive?

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Definition:

An accretive asset is something you buy, the value of which increases after purchasing it — or the addition of which to a company increases the value of that business.

🤔 Understanding accretive

An asset is accretive if it increases in value. For example, a bond is accretive if you pay $400 for it while it has a maturity value of $500. The increase of $100 is due to the accretion of the asset. In mergers and acquisitions, a deal is accretive if it improves the company’s earnings per share (EPS) — Which is the company’s earnings divided by the number of outstanding shares. Through the acquisition, the former business improves (often by becoming more efficient), and the new company’s earnings increase. Shareholder Equity should increase through accretion.

Example

On February 26, 2020, VIQ solutions (a digital voice and video capture company) acquired WordZXpressed Inc. (a transcription service provider). VIQ expects to immediately add $6 million of recurring profitable revenue to its annual cash flow through this acquisition. Because the deal creates growth and adds value to the company, it is considered to be an accretive acquisition.

Takeaway

Being accretive is like a reduction in cooking…

There are a lot of flavors in a stock or sauce. But with too many liquids and impurities, the full effect of what you are trying to accomplish is difficult. By applying a little heat over a few hours, you can allow some of those unwanted dilutive liquids to evaporate. What you are left with is a reduction that has more concentrated flavors and a stronger taste. Similarly, a deal is accretive if it unlocks value like a reduction unlocks flavor.

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How does accretion work?

Accretion means that something grows by adding to it. In business, it can happen organically, as a company expands its operations. Or it can happen through accretive investments, which add to the company’s income and profits.

Internal accretion can happen when a business reinvests its earnings into income-producing expansions. That could include adding a new product line, expanding into a new market, or adding facilities to increase output.

There are many actions that a company can take to increase its earnings and thus would be accretive. Buying a company that already has a positive revenue stream also grows the acquiring company’s income. It is, therefore, accretive as well. In finance, assets can be accretive by increasing in value over time.

Whenever an asset is purchased at a discount, there is opportunity for accretion. The increase in value shows up as capital gains on the acquirer's financial statement, and may show up in the books as accretion.

What is an accretive acquisition?

In the case of mergers and acquisitions, a deal is accretive if it increases the acquiring company’s earnings.

Adding the revenues of the acquired company to those of the buyer implies growth, which is accretive. But equity owners are also concerned about what the deal does to the value of their ownership. Not all purchases are accretive for the owners at closing.

A company can grow its total revenues without generating value for its existing equity owners. Therefore, investors are rightfully concerned about whether or not the deal is accretive to them.

For shareholders, the test of accretion lies in the earnings per share or EPS (the total earnings of the company divided by the number of outstanding shares).

For example, imagine the fictional company called Make Believe, Inc. has earnings of $100M per year. It also has 5 million shares of common stock outstanding. Dividing those numbers generates an EPS of $20 per share. The stock might be trading higher or lower than the EPS, but it is one measure of the value of owning stock in Make Believe, Inc.

Make Believe, Inc. is considering the acquisition of another fictional company, called Imaginary Unlimited. Current earnings from Imaginary Unlimited are $25M per year.

To raise the capital needed to close the deal, and buyout all of Imaginary Unlimited’s existing equity owners and debt holders, Make Believe, Inc. must issue another 1 million shares of common stock. Now you can recalculate the EPS after the acquisition.

EPS = $125M / 6 million shares = $20.83

Because the deal ends up increasing the company’s future EPS, the current shareholders (all things being equal)should see an increase in the value of their ownership over time. That means this is an accretive acquisition for the owners, posting $0.83 of accretion to each of their shares.

What is the difference between accretive and dilutive mergers?

An accretive merger is one that increases the company’s earnings per share (EPS). The opposite of accretion is dilution. Therefore, dilutive mergers are ones that decrease the company’s earnings ratio.

In some cases, the buyer might feel that efficiency gains and synergies will lead to growth. If so, they may be willing to pay more than the current market value of the company.

Such an acquisition may not be accretive right away, but the executive leadership believes it will ultimately lead to more profits.

A venture capital firm or investment banker might do an accretion/dilution analysis to determine if a target company is a candidate for a takeover.

In most cases, a merger or acquisition is immediately accretive to the business. If an acquiring company can purchase a business at a discount to its enterprise value (the value of the outstanding stock plus net debts) that purchase will generate additional profits for the company.

The increase in earnings is an accretive acquisition. However, that might not mean that existing shareholders see the benefits. They may see their equity position get diluted by the purchase.

Take another look at the deal between the fictional companies Make Believe, Inc. and Imaginary Unlimited. Let’s still assume that Make Believe, Inc. has $100M and Imaginary Unlimited $25M in annual earnings.

To close the deal, Make Believe, Inc. sells 2 million shares, bringing its total outstanding shares to 7 million. The agreement immediately adds $12.5 per share in value to Make Believe, Inc. However, it dilutes the value of the first 5 million shares.

You can see that impact by recalculating the EPS.

EPS = $125M / 7 million shares = $17.86

Although the deal grows the business of Make Believe, Inc., it is dilutive for the existing owners. Those shareholders see the value of each of their shares fall by $2.14 (from $20 to $17.86).

Perhaps the board thinks that plugging the Imaginary Unlimited product line into Make Believe’s distribution chain will increase sales. In that case, the acquisition should become accretive due to the synergy. But the immediate impact of the deal is dilutive for existing owners.

What is margin accretive?

While most investors focus on whether or not a deal is earnings accretive, some may be interested in the impact of an acquisition on a corporation’s margins. A merger or acquisition is considered to be earnings accretive if it increases the company’s profits. In most cases, investors care specifically about the impact on earnings per share.

But it is also essential to see how a deal impacts the efficiency of business operations. A transaction is margin accretive if it improves the company’s operating margins (the percentage of the revenues that don’t go toward costs) or its gross profit margins (the amount of a product’s sales price that don’t go toward the direct cost of making it).

What is an accretive asset?

In finance, an asset is accretive if its value increases above what you pay for it. The most common example of an accretive asset is a bond that you purchase at a discount to the face value.

For instance, if a bond will pay $1,000 at maturity, any purchase price below $1,000 will result in accretion. If you spend $900 on the bond, it comes with $100 of accretion. Assuming that the company is solvent.

Whether or not that rate of accretion is a reasonable rate of return will depend on the investor and the opportunity cost (the next best alternative) of their $900.

How do you determine the rate of accretion?

The rate of accretion usually refers to how fast an asset will increase in value. The term most often applies to bonds. When a bond matures, the issuing company is obligated to pay the full face value of the bond to the person who owns it.

For example, a company might issue a $100,000 bond with a five-year maturity. If the bond was issued on January 1, 2020, whoever owns that bond on January 1, 2025, will receive $100,000. There may also be interest payments during those five years, or it may be a zero-coupon bond that was sold for less than $100,000.

Let’s say you purchased this zero-coupon bond for $75,000. Since you know the final value and the time to maturity, you can calculate the rate of accretion.

First, subtract the purchase price of $75,000 from the maturity value of $100,000 — Which yields the total accretion of $25,000.

Next, divide the accretion by the number of periods until maturity. In this case, we can assume you update your financial records once a year. Therefore, the accretion rate is $5,000 per year. That means that each year, you increase the value of the bond as an asset by $5,000. And the accreted value of the asset in year two will be $80,000.

Rate of Accretion = (Purchase Price – Maturity value) / periods until maturity

If you want to know what your annual rate of return on this investment, you would likely use the compound annual growth rate (CAGR) formula.

CAGR = (maturity value / purchase price) ^ (1 / number of years)

In this case, the CAGR would be:

CAGR = ($100,000 / $75,000) ^ (1/5) = 5.6%

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20200401-1137300-3420303

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