Back to Prime Numbers

Stop obsessing about earnings accretion

Vartika Gupta

Engages in research and discussions on capital market diagnostics, financial modeling, M&A, valuation, and cost of capital

David Kohn

Leverages his deep understanding of corporate finance and valuation to provide an investor perspective and help clients identify value-creating strategies

Combines broad cross-sector experience with decades of service to clients in value creation, corporate strategy, capital-markets issues, and M&A transactions

Works at the intersection of strategy and finance with high tech, industrial, and pharmaceutical clients to identify and prioritize corporate strategies for restructuring, performance improvement, and growth

When boards, investors, and executives consider potential acquisitions, talk often turns to whether earnings per share (EPS) will rise or fall because of the deal and, in turn, how the stock market may react. This obsession with EPS has to stop; there is no correlation between whether a deal is accretive or dilutive and the market’s perceptions of it. Regardless of whether EPS is expected to be greater, smaller, or the same two years after the deal, the market’s reaction is likely to be the same one month and then one year after announcement.

Consider this hypothetical example: A company pays $500 million to acquire a business priced at $400 million, resulting in $100 million of acquisition premium. The deal doesn’t create any immediate operating improvements. As a result, the acquirer ends up paying $500 million for an entity that is worth only $400 million. The deal appears to be dilutive. But is it? If this were an all-cash deal (or even an all-stock deal), the next year’s EPS would increase and the deal would be accretive—the result of mathematics rather than of any value created.1

All this attention on EPS is misplaced. Instead, acquirers and the market should focus on deal execution: What is the integration plan? Is there a clear narrative about the acquisition? The bottom line is ensuring that the value of synergies from the deal exceeds the premium paid.

1. The earnings from the acquired company would exceed the after-tax interest payments that would be required for the new debt.

Vartika Gupta is a solution manager in McKinsey’s New York office, where David Kohn is an associate partner; Tim Koller is a partner in the Denver office; and Werner Rehm is a partner in the New Jersey office.

For a full discussion of market dynamics, see Valuation: Measuring and Managing the Value of Companies, seventh edition (John Wiley & Sons, 2020), by Marc Goedhart, Tim Koller, and David Wessels.