AstraZeneca peddles many drugs, but none may be so harmful for shareholders as earnings accretion. Pascal Soriot, the acquisitive chief executive of the UK-based pharmaceuticals group, said on February 4 that from now on, he is only interested in tie-ups that add to earnings from day one. That follows two big, dilutive deals last year. The idea is presumably to reassure investors, but the effect should be the opposite.
Mergers that increase earnings, typically expressed as earnings per share or EPS, sound appealing. After all, investors own shares, and they care about earnings. Yet the logic can rule out good deals, and rule in terrible ones. AOL's famed 2000 deal to buy Time Warner promised to deliver earnings accretion in the first year. So did Kmart's purchase of Sears, Roebuck and Rio Tinto's purchase of aluminium miner Alcan. All three were disasters.
Executives and shareholders can get caught out too easily by "bootstrapping". When one company uses its stock to buy another business which trades on a lower price-to-earnings multiple, earnings per share arithmetically go up. But the price may still have been excessive - or the combined company's PE ratio may fall, bringing down its share price.
Pay instead with borrowed cash, and the acquired profit only needs to exceed the interest payments to boost EPS. How a business is paid for shouldn't define its value to an acquirer, but the accretion test depends heavily on just that.
Investors are better off asking whether the overall expected return on an acquisition beats the target company's cost of capital. When brewer InBev bought Anheuser-Busch in 2008, it said it wouldn't add to earnings per share for over a year, but would create a return on investment above the cost of capital within two years. By that time, the shares had risen by almost 50 per cent.
They might also enquire how any deal premium relates to the present value of anticipated cost savings - a simple check on whether the buyer is overpaying.
Soriot, whose bonus is partly linked to EPS growth, isn't alone. Other recent accretion-addicted acquirers include Pfizer, Royal Dutch Shell and Charter Communications. Of the 15 companies to announce deals worth over $1 billion in 2016 in Europe and the United States, 11 have promised earnings accretion. It's time to kick a bad financial habit.
Mergers that increase earnings, typically expressed as earnings per share or EPS, sound appealing. After all, investors own shares, and they care about earnings. Yet the logic can rule out good deals, and rule in terrible ones. AOL's famed 2000 deal to buy Time Warner promised to deliver earnings accretion in the first year. So did Kmart's purchase of Sears, Roebuck and Rio Tinto's purchase of aluminium miner Alcan. All three were disasters.
Executives and shareholders can get caught out too easily by "bootstrapping". When one company uses its stock to buy another business which trades on a lower price-to-earnings multiple, earnings per share arithmetically go up. But the price may still have been excessive - or the combined company's PE ratio may fall, bringing down its share price.
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Investors are better off asking whether the overall expected return on an acquisition beats the target company's cost of capital. When brewer InBev bought Anheuser-Busch in 2008, it said it wouldn't add to earnings per share for over a year, but would create a return on investment above the cost of capital within two years. By that time, the shares had risen by almost 50 per cent.
They might also enquire how any deal premium relates to the present value of anticipated cost savings - a simple check on whether the buyer is overpaying.
Soriot, whose bonus is partly linked to EPS growth, isn't alone. Other recent accretion-addicted acquirers include Pfizer, Royal Dutch Shell and Charter Communications. Of the 15 companies to announce deals worth over $1 billion in 2016 in Europe and the United States, 11 have promised earnings accretion. It's time to kick a bad financial habit.