Focus on Value Creation, Not Accounting  607 an acquisition on accounting numbers but react only to the value that the deal is estimated to create. Focusing on accounting measures is therefore danger- ous and can easily lead to poor decisions. For example, in 2005, both International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP) eliminated amortization of goodwill. Overnight, most acquisitions that would have been dilutive to earnings per share (EPS) were now accretive. In cash deals, the only dilution is from additional interest expense, which after taxes is typically less than 4 percent of the deal value. In the case of share deals, the deal is accretive if the acquirer’s P/E is higher than the target’s. But changing accounting doesn’t change the economics of the deals. Many acquisitions are earnings accretive but destroy value. Consider the hypotheti- cal deal in Exhibit 31.9. You are deciding whether to purchase a company currently priced in the market at $400 million for $500 million in cash. Your company, the acquirer, is worth $1.6 billion and has a net income of $80 million. For simplicity, assume there are no operating improvements to come from the deal. You decide to finance this deal by raising debt at a pretax interest rate of 6 percent. This deal destroys value: you overpay by $100 million (remember, no improvements). Even so, next year’s earnings and earnings per share actu- ally increase because the after-tax earnings from the acquired company ($30 million) exceed the after-tax interest required for the new debt ($19.5 million). How can a deal increase earnings yet destroy value? The acquirer is borrow- ing 100 percent of the deal value based on the combined cash flows of both com- panies. But the acquired business could not sustain this level of debt on its own. Since the acquirer puts an increased debt burden on the existing shareholders without properly compensating them for the additional risk, it is destroying value. Only when the ROIC (calculated as target profits plus improvements EXHIBIT 31.9  EPS Accretion with Value Destruction Impact on EPS Cash deal Stock deal Assumptions Acquirer Target Net income, $ million 80.0 30.0 Shares outstanding, million 40.0 10.0 EPS, $ 2.0 3.0 Preannouncement share price, $ 40.0 40.0 Price-to-earnings ratio 20.0 13.3 Market value, $ million 1,600.0 400.0 Price paid, $ million – 500.0 Net income, $ million Net income from acquirer 80.0 80.0 Net income from target 30.0 30.0 Additional interest1 (19.5) – Net income after acquisition 90.5 110.0 Number of shares, million Original shares 40.0 40.0 New shares – 12.5 Number of shares 40.0 52.5 Earnings per share, $ EPS before acquisition 2.00 2.00 EPS accretion 0.26 0.10 EPS after acquisition 2.26 2.10 1 Pretax cost of debt at 6%, tax rate of 35%. 608  Mergers and Acquisitions divided by the total purchase price) is greater than the weighted average cost of capital are shareholders appropriately compensated. In our hypothetical deal, the investment is $500 million, and the after-tax profit is $30 million—a mere 6 percent return on invested capital. While this is above the 3.9 percent after-tax cost of financing the debt, it is below the weighted average cost of capital. Now suppose the same target is acquired through an exchange of shares. The acquirer would need to issue 12.5 million new shares to provide the 25 percent acquisition premium that the target company’s shareholders demand.27 After the deal, the combined company would have 52.5 million shares outstanding and earnings of $110 million. The earnings per share for the new company rise to $2.10, so the deal is again accretive without having created any underlying value. The increase is a result of mathematics rather than value created by the deal. Conversely, companies sometimes pass up acquisitions that can create value just because they are earnings dilutive in the first several years. Sup- pose you spend $100 million to buy a fast-growing company in an attractive market, with a P/E of 30 times. Before performance improvements, the earn- ings from the acquisition will be $3.3 million. If you borrow at 4 percent after taxes, interest expense will be $4.0 million, leading to earnings dilution of $0.7 million. However, if you are able to accelerate the target’s growth rate to 20 percent for the next five years and the target earns a 25 percent return on capital, it will probably create value for shareholders, even though the earn- ings and ROIC will be depressed for a couple of years. Financial markets understand the difference between creating real value and increasing EPS. In a study of 117 U.S. transactions larger than $3 billion, our colleagues found that earnings accretion or dilution resulting from the deals was not a factor in the market’s reaction to the deals (see Exhibit 31.10). EXHIBIT 31.10  Market Reaction to EPS Impact of Acquisitions Accretive Neutral Dilutive 63 23 31 42 40 41 52 EPS impact in year 2 Number of transactions1 1 month after announcement Average = 41 Average = 50 Proportion of acquirers with positive market reactions, % 1 year after announcement 43 54 Note: The difference in returns between accretive and dilutive is not statistically significant. Returns were risk-adjusted using the capital asset pricing model (CAPM). 1 The sample set included 117 transactions greater than $3 billion by U.S. companies between January 1999 and December 2000. Source: Thomson, analyst reports, Compustat. 27 The exchange ratio in this hypothetical deal is 1.25 shares of the acquiring company for each share of the target company. We assume that the capital market does not penalize the acquirer and that the exchange ratio can be set in relation to the preannouncement share price plus the 25 percent acquisition premium.