Damodaran on Valuation

15.3. DUBIOUS SYNERGIES

Now that we have valued operating and financial synergies, we turn to a third group of synergies that we consider of dubious merit. In this group, we include those synergies that require gross misjudgments by markets to have value.

15.3.1. Accretive Acquisitions

In many firms, there is a focus on whether the acquisition will be accretive or dilu-tive. An accretive acquisition is one where the earnings per share of the acquiring firm will increase after the acquisition, whereas a dilutive acquisition is one where the earnings per share will decrease. What is wrong with this rationale? An accretive merger requires acquisition of companies with price-earnings ratios lower than that of the acquiring company. Thus, a company with a P/E ratio of 30 that acquires a company with a P/E ratio of 20 will see earnings per share increase after the acquisition, whereas acquiring a company with a P/E ratio of 40 will lower earnings per share.

Why are accretive acquisitions viewed more favorably than dilutive acquisitions? Using the rationale that some acquirers employ, the market price per share for the acquirer should go up in an accretive acquisition because the earnings per share are higher. This presupposes that the market does not change the P/E ratio for the company after the acquisition. That makes no sense since the target company presumably had a lower P/E ratio for good reasons—high risk and low growth, for instance. If the market is reasonably forward-looking, ...