Mergers acquisitions and restructuring - Valuation methods a...

Learning Outcomes

This article explains valuation approaches and EPS impact in mergers, acquisitions, and restructurings, including:

• Distinguishing between absolute (DCF-based) and relative (market-multiple and precedent transaction) valuation methods for M&A target and acquirer assessment.
• Applying appropriate valuation techniques to different industries and transaction contexts, and judging when deal comparables provide reliable pricing guidance.
• Linking combination benefits, control premiums, and transaction costs to maximum justifiable offer price and to value creation versus value transfer.
• Computing pro forma post-merger earnings, shares outstanding, and EPS, and determining whether a proposed transaction is EPS-accretive or EPS-dilutive.
• Evaluating how consideration mix (cash, debt, equity) and financing structure affect post-deal EPS, leverage, and risk for the acquirer’s shareholders.
• Interpreting the role of relative P/E ratios, purchase premiums, and expected combination benefits as key drivers of accretion or dilution outcomes.
• Identifying limitations of accretion/dilution analysis, including its narrow EPS focus and potential to misrepresent true economic value creation.
• Linking valuation results, deal structure, and combination-benefit analysis to judge whether a transaction enhances combined firm value in line with CFA Level 2 expectations.

CFA Level 2 Syllabus

For the CFA Level 2 exam, you are required to understand valuation and analysis of mergers, acquisitions, and corporate restructurings, with a focus on the following syllabus points:

• Identify and describe absolute and relative valuation techniques for M&A transactions
• Calculate pro forma post-merger values and EPS
• Analyze the effects of deal structure, purchase consideration, and transaction benefits on value creation
• Evaluate whether a deal is likely to be EPS-accretive or EPS-dilutive for the acquirer
• Discuss limitations and practical considerations of accretion/dilution analysis
• Interpret the impact of acquisition financing (cash, debt, equity) on value and EPS

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

A large listed company, AlphaTech, is considering acquiring a smaller listed competitor, BetaSystems. Selected information is shown below (all figures in millions, except per-share data):

• AlphaTech: net income = 300; shares = 150; share price = 60
• BetaSystems: net income = 45; shares = 15; share price = 45
• Estimated after-tax annual combination benefits from the deal = 15
• AlphaTech’s after-tax cost of new debt = 5%
• Cash currently earns negligible return. Ignore transaction costs and tax effects other than those explicitly given.

AlphaTech is evaluating different pricing and financing structures for the deal.

1. To estimate BetaSystems’ standalone value as a going concern, assuming its cash flows are expected to grow with the industry and it has some unique intangible assets, the most appropriate primary valuation method is:
   1. Asset-based (replacement cost of net assets)
   2. Discounted cash flow (DCF) using free cash flow to the firm
   3. Price-to-book multiple based on current comparables
   4. Precedent transaction EV/EBITDA multiple
2. Suppose AlphaTech offers a 25% premium to BetaSystems’ current share price, paid entirely in cash, and funds the entire purchase price with new debt at a 5% after-tax rate. Ignoring combination benefits, the effect on AlphaTech’s EPS is most likely:
   1. Accretive, because AlphaTech is using debt rather than equity
   2. Dilutive, because AlphaTech’s P/E is higher than BetaSystems’ P/E
   3. Accretive, because BetaSystems’ earnings yield exceeds the after-tax cost of debt
   4. Dilutive, because AlphaTech is paying a control premium
3. Using the same 25% premium, assume instead that AlphaTech pays entirely with stock at BetaSystems’ pre-announcement market price (i.e., the premium is delivered via a higher exchange ratio). Ignoring combination benefits, the deal is most likely to be:
   1. EPS-accretive, because AlphaTech’s P/E exceeds BetaSystems’ P/E
   2. EPS-dilutive, because AlphaTech must issue shares at a higher P/E to buy lower-P/E earnings
   3. EPS-dilutive, because the effective P/E AlphaTech is paying (including the premium) exceeds its own P/E
   4. EPS-neutral, because the two firms’ P/Es are similar before the premium
4. Assume the deal is completed at a 25% premium and paid in stock. Including the expected after-tax combination benefits of 15 and ignoring any financing costs, which statement best describes the deal’s impact on AlphaTech’s shareholders?
   1. The deal must be value-creating whenever it is EPS-accretive
   2. The deal is value-creating if the combined firm value including combination benefits exceeds the sum of standalone values plus the premium paid
   3. The deal is always value-destroying if a control premium is paid
   4. The deal is value-neutral because combination benefits and premiums offset each other by definition

Introduction

Valuation is central to the analysis of mergers, acquisitions, and corporate restructuring transactions. For the CFA Level 2 exam, you must be able to compare valuation approaches, recognize how deal structure affects value, and understand how a proposed transaction can alter post-merger earnings per share (EPS). Accretion/dilution analysis is widely used in practice to assess the financial effects of a deal on shareholders and has significant exam relevance.

Key Term: Fundamental value
Fundamental value is the value of a company or asset based on its core fundamentals and expected cash flows, as assessed by an informed analyst, independent of the current market price.

Key Term: Investment value
Investment value is the value of a company to a specific buyer, reflecting that buyer’s expectations, combination benefits, and strategic fit, and can differ from both fundamental value and market price.

In M&A, the acquirer is often interested in investment value: the target’s standalone fundamental value plus any additional value from combination benefits or strategic benefits to the acquirer, net of transaction costs. Whether a deal is value-creating depends on how this investment value compares with the total consideration paid.

EPS accretion or dilution is only one dimension. A deal can increase EPS yet destroy value if the acquirer overpays or increases risk disproportionately. The exam expects you to connect valuation, deal pricing, and EPS impact into a consistent analytical view.

Key Term: Absolute valuation
Absolute valuation means estimating firm value directly from its fundamentals and the present value of expected future cash flows, typically using discounted cash flow (DCF) models.

Key Term: Relative valuation
Relative valuation means valuing a company by comparing its price multiples to those of peer companies or past transactions, such as P/E or EV/EBITDA.

VALUATION METHODS IN M&A AND RESTRUCTURING

Transaction valuation commonly uses both absolute and relative approaches:

• Absolute valuation: Discounted cash flow (DCF) approach estimates target value using forecasted free cash flows and a risk-adjusted discount rate.
• Relative valuation: Market-based multiples such as P/E, EV/EBITDA, and precedent transaction analysis compare the target to similar firms or recent deals to assess a reasonable price.

Absolute Valuation: DCF in an M&A Context

In corporate restructuring and M&A, the most common absolute method is a DCF based on free cash flow to the firm (FCFF).

Key Term: Free cash flow to the firm (FCFF)
FCFF is the cash flow available to all providers of capital (debt and equity) after operating expenses, taxes, and necessary investments in working capital and fixed capital.

A basic FCFF valuation for the target is:

where:

• $FCFF_t$ are forecast free cash flows to the firm
• $WACC$ is the target’s weighted average cost of capital
• $TV_n$ is a terminal value (often a multiple of a terminal-year metric or a Gordon-growth value)

In M&A, analysts often build two DCFs:

• Standalone DCF: target’s value assuming it continues independently
• Combination-benefit DCF: incremental cash flows expected only if the deal occurs (cost savings, revenue enhancements, tax benefits), after tax and net of implementation costs

The investment value of the target to a particular acquirer is:

DCF is best suited when:

• The business has reasonably predictable cash flows
• Comparable trading or deal multiples are unreliable or sparse
• The transaction is large and bespoke (e.g., cross-border deals, private targets, complex restructurings)

Relative Valuation: Comparables and Transactions

Relative valuation benchmarks the target against peer companies or comparable deals.

Key Term: Comparable company analysis
Comparable company analysis (CCA) values a firm by applying market-based trading multiples (e.g., EV/EBITDA, P/E) from similar publicly traded companies to the target’s fundamentals.

Key Term: Comparable transaction analysis
Comparable transaction analysis (CTA) values a firm using pricing multiples implied by recent M&A transactions involving similar targets, capturing the premiums typically paid for control.

Key steps in CCA:

• Identify a peer group similar in business model, growth, and risk
• Compute trading multiples such as EV/EBITDA, EV/EBIT, P/E, or sector-specific metrics
• Apply mean or median multiples to the target’s metrics to estimate an equity or enterprise value

Key steps in CTA:

• Identify completed or announced transactions involving similar targets
• Extract transaction multiples (often based on EV/EBITDA or EV/EBIT at deal announcement)
• Apply these “deal multiples” to the target’s metrics

Because deal prices reflect control premiums and expected combination benefits, CTA often yields higher implied values than CCA for the same target.

Control Premiums and Takeover Pricing

Key Term: Control premium
A control premium is the excess of the acquisition price over the target’s unaffected standalone market value, paid to obtain control and the ability to realize combination benefits or change strategy.

The total “takeover premium” embeds:

• The value of control and strategic flexibility
• The portion of combination benefits the acquirer is willing (or forced) to share with target shareholders
• Any competitive bidding pressure

Key Term: Combination benefits
Combination benefits are the increase in combined company value arising from expected cost savings, revenue enhancements, tax benefits, or better use of assets from a merger or acquisition.

Analytically, the maximum justifiable price for the target to leave the acquirer’s shareholders no better or worse off is:

Paying less than this creates value for the acquirer’s shareholders; paying more destroys value for them, even if the deal may still be favorable to target shareholders.

Choosing the Valuation Method

• DCF is best suited for targets with predictable cash flow and clear growth prospects, or when valuing private targets or segments in spin-offs.
• Relative valuation using comparable companies is appropriate in established industries with robust public markets and when quick, market-based benchmarks are needed.
• Precedent transaction analysis is preferred for established industries where recent M&A deals are publicly disclosed and truly comparable; it is especially useful for assessing “fair” control premiums.
• Asset-based or sum-of-the-parts approaches become more relevant for asset-heavy or distressed entities, or when different business segments have distinct risk-return profiles.

Combination benefits—improvements in revenues or reductions in costs—are often a critical part of value estimation in M&A. Properly valuing combination benefits is essential for determining the maximum justifiable price and for distinguishing value creation from mere value transfer between acquirer and target shareholders.

ACCRETION AND DILUTION ANALYSIS

Key Term: Accretion/dilution analysis
Accretion/dilution analysis assesses whether a proposed merger or acquisition increases (accretes) or reduces (dilutes) the acquirer’s earnings per share.

Accretion occurs when the pro forma EPS after a deal is higher than the acquirer’s standalone EPS; dilution occurs when EPS falls post-transaction. Because EPS is a key performance metric, management, investors, and boards often use accretion/dilution analysis as an initial screening tool, especially for all-stock or mixed consideration deals.

Calculating Pro Forma EPS

For a straightforward acquisition, the acquirer must estimate:

• Combined post-merger net income, including:
  • Target’s standalone net income
  • After-tax combination benefits (cost savings and incremental margins on revenue improvements)
  • Incremental after-tax financing costs (interest on new debt, lost interest on cash used)
  • Any recurring incremental operating costs
• The new total number of outstanding shares (including newly issued shares for stock-financed deals)
• Pro forma EPS:

The deal is:

• EPS-accretive if Pro forma EPS > Acquirer standalone EPS
• EPS-dilutive if Pro forma EPS < Acquirer standalone EPS

Worked Example 1.1

A large company (AcquirerCo) with net income of $200 million and 100 million shares (EPS = $2.00) seeks to acquire a smaller company (TargetCo) with net income of $40 million and 20 million shares (EPS = $2.00). AcquirerCo is paying for the deal entirely in stock, offering 0.5 AcquirerCo shares for every TargetCo share. No combination benefits are anticipated.

Is this deal accretive or dilutive to AcquirerCo’s EPS?

Answer:
Total shares post-merger: 100M (existing) + 10M (from 0.5 × 20M Target shares) = 110M. Combined net income: $200M + $40M = $240M. Pro forma EPS = $240M / 110M = $2.18. Since this is higher than standalone EPS ($2.00), the deal is EPS-accretive.

Notice that even without combination benefits, EPS increases because AcquirerCo issues shares at a higher P/E than the effective P/E it is paying for TargetCo’s earnings. This “P/E arbitrage” is a key driver of EPS accretion in stock deals.

Relative P/E and EPS Impact in Stock Deals

A useful rule of thumb for all-stock deals (ignoring combination benefits and transaction costs) is:

• If acquirer’s P/E > effective P/E paid for target’s earnings ⇒ likely EPS accretion
• If acquirer’s P/E < effective P/E paid ⇒ likely EPS dilution

The effective P/E paid incorporates both the target’s pre-deal P/E and the control premium. A high premium can push the effective P/E above the acquirer’s own P/E, turning an otherwise accretive deal into a dilutive one.

Exchange Ratios and EPS

Key Term: Exchange ratio
The exchange ratio is the number of acquirer shares offered for each target share in a stock-for-stock transaction.

The number of new shares issued equals:

Higher exchange ratios (from higher offered prices or lower acquirer share prices) increase dilution pressure by expanding the denominator of EPS.

DRIVERS OF ACCRETION AND DILUTION

Key determinants:

• Relative P/E multiples:
  If acquirer’s P/E is substantially higher than the target’s effective P/E (including the premium), stock-financed deals are likely accretive, all else equal. Conversely, issuing undervalued acquirer stock (low P/E) to buy high-P/E target earnings typically causes dilution.

• Purchase price/consideration:
  Paying a high premium raises the effective P/E or reduces the effective earnings yield the acquirer is buying. This can negate accretion even when the target’s pre-deal P/E is low. Exam questions often ask you to recognize that “overpaying” can flip an initially accretive deal into a dilutive one.

• Combined benefits:
  Realistic operational or financial benefits can make otherwise neutral or dilutive deals accretive. These benefits add to the numerator (net income). However, these benefits frequently take time to realize and may require upfront implementation costs, which sophisticated models should reflect.

• Financing method:
  The use of debt, cash, or stock affects both the numerator and denominator of EPS:

  • Debt financing increases interest expense (reducing net income) but does not add shares
  • Cash financing foregoes interest income (if cash previously earned a return) but also preserves share count
  • Stock financing adds shares but no explicit interest cost; its economic cost is the cost of equity

This logic is closely related to share repurchase analysis: EPS rises when the earnings yield on purchased earnings (or retained earnings) exceeds the after-tax cost of the funds used.

Key Term: Earnings yield
Earnings yield is earnings per share divided by share price (E/P), the inverse of the P/E ratio. It is often compared with the cost of financing to judge whether an action is EPS-accretive.

In a debt-financed acquisition, ignoring combination benefits and taxes other than those on interest, the deal tends to be EPS-accretive if:

The same logic applies for cash financing, with the relevant “financing cost” being the foregone after-tax return on cash.

Key Term: Purchase consideration
Purchase consideration is the mix of cash, stock, debt, or other instruments offered by the acquirer to buy the target firm.

LIMITATIONS OF ACCRETION/DILUTION ANALYSIS

Although central in practice, accretion/dilution analysis has important limitations:

• Narrow focus on EPS, not value:
  EPS is an accounting measure and does not directly capture cash flows, risk, or cost of capital. A deal can be EPS-accretive yet destroy value if the acquirer overpays relative to the present value of cash flows.

• Insensitive to financing-structure-neutral cash flows:
  From the standpoint of free cash flows, financing decisions (dividends, repurchases, or issuing debt vs equity) largely do not affect FCFF or FCFE, but they can change EPS significantly. Focusing on EPS can therefore distract from the core question of whether the deal’s cash flows exceed its cost.

• Static earnings assumptions:
  Simple accretion/dilution models often assume that earnings remain constant apart from combination benefits and financing costs. They rarely incorporate post-merger implementation risk, changes in business risk, or cyclical effects on earnings.

• Accounting and one-off items:
  Short-term EPS can be affected by one-time restructuring charges or changes in accounting methods (e.g., depreciation or amortization), which should be normalized for valuation purposes.

• Timing issues:
  Combination benefits may phase in over several years, whereas financing costs start immediately. A one-period EPS analysis can misrepresent the time pattern of value creation.

Exam Warning

Valuing a deal solely based on its immediate EPS accretive/dilutive impact is a common error. Many value-destructive deals appear accretive because of differences in P/E ratios, not genuine value creation. Always relate accretion/dilution to fundamental business value and risk.

On the exam, when a vignette highlights EPS accretion but also mentions a very high premium or weak strategic fit, you are expected to question whether the deal truly creates value.

ASSESSING VALUE CREATION

A transaction is value-creating if the combined firm’s value (including combination benefits, net of transaction costs) exceeds the sum of the standalone firm values.

Mathematically:

For the acquirer’s shareholders, the relevant metric is whether the price paid is less than or equal to the portion of this combined value they capture.

Worked Example 1.2

Acquirer offers $500 million for a target whose standalone value (using DCF) is $450 million. The expected net present value of combination benefits is $60 million, and transaction costs total $10 million. Is the deal value-creating at this price?

Answer:
Combined value from the deal for the acquirer’s shareholders can be framed via the maximum justifiable price:

$$\text{Max justifiable price} = V_{\text{target, standalone}} + PV(\text{combination benefits}) - \text{Transaction costs}$$ $$= 450 + 60 - 10 = 500 \text{ million}$$

Since the price equals this maximum value, the deal is value-neutral for the acquirer’s shareholders. Any price below $500 million would create value for them; any higher price would destroy value.

This example illustrates:

• Value creation is about the relationship between price, standalone value, and combination benefits
• EPS accretion alone cannot determine whether the acquirer overpaid

DEAL STRUCTURE IMPACT

Form of consideration directly impacts accretion/dilution and risk:

• Cash:

  • No share dilution, so shares outstanding remain unchanged
  • Reduces cash balances; if financed by drawing down excess cash, opportunity cost is lost interest income
  • If financed by new debt, adds leverage and interest expense
  • Often viewed as a stronger signal of confidence, since the acquirer commits cash

• Debt:

  • Increases leverage and interest obligations
  • Interest expense reduces net income but is tax-deductible
  • If after-tax cost of debt is lower than target’s earnings yield, EPS tends to increase, similar to a leveraged share repurchase
  • Adds financial risk and potentially affects credit ratings and WACC

• Stock:

  • No explicit interest expense, but shares are issued to target shareholders
  • Dilutes existing shareholders’ ownership and EPS unless target earnings yield (after premium) exceeds acquirer’s earnings yield
  • Shifts risk of benefit realization to target shareholders, who become part-owners of the combined entity
  • Often attractive if the acquirer’s shares are perceived as overvalued

Worked Example 1.3

A debt-financed deal is anticipated to have annual after-tax interest expense of $12 million, but expected cost savings are $15 million per year. If the incremental net income is positive post-financing, will the debt-funded deal be accretive?

Answer:
Incremental net income from combination benefits after financing cost is $15M – $12M = $3M per year. All else equal, this increases the combined firm’s net income without increasing the number of shares, so EPS should rise. The deal is likely EPS-accretive, though you would still need to consider any premium paid and any impact on the acquirer’s standalone earnings.

Worked Example 1.4

Assume AcquirerCo from Example 1.1 instead finances the purchase of TargetCo entirely with new debt at an after-tax cost of 4%. TargetCo’s purchase price is $400 million, and its net income is $40 million. There are no combination benefits. AcquirerCo has net income of $200 million and 100 million shares.

Is the deal EPS-accretive?

Answer:
TargetCo’s earnings yield based on price paid is:

$$\text{Target earnings yield} = \frac{40}{400} = 10\%$$

After-tax cost of debt = 4%.

Incremental net income from acquiring TargetCo’s earnings and paying interest is:

$$\Delta \text{NI} = 40 - (0.04 \times 400) = 40 - 16 = 24 \text{ million}$$

Pro forma net income = $200M + $24M = $224M. Shares outstanding remain 100M, so:

$$\text{Pro forma EPS} = \frac{224}{100} = \$2.24$$

Standalone EPS is $2.00, so the deal is EPS-accretive. This mirrors the logic of a leveraged share repurchase: buying earnings at a yield higher than the after-tax financing cost increases EPS.

Despite EPS accretion, further analysis is needed to determine whether the 10% earnings yield is adequate compensation for the increased leverage and risk.

Summary

Valuation of mergers, acquisitions, and restructurings requires careful application of absolute and relative methods. DCF analysis provides standalone and combination-benefit values; comparable company and transaction multiples provide market-based pricing benchmarks and help assess the reasonableness of implied premiums.

Accretion/dilution analysis estimates the impact of a transaction on acquirer EPS but should not be the sole criterion for deal assessment. True value creation requires combined firm value (including substantiated combination benefits, net of all costs) to exceed the sum of standalones, and for the price paid to allow acquirer shareholders to capture a reasonable share of that value.

Transaction structure, consideration type, and financing all influence both EPS impact and fundamental risks. For the exam, you should be able to:

• Compute pro forma EPS and identify accretion or dilution
• Relate EPS outcomes to relative P/E ratios, premiums, and financing costs
• Judge whether EPS accretion aligns with genuine value creation, considering combination benefits, risk, and maximum justifiable price

Key Point Checklist

This article has covered the following key knowledge points:

• Key M&A valuation methods: DCF (using FCFF) and relative multiples (P/E, EV/EBITDA, precedent transactions)
• Use of standalone and combination-benefit DCFs to compute investment value and maximum justifiable offer price
• Distinction between combination benefits, control premiums, and transaction costs in pricing transactions
• Calculation of pro forma post-merger net income, shares, and EPS, and assessment of accretion or dilution
• Impact of deal financing (stock, cash, debt) on EPS, leverage, and risk, including the role of earnings yields vs financing costs
• Interpretation of relative P/E ratios and effective P/E paid as key drivers of EPS accretion/dilution in stock deals
• Identifying value creation: combined firm value with benefits exceeding sum of standalones, and price paid below maximum justifiable value
• Recognizing limitations of accretion/dilution analysis and the need to link EPS effects back to cash flows and risk

Key Terms and Concepts

• Fundamental value
• Investment value
• Absolute valuation
• Relative valuation
• Free cash flow to the firm (FCFF)
• Comparable company analysis
• Comparable transaction analysis
• Control premium
• Combination benefits
• Accretion/dilution analysis
• Exchange ratio
• Earnings yield
• Purchase consideration