Trading Acquisitions Part 1

What Happens to Stock Prices During Acquisitions?

Mergers and acquisitions are two important concepts in corporate finance. An acquiring company can either take a majority stake in the target company and let it continue to operate under its previous name or absorb the target company into its existing operations. Since acquiring companies should only choose targets in which they see value, acquisitions are good for the stock price of the target firm.

Why Do Companies Make Acquisitions?

The company making the acquisition is usually a larger firm that sees value and opportunity in owning the target firm. Larger companies acquire smaller companies for a lot of reasons. The acquiring company may see the target as a growth opportunity that will improve its overall value. These types of acquisitions often involve targets than have been successful in a specific niche the acquiring company wants to enter or control. The acquiring company may also be motivated by a desire for diversification. Entering new business areas or product lines can be a way for a company to reduce the risk associated with its operations. Alternatively, the acquiring company may be looking to achieve better economies of scale or to increase its overall market share. If the target is a competitor, the acquisition will increase the market share and market power of the acquiring company.

Financing Acquisitions

The acquiring company may purchase the target in a cash buyout. In this type of purchase, the acquiring company pays the shareholders of the target firm a small premium above the market price of the target shares on the day the acquisition deal is complete. The acquiring company may pay for these shares with cash on hand or get additional capital for the purchase by issuing new equity or debt or by receiving financing from a large financial institution.

Sometimes an acquisition is financed either entirely or partially with the stock of the acquiring company. In this case, the shareholders of the target firm receive a set number of shares of the acquiring firm in exchange for their each share they own. Cash may also be a part of this deal.

The Impact on Stock Prices

Interestingly, acquiring firms generally don’t experience a boost to their stock prices due to an acquisition. If anything, acquiring firms experience a temporary decline in their stock prices because shareholders worry that the company paid too much for the acquisition and that the acquisition won’t prove to be as profitable as the managers expected. While managers of the acquiring company feel that the deal is ultimately a long-term benefit to the company, investors fear the worst and realize that mergers and acquisitions always have unexpected problems.

In addition to concerns about the overpricing of the target, shareholder in the acquiring company must consider several other potential issues related to the acquisition. Integrating the new company into the current corporate structure is difficult. Managers must deal with combining two different corporate cultures, and employee morale may be low due to the threat of job loss. There can be both a loss of productivity and morale during this time because employees must be let go in order to avoid additional expenses due to overlapping business functions between the two companies. Accounting issues such as restructuring charges and goodwill can weaken the acquiring company’s financial position. Additional debt and expenses that the company incurs as part of the acquisition also weaken the financial position of the firm in the short-term. All of these factors may be responsible for driving down the stock price of the acquiring firm.

The share price of the target firm usually goes up when the acquisition is first announced. Since the acquiring firm offers a premium on top of the share price on that day, the price of the target’s shares quickly increases to just below that offer price. Consider an example where the target’s shares are trading at $25 at the time of the acquisition announcement, but the acquiring firm is offering to pay $35 per share. Based on the new information, the shares are no longer worth $25 but are suddenly worth $35. So, the market will adjust its valuation accordingly. The stock price, however, won’t adjust all the way to the offer price because there is still some uncertainty regarding whether or not the deal will actually close. The more certain investors are about the deal, the closer to the offer price the stock will trade.

On June 13, 2016, Microsoft announced that it had reached an agreement with LinkedIn to acquire the company for $194 per share. LinkedIn had closed at a price of $131.08 on Friday, June 10, 2016. Microsoft announced the acquisition on Monday morning, and LinkedIn’s stock closed at $192.21 that day.

Asset Acquisitions

Rather than acquiring the entire firm, sometimes a company decides to acquire just a particular asset or business unit from the target. In these cases, there is usually a smaller boost to the target’s share price. Although the target’s shareholders can expect some extra premium for the purchase, it is not as large as they would expect from the acquisition of the entire firm. In addition, the asset or unit may have been one that provided the first with revenue and growth opportunities that it will no longer have.

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