Merger and acquisition are common phenomena in the financial world.
It is as common as having your second meal of the day.
You must have got the context of ‘Merger and Acquisition’ either while browsing across the net, new channel or you must have heard about the news of companies going for it.
Such a phenomenon is engraved as one of the paramount happenings for a company or organization.
It’s the ultimate decision taken by the board members of the company.
I understand that until now you must have already listed down some questions…
But what are mergers and acquisitions all about?
Does that affect the stock prices in the market?
If yes, how does the effect propagate?
Let’s us look into aspect one by one.
Merger and Acquisition are separate terms.
They hold their own importance and uniqueness.
What is a Merger?
During Merger two companies, of similar size and structure, decide to fuse into one new legal entity.
Here there is special emphasis on the word ‘equal’.
This is because when they form a new entity, profit sharing and rights are decided mutually.
Once two companies merge the original company dissolve.
There are different types of mergers like:
Conglomerate – where two or more companies in unrelated business activities merge and create synergy to enhance value, save costs, and boost performance.
In simpler terms, a conglomerate has companies that don’t have much in common.
Product Extension – where two companies operating in the same sector and having a similar target audience with the objective of creating a new entity with a wider range of products being offered to customers.
Market Extension – where two companies operating in the same sector but different markets come together to form a new company with access to a wider market and a bigger client base.
Horizontal Mergers – where two companies operating in the same sector with similar products and markets form a new entity for more market control, reduce competition, and benefit from the economies of scale.
Vertical Mergers – where two companies at different stages of the product development/selling cycle merge to form a new entity that is more self-sufficient with a reduction in cost and increased synergies. Typically, vertical mergers happen between companies at different levels of a sector’s supply chain. For example, a manufacturer can vertically merge with a raw material provider to create a stronger company.
What is an Acquisition?
Acquisitions are initiated by a larger company to absorb a smaller one.
Unlike mergers, they are not necessarily between equal companies and are definitely not voluntary.
The process in which the acquiring company purchases more than 50 per cent of the acquiree or target company is known as acquisition.
Large companies acquire smaller ones for various reasons including:
Market Expansion – where a company acquires a small company in a market where it wants to expand its operations. Purchasing a running business can save a lot of hassle and costs associated with setting up a new business in a new market.
Growth Strategy – where a large company has reached its optimal limit of operations, logistics, resources, etc., then it might start looking at young and promising companies to acquire and incorporate into its revenue stream.
Reduce Competition – where a large company tries to acquire smaller ones in its sector to control the flow of products and services into the market. This helps reduce competition and keep the monopolistic competitive nature of the market alive.
Technological Advantage – where a large and established company acquires a young and technologically-driven one to benefit from new technologies. This is usually a faster and cost-efficient way to implement new technology.
When the target company does not consent to the acquisition, the process is usually called a Takeover.
Why does a company go for M&A?
There is an ocean of reasons as to why companies go for mergers and acquisitions.
But the major reasons are to expand the economics of the companies and gain competitive grounds that were previously hard to access.
M & A enhances a company’s capability in terms of performance.
They can call upon increased research and development, or manufacturing facilities or new technologies that will help them to gain a vital advantage in the industry.
Some of the companies choose mergers and acquisitions so that they can diversify their product portfolio and expand their horizons.
For instance, two companies, completely different business and product lineage can merge and scale up their own product line.
Retrenching stocks is another major reason for M & A.
If two companies are in the same line of the field then mergers or acquisitions benefit from cutting on costs and improve the profit range significantly.
Impact of M&A on stocks
It is important to note that every merger or/and acquisition is unique.
Even if there is a recurring type of situation between companies the results are different.
Therefore, it affects the stock prices in a different way.
However, investors can keep an eagle on certain identifiable patterns to make informed decisions about taking an action on the stocks of these companies.
Here are some patterns that highlight the effects of mergers and acquisitions:
- Stock Price volatility
Immediately after the act of merger or/and acquisition, high volatility of the stock prices of both companies is certain.
The process is usually over a long horizon which includes formalities such as legalities, compliances, and finer details to fulfil.
Therefore, there is already a race between analysts and traders to predict the outcome and assess if the new company will be stronger than the two individual merged companies.
This leads to a lot of information made available to investors who tend to react to it causing volatility in stock prices.
As an investor, if the companies that you have invested in are undergoing a merger or acquisition, then expect the stock prices to be volatile during the process.
2. Impact on the stock prices of merging companies
During the process of the merger, factors such as market capitalization, macroeconomics and the merger process as a whole impacted have a great impact.
Usually, while the merging companies are similar in size and profitability, the company which gains an advantage due to the merger experiences a rise in stock prices.
Such volatility paves the way in increased volume trading which therein inflates the prices.
The stocks become overbought and after the merger is finalized, the stock price of the newly formed company is generally higher than the price of each of the underlying company’s stocks.
3. Impact on the stock price of the target company (in the case of acquisitions)
After an acquisition, the value of the combined companies increases so does the stock price.
This is on the investor’s common belief that in an acquisition, the acquiring company pays a premium to acquire the target company.
This assumption is based on the maxim that an acquisition takes place only when both the acquirer and acquire benefit from the deal.
Hence, the acquirer makes an offer to a company if it sees future potential in it and the target company agrees to the deal if the purchase price offered is greater than its current market value.
Therefore, even if there is a small rumour about a company being acquired by a larger company, its stock prices start spiking.
However, this volatility is usually short-term as once the proposed purchase price is released the stock price of the target company becomes steady.
4. Impact on the stock price of the acquiring company (in the case of acquisitions)
In an acquisition, the market tends to become biased.
In other words, investors tend to look for winners and losers in the proposed deal.
Since the acquiring company is making the purchase, unless the profitability from the deal is not evident to the investors, the stock price of the acquiring company tends to get affected negatively.
As explained above, the acquiring company pays higher than the current market price to acquire the target company.
This can impact its cash reserves and/or lead to an increase in debt which can impact its short-term performance and hence cause investors to sell resulting in a drop in stock price.
Further, if the general view is that the acquiring company is paying too high a premium for the acquisition, then it can negatively impact its stock price too.
Additionally, there can be concerns relating to the integration of the work culture of the target company with the acquiring company, regulatory issues stretching the timelines, power struggles in the management teams of both the companies, etc.
In a nutshell, the stock price of the acquiring company will behave based on the market sentiment towards the deal. If the analysts and/or traders believe that the deal can create value for the acquiring company, then its stock price can rise too.
It is also important to note that these price fluctuations are usually short-term since they are based on general sentiment.
If the acquiring company has valued the target company adequately and ensures a smooth integration of both the companies, then, in the long run, its share price can flourish.
Mergers and acquisitions are part of the business operation.
This process of merger and acquisition tends to affect the stock prices of the company in the immediate aftermath and will be based on how the companies tend to perform in the long run.
If the company runs in line with its operational goals, then it is likely that the stock price will grow with time.
As an investor, it is advised that you should be watchful of the market before investing.
