A merger occurs when one company combines shares with another for the sake of general economic growth and profits. A company that is struggling, yet shows great potential, may just be the victim of poor management. A more competent firm, noticing this, might make an offer to partner with it, knowing that they can turn things around. Usually, the acquiring stockholders temporarily lose money in the transaction because of the nature of stock prices when a firm becomes a merger or takeover target.
The best targets for a merger are firms that are doing poorly, yet have the potential to do well. A strong company might make an offer, which usually causes the target company's stock to rise. Being the victim of a merger or even a buy-out might mean a strong future for the company being bought. This also means that the acquiring stockholders might take a loss, yet this is only temporary since it refers to the market value of the acquired stock which has temporarily increased.
It is possible that the acquired stock might be falling in value, with the result that the buying firm seems to be getting a weaker company. In some cases, stockholders of a targeted company might jump ship. The fact is that a company that is a target might be struggling, and stockholders might show their displeasure by selling rapidly. This can quickly depress the stock price, especially if the targeted firm is not doing well regardless. This makes it appear that the buyers are getting a very weak firm for a comparatively high price. It looks like they are losing money, but like all these phenomena, it is a temporary market blip, and not indicative of the potential of increased profits after the merger.
The company buying another suffers temporarily from what is called a “merger premium.” This means that a company that seems to be a perfect target for a buyout might see its value increase. It increases only because it seems to be an attractive target. Like anything else, potential buyouts themselves create a market. Those firms that are attractive then increase in value in that market. This increase is called the “premium” and refers to the potential profits to be made after the merger or acquisition is completed.
The firm doing the buying might see a rapid, but temporary, slip in their own stock prices. When a firm makes a decision to buy another or merge, this represents a huge capital outlay. The result might be a brief period of investor discomfort, and shares of the buying company might be sold. Investors may see the merger as an error, since the large capital outlay might be excessive, especially if the target company would take a large amount of refurbishing in order to make it productive. Investors might think that money would be better used for its own reinvestment, not the buying of other firms.
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