Depending on how the target company is valued in a merger, the acquiring company and its stockholders may gain or lose money. However, in normal circumstances, the acquiring company may not want to undervalue the target company because then the proposed merger likely wouldn't be approved by shareholders of the target company. Therefore, if the target company is overvalued, stockholders of the acquiring company pay more for what the target company is worth, essentially losing money in the merger transaction.
Companies in a leading position in their business are often willing to pay premiums when considering buying out their competitors. The basic valuation principle of purchasing a business is to apply the risk factor of the business to its future earnings capability. The more risky a company's business is, the less value the business possesses. Companies that are merger targets are often in worse business situations with more risks comparing to the acquiring company, and thus have lower fair values. However, by merging the target company into its own business, the acquiring company expects that it can make the target company's business better and safer in the future and thus often overvalues the target company by assuming a lower level of risk.
Target Company's Stock
Business valuation is ultimately reflected in stock prices. In a merger speculation, the price of the target company's stock often goes up. Once the news of a potential merger breaks out, there's normally increased demand for the target company's stock from investors who expect that the acquiring company will overpay the target company. In fact, the acquiring company often announces its proposed price tag for the target company's stock with a premium. But due to uncertainties for any pending merger, the target company's stock may not trade all the way up to the proposed merger price. Furthermore, if the merger fails to come through, the target company's stock is likely to drop significantly.
Acquiring Company's Stock
The same business valuation affects the acquiring company's stock in the opposite direction, with its price going down during merger talks. Concerned about the potential decrease in the value of their stock, current investors of the acquiring company may want to sell their holdings before the price is sure to drop when the merger is confirmed. Anyone who holds onto their existing position suffers from equity dilution to the extent that the target company is overvalued.
The acquiring company may pay for the merger with cash, its stock or a combination of both. Given that the target company is overvalued, when paying with cash, shareholders of the acquiring company simply exchange more of their cash for fewer assets of the target company, resulting in an unrealized loss to their equity base. When paying with its own stock, the acquiring company essentially gives more shares to shareholders of the target company for their equity value compared to the fewer number of shares acquiring stockholders own on an equal book-value basis.
Mergers are based on the concept of business synergy --- that is, by combining two companies, the resulting entity as a whole can achieve better business performance. If, in the long run, such a business synergy is realized, stockholders of the acquiring company gain additional appreciation to compensate for their money loss in the current merger transaction. Business synergy involves not only the better use of the target company's physical assets, but also effectively incorporating two different management styles and corporate cultures, both of which affect future returns for the acquiring stockholders.
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