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How do Mergers and Acquisitions Affect Stock Prices?

Mergers and Acquisitions are a way through which two companies can combine to form one stronger company. A company may choose to merge or agree to acquisition for a variety of reasons. Some of the reasons may be for boosting market share, expanding geographically, lowering competition, and so on.

In reality, this happens more frequently than people think. But most mergers and acquisitions don’t reach the news unless the firms involved are large and well-known.

What happens to the stock price of a publicly-traded firm if it merges or is purchased by a larger corporation? Today, we’ll discuss mergers and acquisitions and examine how they affect the stock values of the firms involved.

What is a Merger?

A merger is a voluntary agreement between two firms of comparable size and structure to merge into a single legal entity.

It’s crucial to keep in mind that most mergers occur between firms that are “equal” in many respects. As a result, when they create a new organisation, they decide together on rights and profit-sharing.

In addition, after they merge, the old firms vanish, leaving only the new company to exist. There are several sorts of mergers, including:

1. Conglomerate

When two or more firms engaged in unrelated business operations join and generate synergy to increase value, reduce expenses, and improve performance. In plain words, a conglomerate is a collection of firms with little in common.

2. Product Extension

Product Extension is when two firms in the same industry and with a similar target audience join forces to form a new entity with a broader selection of items to offer consumers.

3. Market Extension

Market Extension is when two firms in the same industry but separate markets join forces to establish a new company with access to a larger market and client base.

4. Horizontal Mergers

Horizontal Mergers – when two firms in the same industry with comparable goods and markets merge to gain more market dominance, minimize competition, and take advantage of economies of scale.

5. Vertical Mergers

When two firms at different phases of the product development/selling cycle join forces to establish a new entity that is more self-sufficient, has lower costs and has greater synergies. Vertical mergers typically occur between companies at various levels of a sector’s supply chain. A factory, for example, can vertically combine with a raw material source to form a stronger entity.

What is an Acquisition?

Acquisitions are undertaken by a larger firm to absorb a smaller one, whereas mergers are between equals and consensual. It’s a transaction in which the acquiring firm buys more than half of the acquiree or target company. For a variety of reasons, large corporations buy smaller businesses, including:

1. Market Expansion

Market Expansion is when a large corporation buys a small business in a market where it wishes to extend its activities. Purchasing a running business can save a lot of hassle and costs associated with setting up a new business in a new market.

2. Growth Strategy

When a major business reaches its ideal operating limit, logistics, resources, etc., then new and promising enterprises can begin to buying and integrating into its income stream.

3. Competition Reduction

When a major corporation seeks to buy smaller companies in its industry to control the circulation of products and services on the market. This contributes to reducing competition and maintaining the monopolistic competitiveness of the market.

4. Technological Advantage

A large and established firm purchases a small company powered by technology to profit from new technology. This typically means that new technologies may be implemented quicker and more cost-efficiently.

If the firm target does not agree to the purchase, the procedure is typically referred to as a takeover.

How do Mergers and Acquisitions Affect Stock Prices?

Every merger or Acquisition is unique and might affect the stock prices of the involved firms differently. Investors can, however, keep their eyes out for some recognizable patterns and make educated judgments on the sale of the firms’ stocks. Here are some designs which emphasize the impact of fusions and acquisitions:

1. The volatility of the stock price

Whether two businesses merge or one acquires the other, both companies’ stock values may become very volatile.

The fusion and acquisition procedure is generally a process long overdue where laws, conformity, and technicalities must be taken into account before the dotted line is signed. Furthermore, based on the agreement between the combined firms’ ultimate structure may differ.

And so experts and traders are striving to take the race ahead by predicting the outcome and evaluating if the new enterprise is stronger than the two single mergers. This gives investors a great deal of information, which tends to respond to it, which causes stock price volatility.

Therefore, when an investor undergoes a fusion or acquisition in the firms in which you invested, the stock values are expected to be volatile during the process.

2. Impact on mergers’ stock values

During the merger process, the stock price of both businesses is influenced by several elements such as their market capitalization, fusion procedure, and macroeconomic considerations in different ways.

While the mergers are equal in size and profitability, stock prices grow in the enterprise which gets advantages via mergers.

Stock price volatility also leads to a rise in its quantities, which further inflates its pricing. The newly created firm usually exceeds the prices of each of its equities after the merging process is complete.

If the overall feeling towards a merged company is that their market capitalization will be higher than the sum of the underlying companies’ market capitalizations, the investors will be optimistic about increasing the company’s stock price, unless there are changes in the economic landscape or any dramatic reports which could have a negative effect on the deal.

3. Impact on the target company’s share price (in the case of acquisitions)

The target company’s stock price generally rises as a result of an acquisition. This is because most investors feel that the acquiring firm pays a premium to acquire the target company in an acquisition.

This assumption stems from the idea that acquisition occurs only when both the acquirer and the acquiree gain from the transaction.

As a result, if an acquirer sees promise in a firm, it makes an offer, and the target company accepts the deal if the acquisition price given is more than its existing market worth.

As a result, even if there is a rumour that a business will be purchased by a larger company, the stock price of that company will rise quickly.

However, this volatility is generally very temporary, since once the proposed acquisition price is announced, the target company’s stock price stabilizes.

4. Effect on the Acquiring Company’s Stock Price (in the case of acquisitions)

When it comes to acquisitions, the market has a habit of picking favourites. To put it another way, investors search for winners and losers in a proposed agreement. Since the acquiring business is making the acquisition, the stock price of the acquiring company is likely to be negatively affected until the deal’s profitability is apparent to investors.

As previously stated, the acquiring firm pays a premium above the existing market price for the target company.

This may have an impact on its cash reserves and/or lead to an increase in debt, both of which can influence its short-term performance and, as a consequence, prompt investors to sell, resulting in a stock price decline.

Furthermore, if the public consensus is that the acquiring firm is overpaying for the purchase, this might have a negative influence on its stock price.

There may also be worries about the target company’s work culture being integrated with the purchasing company’s, regulatory difficulties delaying the transaction, power disputes in the management teams of both firms, and so on.

In a nutshell, the acquiring company’s stock price will respond to market sentiment toward the transaction. If analysts and/or traders feel the acquisition will add value to the acquiring firm, its stock price will climb as well.

It’s also worth noting that because these price swings are dependent on broad emotion, they’re generally just temporary.

If the acquiring business properly values the target company and guarantees a smooth integration of the two companies, the target company’s share price can rise in the long run.

Summary

The effects of mergers and acquisitions on stock prices may be seen in two ways: short-term and long-term.

While traders seeking volatility to record gains favour the short-term view, long-term investors must spend more time evaluating the deal’s profitability before acquiring a long-term stake in firms undertaking a merger or acquisition.

Because market players react to news of a merger or acquisition based on the information available to them, there are no set guidelines.

For example, when Walmart paid USD16 billion for Flipkart, market participants thought the purchase was overvalued, causing Walmart’s stock to drop 4%.

As an investor, you should exercise caution when determining whether to purchase or sell shares of a business that is undergoing a merger or acquisition, because market consensus can be inaccurate. Read more related articles here.

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