Effect of M&A on stock prices – Part I

Continuing further from my previous article about Introduction to MnA, let's analyze how the stock prices behave when there is a news about MnA.

We will take the example of 2 companies which have decided to join hands or one is buying out the other. In most of the cases, a larger company buys out the smaller company. So we will name the companies as BIG and SMALL, so as to have clarity in naming convention. Sometimes it may happen that a smaller company may buy a larger company, just because its owner has surplus cash. The deal between Tata and Corus steel was of the 2nd type because Tata Steel was less in value compared to Corus, but Tata had additional funds from other sources.

But in essence, it's the money value that decides who buys out whom. So even if a small value company is buying out a big value company, the small value company is still considered bigger because it has sufficient money to buyout the other big firm. Hence, we always say that a big company has bought smaller company.

But what matters most to us is how do the stock prices of these two companies behave or react? In general, the stock price of the buying company (bigger company) usually goes down, while that of the company being bought goes up.

That seems to be a strange happening, but let's look at it with a simple example:

Imagine there are 2 balloons of 2 different sizes, one filled with 1 unit of gas and other filled with 10 units of gas. Initially, the 2 are existing as separate balloons. Now suppose that these 2 balloons are joined with a pipe. The following 3 things are possible:

1. Bigger balloon transfers gas to smaller one till equilibrium is established and both balloons become of equal size.
2. All the gas of smaller balloon 1 goes to bigger balloon 2
3. All the gas of bigger balloon 2 goes to smaller balloon 1

If you talk about principles of physics, then option 1 is what happens. How about the stock prices for this kind of joining of 2 companies in case of balloons?

The way the market perceives the news of takeover is also following the same principle, atleast in the short term. Whenever a bigger n financially healthy company takes over a smaller or diseased company, the market sees it as if the funds (like gas in a balloon) will flow from the bigger company to the smaller company, so that the smaller company is brought upto the level of the bigger company and then it can get absorbed in the bigger company completely. Ultimately, the bigger company and smaller company will both become one, but in the beginning for a short period of time, the market perception about the health of the companies and flow of fund is what is explained above.

It is perceived that the bigger company will have to pay for a makeover n upgrading of the smaller company. Hence, smaller company will be in benefit for sometime. Therefore, the price of a company being taken over starts to increase, while that of the company taking over may decrease or stay the same. The other reason for stock price decline of bigger company is because the market may believe that it has paid a heavy price for the acquisition, with regard to the benefit it may generate from the synergies. Hence, in almost all of the cases, it's the smaller company investors who get the benefit of takeover, while the bigger company investors may suffer a loss in the short term.

So for trading activities in the short term, better to be with a small company which may be taken over.

Continue to Part II of this article