Oftentimes, larger companies buy smaller companies for a wide variety of reasons, but usually to increase future revenues. To explain what this means for you as a shareholder, let’s create a fictional example.
Company AAA has just acquired the company BBB. Before the announcement, AAA’s share price was $20, and BBB’s was $100. There are a couple of different types of acquisitions, so make sure you know the difference.
- In an “all cash” deal, BBB shareholders receive a specified dollar amount for every share they own. Unless there had been public rumors of an acquisition that drove up the stock price of BBB (let’s say from $80/share to $100/share), then AAA must offer more than the current share price of $100. If there had been public rumors, then AAA could offer anything above $80/share, which means it may be lower than the current share price of $100/share.
- In an “all stock” deal, BBB shareholders receive a specified amount of AAA shares for every BBB share they own. Similar to an “all cash” deal, the value of the acquisition must be greater than the value of the BBB shares before the announcement was made. In other words, the number of AAA shares received (possibly a fraction) for every BBB share owned multiplied by the current AAA share price must be greater than the BBB share price before the announcement. In this scenario, AAA would have to offer BBB shareholders at least five AAA shares for every BBB share they own.
- In a “cash and stock” deal, BBB shareholders receive cash and AAA shares. A possible deal would be $40 and 3.25 AAA shares for every BBB share owned. This deal is worth $105 per BBB share (40 + 3.25*20 = 105).
Here is what you can expect in regards to the share price immediately after the announcement:
- BBB’s share price will likely skyrocket on the news to the value of the deal. For example, if AAA offers $140/share, then BBB’s share price will jump to $140.
- AAA’s share price can go either way. Oftentimes, the share price will go down because they just spent a lot of money and/or increased their debt, which will hurt them short term. The share price might also go down because investors think that AAA overpaid for BBB. However, AAA’s share price can go up on the news as well if investors realize the potential of the combined companies. In all, the share price of AAA is really unpredictable.
After the announcement, it’s not uncommon to see some more movement in the share price of BBB. Referring to the type of acquisitions mentioned earlier, here’s why the share price of BBB may fluctuate.
- In this “all cash” deal, BBB shareholders are offered $120/share.
In this “all stock” deal, BBB shareholders are offered six AAA shares for every BBB share they own.
- If BBB shares trades at $110, some investors may consider this a chance to secure a 9% return. However, if the share price is trading below the offer, it may be because investors doubt the deal will actually go through. There’s no such thing as a free lunch.
- If BBB shares are trading at $130, some investors may think it’s time to get out before the deal goes through and they receive $120/share. Although there is nothing wrong with taking a profit, the reason BBB is trading above the offer is the belief that an even better offer will arise. Regardless, this is good news if you own shares in BBB.
In this “cash and stock” deal, BBB shareholders are offered four AAA shares and $30 for every BBB share they own.
- At the time of the offer, the deal was worth $120 per BBB share (6 * $20 per AAA share). However, the share price of AAA can fluctuate, which means the value of the deal will fluctuate as well. For example, if AAA goes up to $30/share, then the deal is now worth $180 per BBB share.
- Similar to the case above, if the share price of AAA goes up to $25/share, then the value of the deal goes from $110 per BBB share (4*20 + 30) to $130 per BBB share (4*25 + 30), thus the share price of BBB will rise to $130/share.