An introduction to company acquisitions

Author: Steven posted in Investing basics tagged with Investing 101, Stock market

Companies that have cash available can either decide to pay dividends out to the shareholders, buy back company stock, or acquire another company. This depends on the nature and business model of the company. Acquisitions can be used to fuel the growth of the company and gain access to new products, IPs and new markets or simply strengthen the competitive position within existing markets. Provided that the acquisition is completed at a reasonable price and the integration goes smooth, it might turn out as a great ROI opportunity for the shareholders. If the acquired company is integrated well within the existing structure, it is not uncommon to see higher revenues and operating income. The higher operating income results from the combination of the revenue stream of the acquired company and the reduced overhead costs which are usually associated with acquisitions. If as a result of the acquisition the company gains a dominant market share position, it can also potentially leverage a higher pricing strategy, thus resulting in higher profits. But what is the effect on the share price?

Short-term share reaction

Short-term you can expect the share price of the target company to appreciate (so if you are the shareholder of a company being bought it is exciting), while that of the buying company to depreciate. The reason this occurs is because the buying company usually pays a premium to take over the company. Such premium acts as an incentive for the shareholders to sell their shares. For the same reason, but not only this reason, the share price of the buying company goes down. They are paying a higher price that what the market valued the company.

Long-term share reaction

If I had an answer to this one I’d probably be writing this article from an island in the Pacific, while sipping on a fresh Pina Colada surrounded by nothing but coconut trees, white sand and crystal clear waters. But here I am, in my tiny living room staring at the poster of such beautiful Island. The truth is that long-term it is impossible to predict the direction of the share price but if the company has good fundamentals and is effective at integrating the acquired company then….Pacific here I come.

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