Understanding mergers and acquisitions

What are mergers and acquisitions (M&A)?

Mergers and acquisitions are financial transactions by which two separate companies can become a single entity. Whether the transaction is a merger or acquisition depends on multiple factors including the deal structure, company valuations and markets affected.

M&As are categorized by type (horizontal, vertical, conglomerate) and form (statutory, subsidiary, consolidation). If you are looking for specific information about mergers and acquisitions, use the links below to navigate through the guide.

What is the difference between mergers and acquisitions?

Mergers involve the combination of two equal companies and result in a new entity formed under one corporate name. In an acquisition, a smaller company is purchased by a larger company. Depending on the terms of the deal, the smaller company may maintain its corporate name and individual status or be completely absorbed into the acquiring company.

Mergers are voted on by boards of both companies and often require shareholder approval, while acquisitions can occur through more aggressive methods carried out by the acquiring company. Some acquisitions are so aggressive they are termed hostile takeovers.

The terms merger and acquisition are often used interchangeably, but most of these deals are technically acquisitions because one company often benefits more than another, if even just slightly.

What is the purpose of mergers and acquisitions?

The purpose of mergers and acquisitions is to allow companies to eliminate threats, acquire new assets, streamline costs and encourage innovation. M&As are the result of a competitive capitalist economy where a crowded marketplace and demand for growth sometimes require companies to acquire or merge with competitors.

How do M&As affect traders and investors?

Mergers and acquisitions can have profound effects on a company’s share price. Share prices of both companies in these transactions may rise or fall depending on the public opinion of the deal made.

Acquisitions

In an acquisition, the buying company must offer a higher price than the current stock price at the time the deal is offered. After an acquisition is announced, the acquiring company’s share price often dips because investors may view the deal as risky or the acquiring company takes on more debt to finance the transaction.

Less often, share prices may rise for the acquiring company. US financial company Charles Schwab’s share price rose 8% in 2019 after announcing a deal to acquire rival TD Ameritrade due to investors approving of the acquisition’s logic and price. TD Ameritrade’s share price also rose 16% after the announcement.

Mergers

In a merger, a new company is established, and shareholders of both companies see their holdings transferred into shares of the new stock. This new stock will be worth more or less than that of the original companies depending on whether shareholders believe the merger will be a success or not.

The transfer of old stock to new depends on the terms of the merger. If one company is valued higher than the other – due to say more revenue or a better debt position – that company’s stock takes precedent. The two merging companies’ stocks are combined in a ratio, for this example say 60:40, which together make up the shares of the new company’s stock. So, if you hold shares of the more powerful company, your holdings would be worth 60% of the new company’s stock, with extra revenue from the deal compensating for the dilution.

This refinancing of old stock can also apply to acquisitions. Continuing with the TD Ameritrade and Charles Schwab example, Ameritrade shareholders were given 1.0837 Schwab shares for every one Ameritrade share held. This was a 17% premium over Ameritrade stock’s 30-day average prior to the deal’s announcement.

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Five types of mergers and acquisitions

M&A transactions can be structured in several ways depending on the companies being combined. The most common structures are vertical or horizontal, which occur when companies share an industry but may or may not be in direct competition with one another.

Horizontal

The simplest type of merger, horizontal mergers involve two companies in direct competition with one another. They may share the same product lines or markets, so merging the two will decrease competition and immediately increase market share.

Vertical

A vertical merger involves two companies on different legs of the buying journey. Think of a direct-to-consumer company merging with a delivery service company to control and profit from both the sale of a product and its shipment.

Market extension

Market extensions involve two companies that offer the same product in different markets, such as two different countries. It may be easier for the companies to merge or for one to acquire the other rather than to expand into a new market already dominated by a similar company.

Product extension

Product extensions involve two companies operating in the same markets that offer related but not identical products. For example, a telecommunications company in Europe may merge with another European company that provides internet-connected devices like phones, televisions or computers.

Conglomerate

A conglomeration occurs when two unrelated companies combine and remain as separate industries. Conglomerate mergers are often done to diversify revenue streams. An example is Walt Disney Company merging with ABC in 1996. The merger allowed Disney to run programs on a popular television network and gave ABC an in-house creative team for future projects.

How mergers and acquisitions are conducted

Once finalized, mergers and acquisitions may take several different routes of integration. These integrations determine how the companies are combined and the transactions carried out. While many deals are classified as plain mergers or acquisitions, these other categorisations provide more information on how the transaction is conducted.

Consolidations

In a consolidation, shareholders of both companies must approve the deal and will receive common equity shares in the new firm. Old corporate structures of both companies are also replaced in consolidations by the establishment of a single new company.

Subsidiary

In a subsidiary merger, the purchasing company uses a subsidiary to buy the target company, allowing the parent company to become the sole shareholder of the target company once the subsidiary company merges with the target company.

Statutory

Statutory mergers can be thought of as an acquisition of assets. It occurs when the acquiring company purchases a smaller company’s assets and liabilities, after which the smaller company no longer exists. Companies can also acquire the assets of another company during a bankruptcy proceeding in which companies are invited to bid on the assets of the bankrupted company.

Management acquisitions

In a management acquisition, also known as a management-led buyout, a public company’s executive branch purchases a controlling stake of their company to take the business private, allowing them more control over operations. Acquisitions like this are typically financed with a mixture of personal resources and debt.

Dell Corporation was a publicly-traded company until its founder Michael Dell acquired the company this way in 2013.

How are mergers and acquisitions financed?

Mergers can be financed either as a purchase merger or consolidation merger. In a purchase merger, one company purchases another with cash or through the issue of a debt instrument. In a consolidation merger, a new company is formed which both companies are brought into.

Assets acquired by the purchasing company such as intellectual property or office space can then be written up to a purchase price and the difference between the purchase price and book value will depreciate annually, allowing the acquiring company to reduce taxes payable.

Acquisitions are typically financed through cash, stock, or an assumption of debt. Some combinations of the three can also be used. Acquisitions can also be financed by acquiring another company’s assets; in this case, the acquired company becomes a shell and must either liquidate or enter new areas of business.

How mergers and acquisitions are valued

Valuations are done by both companies involved in an M&A transaction. The acquirer will seek to purchase the target company at the lowest possible price, while the target company will shoot for the highest price possible. To reach an agreement, companies typically use these metrics.

Comparable analysis

The companies will reference valuations of similar companies to determine a price for the acquired company; if possible, they will also look at similar transactions that have occurred in the industry to help set a price.

Price-to-earnings (P/E) ratio

The acquiring company may compare the price-to-earnings ratio of a target company to all other companies in the same industry to better understand an acceptable purchase price of that company. A company’s price-to-earnings ratio is determined by measuring its current share price to its relative earnings per share.

Discounted cash flow (DCF)

The target company’s value is calculated using projections of its future cash flows. Several considerations are taken including operating profit, depreciation and amortization of assets, operational expenses, taxes, and more.

You can trade shares with City Index in these easy steps:

• Open a City Index account, or log in if you’re already a customer
• Search for the company you want to trade in our award-winning platform
• Choose your position and size, and your stop and limit levels
• Place the trade

Alternatively, you can practise trading shares in a risk-free demo account.