Mergers and Acquisitions

Why this matters

A company can spend years of profit on one purchase, decided in a few weeks. Own shares for long enough and a company you hold is likely to buy something or be bought. In the first case you need to judge whether your money is being spent well. In the second you'll be offered a price and need to decide what to make of it. The tools are the ones from Capital Allocation Decisions, applied to a single large decision.

Why companies buy other companies

• To cut costs. Two companies in the same business need one head office, one set of systems, and fewer overlapping factories or branches.
• To sell more. One company's products go through the other's sales channels, or into its markets.
• To buy what would take years to build: a technology, a brand, a team, or a licence.
• To gain scale against suppliers, customers, or competitors.
• To grow. When a company's own business has slowed, buying another is the quickest way to keep the totals rising. It's the weakest reason of the five.

The extra profit expected from combining is called synergy. Savings from removing duplicated costs are largely within management's control. Extra sales depend on customers, which makes them harder to count on.

The price, and who gets the gains

The target's shareholders can already sell at the market price. To persuade them to give up the whole company, a buyer has to offer more. The difference is the premium, which Comparable Companies and Precedent Transactions introduced. The buyer comes out ahead only if what it gains from combining is worth more than the premium it pays.

A target has 50 million shares trading at $40, a market value of $2,000 million. A buyer offers $52 a share in cash, a 30% premium. It expects savings of $50 million a year after tax, valued here at a 10% required return. Assume the market price was a fair value for the target as an independent company.

	All savings arrive	60% of savings arrive
Value of the target on its own	2,000	2,000
Value of the savings	500	300
What the buyer receives	2,500	2,300
What the buyer pays	(2,600)	(2,600)
Gain or loss to the buyer's shareholders	(100)	(300)
Gain to the target's shareholders	600	600
Value created by the deal	500	300

The deal creates value in both columns. Combining the companies really does save money. But the buyer paid $600 million for savings worth $500 million at best, so all of the gain and a little more went to the sellers. The target's shareholders collect their premium in cash on the day the deal closes. The buyer's shareholders are left with the task of earning it back.

This is how a merger can be a success for the economy and a failure for the company that paid for it. The seller's gain is certain and immediate, and the buyer's depends on forecasts made by the people who wanted to do the deal.

What the evidence says

A study of mergers from 1973 to 1998 found that the stock market's response at announcement was positive for the two companies taken together, which suggests that mergers created value for shareholders overall.¹

How that value is divided is another matter. A second study found that in the 1980s the shareholders of acquiring companies lost 1.6 cents at announcement for every dollar spent on acquisitions, a loss more than offset by the gains to shareholders of the companies acquired. From 1998 through 2001 they lost 12 cents per dollar spent, $240 billion in total. That loss came from a small number of deals announced by companies with extremely high valuations. Without those deals, the acquirers' shareholders would have gained.²

Two things follow. An acquisition isn't bad news by default. And in that period the deals that did the most damage had a recognizable shape: very large, and made by a company whose own shares were priced for great things.

The rest of this lesson is for members

Still to come in this lesson: Cash or shares, What gets disclosed, Judging a deal, the key takeaways, and 2 quiz questions with explanations.

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