LEVEL: BEGINNER
Mergers and acquisitions, often shortened to just “M&A”, are significant events in a company’s history that has tremendous impact on the company’s investors. In many cases, entrepreneurs begin their companies with the hope of being acquired by a bigger company, or small companies will often combine their forces with other companies to create larger, more efficient, and profitable ventures.
At its core, a “merger” is when two companies become one, and a merger is usually a mutually beneficial agreement between two companies who believe that combining will increase their profits and revenue. An “acquisition” is not always mutually beneficial, and may often be disastrous for the company being acquired.
For now, we’ll focus on mergers.
The Decision to Merge
When two companies who have been business partners decide that their practices are compatible, they may decide to merge to combine resources so that new business opportunities might flourish. Alternatively, two competing companies in the same space may decide that the market has changed in such a way that it would be better for both companies to come together and work as one. In some cases this is because the market has gotten smaller, but in several cases it’s a sign that market growth is allowing for substantial opportunities.
Several possible motivations might be behind a merger, but on the whole these moves are usually seen as positive in the market. One reason for this is that it gives greater insight into the value of both companies, and it suggests that the new company, with the combined financial and manpower resources of the two smaller companies, will be stronger than either previous company was alone.
Since a merger can involve the exchange of hundreds of millions of dollars and involves both companies deciding on the value of each other, it is also a good indicator for the market to know exactly how much each share is worth. Since the most valuable asset in investing is certainty, this kind of knowledge usually boosts confidence and raises the price of the company’s stock.
The Effects on Stock Price
On the day a merger is decided, the price of both companies will usually shoot up. If the companies decide that one of the companies is worth more than the current share price, it can make that company’s stock go up even higher.
Even if no upward revaluation of stock price is announced, companies tend to see their stock prices increase as investors get optimistic. For example, when mining company Xstrata (LON: XTA) and commodity producer Glencore (LON: GLEN) announced their plans to merge at the beginning of February 2012, both stocks shot up over 15% in three days. While both companies’ shares lost a bit of value in later days, the companies’ stocks maintained higher values as investors anticipated the boost that the stocks would get from an announcement that either company was going to announce that the other company was worth more than the market’s current price.
Pitfalls and The Long-Term Impact for Investors
The Glencore-Xstrata case is a good example of one of the biggest pitfalls of mergers: they often fail. As winter merged into spring and opposition from some high-profile investors delayed the deal, the deal became less and less likely, and the value of both companies fell. By the end of August, analysts were saying that the deal was dead.
Part of this opposition came from a common problem with mergers: disagreement on value. Xstrata investors demanded that Glencore pay 3.5 shares of the company in exchange for every share of Xstrata, while Glencore offered only 2.8 shares. In other words, they disagreed on the value of the company, with both sides saying the other side was incorrectly valuing the company by 25%.
That’s a big margin of error and the failure for both sides to agree on a fair price has resulted in the merger failing. The gains that the merger announcement gave the stock are gone, and both companies’ shares are worth even less than before the merger was announced.
While mergers are often met with enthusiasm and hope in the market, when they fail, they can hurt companies both in the short and long terms. This is partly why a successful merger involves a huge spike in a company’s value: in many cases, the announcement causes the stock to go up, and then when the deal is done, the stock goes up even more.