What investors can learn from M&A payment methods

How management views their company and the expected synergies of mergers or acquisitions (M&A) are usually reflected in the payment methods used by the company, which is valuable information for investors. The payment method makes a candid assessment of the relative value of the company’s stock price from the perspective of the acquirer.

Mergers and acquisitions is a general term used to describe company mergers. In a merger, two companies merge to form a new entity, while in an acquisition, one company seeks to buy another company. In the latter case, the acquiring company is acquiring and the target company is being acquired.

Key points

  • In a merger, the two companies merge to form a new entity. In an acquisition, one company buys another company.
  • The payment method for a merger or acquisition usually reveals how the acquirer views the relative value of the company’s stock price.
  • M&A can be paid by cash, equity or a combination of the two, equity is the most common.
  • When a company uses cash to pay for mergers and acquisitions, it firmly believes that the value of the stock will rise after the synergy is realized. For this reason, the target company is more willing to pay in stocks.
  • The less the company believes in mergers and acquisitions, the more likely it is to pay in stocks, because the target company now also shares some of the risks.
  • If a company’s stock is overvalued, it will choose to use stock to pay for the acquisition. On the contrary, if its stock is undervalued, it will choose to pay in cash.

M&A basis

There are many types of M&A transactions.The merger can be classified as a legal merger, where The target company is completely merged into the acquirer and ceases to exist thereafter; in a merger, two entities merge into a new company or subsidiary, and the target company becomes a subsidiary of the acquirer. During the acquisition process, the acquirer may try to acquire the target company in a friendly manner, or it may acquire a target company that is unwilling to be acquired through a hostile acquisition.

There are several types of mergers. Horizontal mergers are acquisitions of competitors or related businesses. In horizontal mergers, the acquirer hopes to achieve cost synergy, economies of scale and gain market share. A well-known example of a horizontal merger is the merger of automakers Fiat and Chrysler.

Vertical merger is the acquisition of a company in the production chain. The acquirer’s goal is to control the production and distribution process through integration and obtain cost synergies. A hypothetical example of a vertical merger is the acquisition of a tire manufacturer by an automobile company. Integration can be backwards (acquirer buys supplier) or forward (acquirer buys distributor). The purchase of dairy farms by milk distributors is a backward integration. Or, the dairy farm buying milk dealers illustrates the forward integration.

A business group merger refers to the acquisition of a company that is completely beyond the scope of the acquirer’s core business. Take General Electric (GE) as an example. It is one of the largest multinational companies in the world. Since its founding in 1892 by Thomas Edison, GE has acquired companies from a wide range of industries (such as aviation, entertainment, and finance). GE itself was formed by the merger of Edison General Electric and Thomson-Houston Electric Company.

Payment method announced

Investors can evaluate these different types of mergers and acquisitions to understand management’s vision and goals. Acquirers may use mergers or acquisitions to release hidden value, enter new markets, acquire new technologies, take advantage of market deficiencies, or overcome unfavorable government policies.

Similarly, investors can evaluate the value and payment methods that the acquirer provides to potential targets. The choice of cash, equity, or combination provides an internal understanding of how management evaluates its stock and the acquirer’s ability to unlock value through acquisition.

Cash, securities or mixed issuance

Companies must consider many factors when preparing an offer (the potential presence of other bidders, the target’s willingness to sell and payment preferences, tax implications, transaction costs of issuing shares, and the impact on capital structure). Once the bid is submitted to the seller, the public can gather a lot of information, such as how the insiders of the acquiring company perceive the value of its stock, the value of the target company, and their confidence in the ability to realize value through the acquisition. merge.

You can use cash, stocks, or a mixture of the two to buy the company. Stock purchases are the most common form of acquisition; however, the greater the confidence of management in the acquisition, the more they are willing to buy stocks with cash. This is because management believes that these shares will ultimately be more valuable after the merger achieves synergies.

Under similar expectations, the target company will want to pay in stocks. If the payment is made in stocks, the target company will become part of the owner of the acquirer and the beneficiary of the expected synergy. Or, the lower the buyer’s confidence in the relative valuation of the target company, the more the buyer wants to share some risks with the seller. Therefore, the acquirer will want to pay in shares.

Financing

Mergers or acquisitions can also be paid for by taking on debt, which is a different method with pros and cons.

Stocks as currency

Market conditions play an important role in M&A transactions. When the acquirer’s stock is deemed to be overvalued, management may be more willing to pay for the acquisition through share swaps. Stocks are essentially regarded as a form of currency. Since the price of the stock is considered to be higher than its value (based on market perception, due diligence, third-party analysis, etc.), the acquirer obtains greater benefits through stock payment. If the acquirer’s shares are deemed to be undervalued, management may be more willing to pay for the acquisition in cash. By treating stocks as equivalent to currency, more stock transactions are required to pay for purchases at a price lower than their intrinsic value.

Of course, why the company chooses to pay in cash or stock, and the reasons for considering the acquisition (that is, the acquisition of a company that has accumulated tax losses in order to immediately recognize the tax loss, and the purchaser’s tax liability is significantly reduced).

Bottom line

The payment method is the main signal of management. When paying for the acquisition in cash, this is a sign of strength, while the stock payment reflects management’s uncertainty about the potential synergies of the merger. Investors can use these signals to value acquirers and sellers.

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