Investors can learn a lot about how management views the value of their firm, and the synergies expected to be realized from a merger or acquisition based on how the company pays. The payment method provides a candid assessment from the acquirer's perspective of the relative value of a company's stock price.

TUTORIAL: Mergers and Acquisitions

M&A Basics
Mergers and acquisitions (commonly referred to as M&A) is the general term used to describe a consolidation of companies. In a merger, two companies combine to form a new entity; whereas during an acquisition, one company seeks to purchase another. In the latter situation, the acquiring company is making the purchase and the target company is being bought. There are many types of M&A transactions: a merger can be classified as statutory (the target is fully integrated into the acquirer and thereafter no longer exists), consolidation (the two entities join to become a new company) or subsidiary (target becomes a subsidiary of the acquirer). During the process of an acquisition, the acquirer may try to purchase the target in a friendly takeover, or acquire a target that does not want to be purchased in a hostile takeover. (To learn more, see Mergers And Acquisitions: Understanding Takeovers.)

There are several types of mergers. A horizontal merger is an acquisition of a competitor or related business. In a horizontal merger, the acquirer is looking to achieve cost synergies, economies of scale and gain market share. A well-known example of a horizontal merger was the combination of auto manufacturers Daimler-Benz and Chrysler. A vertical merger is an acquisition of a company along the production chain. The goal of the acquirer is to control the production and distribution process, and gain cost synergies via integration. A hypothetical example of a vertical merger is a car company purchasing a tire manufacturer. The integration can be backward (acquirer purchases supplier) or forward (acquirer purchases distributor). A milk distributor's purchase of a dairy farm would be a backward integration. Alternatively, a dairy farm's purchase of a milk distributor illustrates a forward integration.

A conglomerate merger is the purchase of a company completely outside of the acquirer's scope of core operations. Consider General Electric, one of the world's largest multinational conglomerates. Since its founding in 1892 by Thomas Edison, GE has purchased companies in a wide range of industries (i.e. electronics, aviation, entertainment and finance). General Electric itself was formed as a merger between Edison General Electric and Thomson-Houston Electric Company. (For more on how mergers should affect your investing decisions, read The Merger – What To Do When Companies Converge.)

Method of Payment is Revealing
These different types of M&As can be evaluated by investors to understand management's vision and objectives. An acquirer might pursue a merger or acquisition to unlock hidden value, access new markets, obtain new technologies, exploit market imperfections or to overcome adverse government policies. Similarly, investors can assess the value and method of payment an acquirer offers for a potential target. The choice of cash, equity or financing provides an inside look into how management values their own shares, as well as the ability to unlock value through an acquisition.

Cash, Securities or a Mixed Offering

Firms have to take many factors into consideration (such as the potential presence of other bidders, the target's willingness to sell and payment preference, tax implications, transaction costs if stock is issued and the impact on the capital structure) when an offer is put together. Once the bid is presented to the seller, the public can glean a lot of insight into how insiders of the acquiring company view the value of their own stock, the value of the target and the confidence that they have in their ability to realize value through a merger. (For more on valuing a company's worth, read What Investors Can Learn From Insider Trading.)

A company can be purchased using cash, stock or a mix of the two. Stock purchases are the most common form of acquisition.

The greater the confidence that management will be able to realize benefits of an acquisition, the more they will want to pay for stocks in cash. This is because they believe the shares will eventually be worth more after synergies are realized from the merger. Under similar expectations, the target will want to be paid in stock. If paid in stock, the target becomes a partial owner in the acquirer and will be able to realize the benefits of the expected synergies. Alternatively, the less confident an acquirer is about the firm's relative valuation, the more they will want to share some of the risk of the acquisition with the seller. Thus, the acquirer will want to pay in stock.

Stock as a Currency
Market conditions play a significant role in M&A transactions. When an acquirer's shares are considered overvalued, management may prefer to pay for the acquisition with an exchange of stock-for-stock. The shares are essentially considered a form of currency. Since the shares are deemed to be priced higher than what they are actually worth (based on market perception, due diligence, third party analysis etc.), the acquirer is getting more bang for their buck by paying with stock. If the acquirer's shares are considered undervalued, management may prefer to pay for the acquisition with cash. By thinking of the stock as equivalent to currency, it would take more stock trading at a discount to intrinsic value to pay for the purchase.

The Bottom Line
Of course, there may be additional factors as to why a firm would choose to pay with cash or stock, and why the acquisition is being considered (i.e. purchasing a firm with accumulated tax losses so that the tax loss can be recognized immediately, and the acquirer's tax liability is lowered dramatically).

The payment method of choice is a major signaling effect from management. It is a sign of strength when an acquisition is paid for with cash; whereas stock payment reflects management's uncertainty regarding potential synergies from a merger. Investors can use these signals to value both the acquirer and the seller. (For another look at analyzing an M&A deal, check out Accretion / Dilution Analysis: A Merger Mystery.)

Related Articles
  1. Options & Futures

    A New Approach To Equity Compensation

    The new financial accounting standard known as FAS 123R could take a bite out of your portfolio. Find out why here.
  2. Options & Futures

    Should Employees Be Compensated With Stock Options?

    Learn the good, the bad and the ugly sides of this type of payout.
  3. Options & Futures

    Bloodletting And Knights: Medieval Investment Terms

    From bloodletting to ye olde black knights, things on Wall Street are getting downright medieval!
  4. Forex Education

    Mergers & Acquisitions: An Avenue For Profitable Trades

    When major corporate transactions have a big impact on the currency markets, you can benefit.
  5. Mutual Funds & ETFs

    The Buy-Side Of The M&A Process

    With almost $2 trillion in sales yearly, find out how these mergers and acquisitions take place.
  6. Investing

    Mergers Put Money In Shareholders' Pockets

    Learn the five ways mergers and acquisitions can increase a company's value.
  7. Term

    How Market Segments Work

    A market segment is a group of people who share similar qualities.
  8. Active Trading

    Market Efficiency Basics

    Market efficiency theory states that a stock’s price will fully reflect all available and relevant information at any given time.
  9. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  10. Investing

    What Investors Need to Know About Returns in 2016

    Last year wasn’t a great one for investors seeking solid returns, so here are three things we believe all investors need to know about returns in 2016.
RELATED FAQS
  1. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  2. What is the difference between positive and normative economics?

    Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic ... Read Full Answer >>
  3. What is the utility function and how is it calculated?

    In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>
  4. How long does it take to execute an M&A deal?

    Even the simplest merger and acquisition (M&A) deals are challenging. It takes a lot for two previously independent enterprises ... Read Full Answer >>
  5. What are some common accretive transactions?

    The term "accretive" is most often used in reference to mergers and acquisitions (M&A). It refers to a transaction that ... Read Full Answer >>
  6. What are some ways to make a distribution channel more efficient?

    While there are many ways to make a distribution channel more efficient, the three high-level ways to increase the efficiency ... Read Full Answer >>
Hot Definitions
  1. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  2. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  3. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  4. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  5. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  6. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center