Spotting companies that are ripe for a takeover can be a highly profitable way of investing. But to make significant returns, investors need to be invested in the takeover target before there is even a hint of a buyer. In this article, we'll show you seven ways of spotting potential takeover targets before the rest of the market.

Takeover Profits
A takeover, or acquisition, happens when a smaller company is purchased by a bigger one. Owning shares in the smaller target company can be a big boon if it is purchased. That's because, in most instances, the purchasing company offers a price premium for the target company's shares.

Typical takeover premiums are 20-60% above the pre-bid market price. If the takeover turns into a bidding war with other potential buyers, the premium can climb even higher, in the order of an additional 10-25%. (Find out more about acquisitions in The Basics Of Mergers And Acquisitions and Mergers And Acquisitions - Another Tool For Traders.)

As Figure 1 shows, sizable share price gains can occur within days, weeks and months, rather than years.

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Figure 1: Hefty Gains: KOS Pharmaceuticals was acquired by Abbott Labs, November 2006, for a 54% premium.

Clearly, there are profits to be made from spotting a potential takeover target. But ideally, investors need to own shares of the target before market rumblings about a possible acquisition push up the price of the stock. Of course, you can still buy the stock after an acquisition deal is announced, but by then much of the upside will already be factored into the share price. (To read about other areas of takeovers, see Trade Takeover Stocks With Merger Arbitrage, The Wacky World of M&As and Bloodletting And Knights: A Medieval Guide To Investing.)

What to Look For?
So, how does an investor pick out the next target stocks before the market catches on? Here are seven ways to discover those takeover candidates:

1. Check the Industry
Sectors where there are mounting prospects of takeovers and mergers are good places to start looking.

Strong growth tends to get merger juices flowing. In booming industries, cash-rich companies with high valuations often get tempted to make acquisitions. They start to become more outward focused and their chief executives get more comfortable with the idea of combining their companies. Moreover, as the mood turns to growth, lagging companies can be put under pressure to match returns of their faster growing peers.

In many cases, the only path to growth for these companies is through acquisitions. Investors are wise to look at companies operating in sectors that are going global, where the need to expand on a very large scale is especially urgent.

At the same time, industries where growth is lagging can also be good places to find takeover prospects. In some cases, acquisitions can be designed for defensive purposes such as protecting against a market downturn. Look at industries under pressure, where competition and costs are getting intense and companies are better off operating under shared ownership.

Industries facing changes in regulation and legislation are often ripe for takeovers. Industry deregulation, which allows companies to act more freely, can set the stage for merger and acquisition activity, as can a loosening of foreign ownership restrictions, which can set off a wave of takeovers by overseas companies. (To learn more about industries and growth, see The Stages Of Industry Growth, Industry Handbook Tutorial and What is the difference between an industry and a sector?)

2. Find Focused Businesses
Naturally, companies with solid businesses and good long-term prospects are always the most sought after. Look out for companies with proved management and technical experience. Companies with strong, well-focused product lines that can fill gaps in the larger firm's existing business are also promising targets. Alternatively, targets might be companies with assets that are hard to duplicate. They may have production capacity or customers that are coveted. A corporation will seek out a successful company and try to expand its assets and take advantage of synergies the two companies share.

3. Uncover Underperforming Companies
On the other hand, takeover targets can include companies with underperforming assets - businesses that the company proposing the takeover thinks it can run better than the current owner. For instance, a company may underperform because it lacks investment, which limits its growth opportunities. If a new owner provides much-needed capital, then the real value in the business can be unlocked.

Underperforming companies tend to have low market valuations - and corporate buyers love companies that are undervalued. Acquirers can most easily afford to pay the necessary price premium if the shares they buy are bargain-priced, which means that undervalued stocks are among the most likely targets.

These companies frequently sell at lower price-to-earnings (P/E) multiples compared to industry peers. Other times, these companies trade at low asset valuations. They may have several divisions that, if the company were broken up and the pieces sold or spun-off, would return more than the purchase price. (To learn more, see Understanding The P/E Ratio.)

4. Follow the Rainbow to the Pot of Gold
High on acquirers' list of takeover features is strong, steady cash flow. Leveraged buyouts, for instance, require a reliable stream of cash to pay back the enormous debt taken on to purchase the company. Acquirers are most interested in the target's free cash flow (FCF). Definitions of free cash flow vary, but Wall Street analysts commonly use one that's defined as:

fcf.gif

Typically, a company trading at less than six or seven times its free cash flow is attractive.

Look for companies with little long-term debt and plenty of cash on the balance sheet. Low debt leverage - well under 50% of the company's market capitalization - catches the eye of acquirers aiming to finance a deal by ways of bonds or bank debt. Divide the amount of cash on the balance sheet by the number of shares outstanding and compare that figure to the stock price. A stock selling for less than three or four times its cash per share would likely tempt a buyer. (Learn how to read company financials in Breaking Down The Balance Sheet, What You Need To Know About Financial Statements and Advanced Financial Statement Analysis.)

5. Check the Share Register
Look for stocks with partial ownership by other companies. On occasion, ownership may be a prelude to a merger proposal or a tender offer for the remaining shares outstanding. A company with an eye to making an eventual acquisition may begin quietly by accumulating shares. Once the ownership position reaches 5% of outstanding stock, the acquirer must report this information to the Securities and Exchange Commission (SEC) in a 13D filing. In the initial filing, the purchase might be described as for investment purposes, but often the buyer includes an escape clause leaving room for an eventual tender offer. (Read more about this process, see Digging In To 13D Disclosures.)

If the stock is owned by a few large institutional investors or venture capitalists, a bid is more likely to be successful than if the stock is owned by a large number of small investors. Big fund managers with key stakes can be very aggressive in forcing changes in management and ownership. Because takeovers can become attached to high premiums, they are a preferred exit route for these large investors. It's not unknown for institutional investors to quietly do the rounds, sounding out potential acquirers and prompting a bid. So, the trick is to spot small companies owned by big institutional or venture capital investors.

Companies with a strong family holding can also be vulnerable to takeovers. Family members can fall out or want to realize their cash, and that can be a prelude to a sale of the company to outsiders.

6. Listen to the Buzz
It goes without saying that you should invest based on solid research. That said, it's worthwhile listening to others' thoughts on takeover activity. Investment bank and brokerage analysts frequently speculate on potential mergers and takeovers. In some cases, the speculation can become a self-fulfilling prophecy as the banks that employ these analysts are often the same ones putting together takeover deals. Rumblings in online blogs and chat rooms have, in some cases, also turned into actual deals. Of course, you should never buy on rumor or speculation alone, but sometimes, it can certainly help to support an investment thesis. (To read more about following market buzz, see Mad Money ... Mad Market?, Leading Indicators Of Behavioral Finance and Trading Psychology: Consensus Indicators - Part 1.)

7. Don't Dismiss the Obvious
It's not unheard of for companies to report that they are looking to "bulk up" or diversify into a certain sector or product line. At this point, you may want to start looking at potential targets. At the same time, you may read in the press that an underperforming company is pursuing "strategic options", which is often a thinly-veiled way of saying that it is looking for a buyer. Companies' management and major shareholders have been known to openly announce they are assessing buyers' interest.

As Figure 2 shows, even at this stage, it may not be too late for investors to take advantage of further share value appreciation.

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Figure 2: Early Indicators: Phelps Dodge Corp. was acquired by Freeport-McMoran

Conclusion:
Of course, picking a takeover target involves doing a lot of homework, and in each case, there is an element of chance and no guarantee of success. The company you bet on may never get acquired. Moreover, even if a deal is reached, it could very well never come to fruition. It may be blocked by takeover laws or scuttled by financing problems, due diligence outcomes or personality clashes. Nevertheless, being on the right side of a merger deal can be worth the effort and risk.

To continue reading on this subject, see Cashing In On Corporate Restructuring.

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