Is it possible to determine whether a company is a potential takeover candidate before a public announcement has been made? Absolutely—if you know what to look for. Read on to learn the characteristics that well-financed suitors look for in their target companies.

Once you know what the big companies are looking for, you'll be able to determine which companies are prime candidates for takeovers. (See also: Trade Takeover Stocks With Merger Arbitrage and Cashing In on Corporate Restructuring.)

Product/Service Niche

A large company has the luxury of being able to develop or acquire an arsenal of varying services and products. However, if it can buy a company at a reasonable price that has a unique niche in a particular industry (either in terms of a product or service), it will probably do so.

Smart suitors will wait until the smaller company has done the risky footwork and advertising before buying in. But once a niche is carved out, the larger firm will probably come knocking. In terms of both money and time, it is often cheaper for larger companies to acquire a given product or a service than to build it out from scratch. This allows them to avoid much of the risk associated with a startup procedure.

Additional Financing Needed

Smaller companies often don't have the ability to market their items nationally, much less internationally. Larger firms with deep pockets have this ability. Therefore, look for not only a company with a viable product line, but one that, with the proper financing, could have the potential for large-scale growth. (See also: Venturing Into Early-Stage Growth Stocks.)

Clean Capital Structure

Large firms want an acquisition to go forward on a timely basis, but some companies have a large amount of overhang that dissuades potential suitors. Be wary of companies with a lot of convertible bonds or varying classes of common or preferred stock, especially those with super voting rights. (See also: Knowing Your Rights as a Shareholder.)

The reason that overhang dissuades companies from making an acquisition is that the acquiring firm has to go through a painstaking due diligence process. Overhang presents the risk of significant dilution and presents the possibility that some pesky shareholder with 10-to-1 voting rights might try to hold up the deal. If you think a company may be a prospective takeover target, make sure it has a clean capital structure. In other words, look for companies that have just one class of common stock and a minimal amount of debt that can be converted into common shares.

Debt Refinance Possible

In the latter half of the 1990s, when interest rates began to decline, a number of casino companies found themselves saddled with high fixed-interest first mortgage notes. Because many of them were already drowning in debt, the banks weren't keen on refinancing those notes. And so, along came larger players in the industry. These larger players had better credit ratings and deeper pockets, as well as access to capital and were able to buy up many of the smaller, struggling casino operators. Naturally, a large amount of consolidation occurred. After the deals were done, the larger companies refinanced these first mortgage notes, which, in many cases, had very high interest rates. The result was millions in cost savings.

When considering the possibility of a takeover, look for companies that could be much more profitable if their debt loads were refinanced at a more favorable rate.

Geographic Proximity

When one company acquires another, management usually tries to save money by eliminating redundant overhead. In other words, why maintain two warehouses if one can do the job and is accessible by both companies? Therefore, in considering takeover targets, look for companies that are geographically convenient to each other and, that if combined, would present shareholders with a huge potential for cost savings.

Clean Operating History

Takeover candidates usually have a clean operating history. They have consistent revenue streams and steady businesses. Remember, suitors and financing companies want a smooth transition, so they will be wary if a company has, for instance, previously filed for bankruptcy, has a history of reporting erratic earnings results or has recently lost major customers.

History of Enhancing Shareholder Value

Has the target company been proactive in telling its story to the investment community? Has it repurchased its shares in the open market? Suitors want to buy companies that will thrive as part of a larger company, but also those that, if needed, could continue to work on their own. This ability to work as a standalone applies to the investor relations and public relations function. Suitors like companies are able to enhance shareholder value.

Experienced Management

In some cases, when one company acquires another, the management team at the acquired company is sacked. However, in other instances, management is kept on board because they know the company better than anyone else. Therefore, acquiring companies often look for candidates that have been well run. Remember, good stewardship implies that the company's facilities are probably in good order, and that its customer base is content. (See also: Evaluating a Company's Management.)

Minimal Litigation Risk/Threats

Almost every company at some point in time will be engaged in some sort of litigation. However, companies seeking acquisition candidates will usually steer clear of firms that are saddled down with lawsuits. In general, suitors avoid acquiring unknown risks.

Expandable Margins

As a company grows its revenue base, it develops economies of scale. In other words, its revenues grow, but its overhead—its rent, interest payments and maybe even its labor costs—stays the same, or increases at a much lower rate than revenue. Acquirers want to buy companies that have the potential to develop these economies of scale and increase margins. They also want to buy companies that have their cost structure in line, and that have a viable plan to grow revenue.

Solid Distribution Network

Particularly if the company is a manufacturer, it must have a solid distribution network or the ability to plug into the acquiring company's network if it is going to be a serious takeover target. What good is a product if it can't be brought to market?

Make certain that any company you believe could be a potential takeover target has not only the ability to develop a product, but also the ability to deliver it to its customers on a timely basis.

Word of Warning

Investors should never buy a company solely because they believe it is, or may become, a takeover target. These suggestions are merely meant to enhance the research process and to help identify characteristics that may be attractive to potential suitors. (See also: Pinpoint Takeovers First.)

The Bottom Line

With the investment community focused on ever-increasing profitability, large companies will always be looking for acquisitions that can add to earnings fast. Therefore, companies that are well run, have excellent products and have the best distribution networks are logical targets for a possible takeover.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.