Which Stock Rises and Which Stock Falls?

When one company acquires another, the stock prices of both entities tend to move in predictably opposite directions, at least over the short-term. In most cases, the target company's stock rises because the acquiring company pays a premium for the acquisition, in order to provide an incentive for the target company's shareholders to approve the takeover. Simply put, there's no motive for shareholders to greenlight such action if the takeover bid equates to a lower stock price than the current price of the target company.

Key Takeaways

  • When one company acquires another, the stock price of the acquiring company tends to dip temporarily, while the stock price of the target company tends to spike.
  • The acquiring company's share price drops because it often pays a premium for the target company, or incurs debt to finance the acquisition.
  • The target company's short-term share price tends to rise because the shareholders only agree to the deal if the purchase price exceeds their company's current value.
  • Over the long haul, an acquisition tends to boost the acquiring company's share price.

Of course, there are exceptions to the rule. Namely: if a target company's stock price recently plummeted due to negative earnings, then being acquired at a discount may be the only path for shareholders to regain a portion of their investments back. This holds particularly true if the target company is saddled with large amounts of debt, and cannot obtain financing from the capital markets to restructure that debt

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What Happens To The Stock Prices Of Two Companies Involved In An Acquisition?

On the other side of the coin, the acquiring company's stock typically falls immediately following an acquisition event. This is because the acquiring company often pays a premium for the target company, exhausting its cash reserves and/or taking on significant debt in the process. But there are many other reasons an acquiring company's stock price may fall during an acquisition, including:

  • Investors believe the premium paid for the target company is too high. 
  • There are problems integrating different workplace cultures.
  • Regulatory issues complicate the merger timeline.
  • Management power struggles hamper productivity.
  • Additional debt or unforeseen expenses are incurred as a result of the purchase.

It's important to remember that although the acquiring company may experience a short-term drop in stock price, in the long run, it's share price should flourish, as long as its management properly valued the target company and efficiently integrates the two entities.

Pre-Acquisition Volatility

Stock prices of potential target companies tend to rise well before a merger or acquisition has officially been announced. Even a whispered rumor of a merger can trigger volatility that can be profitable for investors, who often buy stocks based on the expectation of a takeover. But there are potential risks in doing this, because if a takeover rumor fails to come true, the stock price of the target company can precipitously drop, leaving investors in the lurch.

Generally speaking, a takeover suggests that the acquiring company's executive team feels optimistic about the target company's prospects for long-term earnings growth. And more broadly speaking, an influx of mergers and acquisitions activity is often viewed by investors as a positive market indicator.