What Happens to Stocks When Companies Merge?

The term “M&A” often conjures up visions of an almost exotic investment opportunity. On the one hand it isn't well understood by the general public, but it can still cause an anticipation of miraculous profits for investors.

M&A, which is an abbreviation for mergers and acquisitions, is a common business occurrence. In some cases, it enables a business to expand without the need to grow organically. In others, it's an action taken to acquire specific assets of another company.

But what exactly is M&A, what happens to stocks when companies merge, and should you invest in a company that announces one?

What Is M&A?

M&A is essentially an activity in which two companies come together. During M&A, the two companies either form a single entity or remain separate organizations, with one owning a controlling interest in the other.

Whether the transaction is a merger or acquisition, the objective is to build synergy between the two organizations. This often happens when two companies engaged in the same industry launch an M&A to expand market reach. Or perhaps two companies in separate but related industries come together to form a more seamless business operation.

An example of the latter is where an automobile manufacturer acquires an auto parts manufacturer. By acquiring the auto parts company, the auto manufacturer gains greater customization and lower costs of parts used to build their cars.

Ultimately, the belief is that two organizations' union will create a stronger company than the two original entities operating separately.

What Happens to Stocks When Companies Merge?

There are many details involved in M&A transactions, but one factor is a constant: Mergers and acquisitions affect stock prices. The effect is positive in enough cases that M&As draw widespread investor interest. In the stock investing universe, M&As holds the very real possibility of making the proverbial quick killing: a stock price rising in double-digit percentages in a matter of days or weeks.

The attraction of mergers and acquisitions is so great that some investors focus much, most or even all their time looking for potential deals. And why not — find the right M&A deal, and your investment can skyrocket, providing returns many times higher than the typical buy-and-hold strategy based on the S&P 500.

But sometimes M&A profits are passive in nature. Because mergers and acquisitions are so common, it wouldn't be unusual to have a stock in your portfolio become part of one overnight. That means you could be sitting on a potential gold mine that's just waiting for the right set of circumstances to play out.

Typically, it's the stock of the company being purchased in the M&A transaction that gets the biggest lift. It can literally explode in price just on the announcement of the deal. However, the acquiring company's stock can also move in a positive direction if the market perceives the deal will significantly improve the operations and profits of that company.  You can use a financial advisor like Personal Capital to easily track your investments in a company that announces an M&A.

The Difference Between a Merger and an Acquisition

Though the terms merger and acquisition are often used interchangeably, each represents a different transaction.

Merger Activity

Because publicly traded companies come in so many different sizes and shapes, a merger of two equal entities is rare. That's why one company usually emerges as the dominant entity after the merger.

With a merger, two businesses combine operations in a transaction designed to improve shareholder value. A merger typically involves one company purchasing the shares of the other based on a certain ratio.

Acquisition Activity

In an acquisition, the company being acquired usually remains a substantially independent entity. The acquiring company buys sufficient stock in the company to give it a controlling interest over the organization.

The two companies remain two separate entities rather than merging into one. The acquired company usually maintains its original form and management lineup. But there may be certain changes in both operations and personnel after the acquisition takes place.

In the acquisition, the larger entity typically purchases the smaller one. But the acquiring company sometimes allows the transaction to be referred to as a merger to preserve the acquired company's goodwill.

Pre-acquisition Volatility

Volatility makes mergers and acquisitions potentially risky investments. While it's true that the stock in the company being acquired can rocket on just the announcement of the merger or acquisition, that doesn't mean the rise is permanent.

That's because a merger or acquisition that's been announced isn't a done deal. In most such transactions — especially those of very large companies — there are a multitude of details that need to be worked out before the deal is consummated. Any one of those details could derail the deal.

An even more significant risk factor is regulatory action. Many mergers and acquisitions must be approved by one or more government agencies. If that approval looks doubtful or is withheld, the deal will be off, and the stock price could crash.

Pre-acquisition Volatility Can Go in Either Direction

The announcement of the deal often causes euphoria surrounding a company that keeps the stock price powering forward. But it's still too early to assess the long-term outcome of the M&A.

Sometimes that produces a serious dilemma if you're already holding stock in a company that's acquired. Let's say the price takes off, producing an instant gain. Now you face a choice. Either sell and collect your profits now or hold and wait for what could be higher gains once the deal is done.

The prospect of a quick killing easily causes emotions to overrun intellect, so it's tough to decide rationally.

Risks & Benefits of M&A Investing

The most obvious benefit to M&A investing is the potential to reap big gains quickly. It's also possible to make an even bigger profit if you hold your stock until the deal is consummated.

• With an announcement of an M&A transaction, excitement over the deal is highest. But the stock price in the company being acquired still typically trades at less than the acquisition price. That's because the market is pricing in the risk that the deal won't happen.
• But if you hold on and the transaction goes through, you get the full amount of your stock's acquisition price. You could see even bigger gains if the market views the M&A as a positive development that will lead to higher company revenues and profits. That's when the price of the stock could rise to well above the acquisition price. But that sometimes requires months of delaying the realization of your gain from the deal.

The Risks Are Large

Naturally, any arrangement as profitable as M&A investing also carries a large degree of risk. And the biggest risk is that the M&A blows up before the deal is finalized.

1. When you buy stock in either company after an M&A is announced, you pay a premium price. And if the M&A falls through, the value of the stock sinks on the announcement the deal has been abandoned.
2. Still another risk is the possibility that the terms of the M&A change before completion. That even includes the acquiring company lowering the price they're willing to pay for the acquired company.

In either of the previous two situations, you have less risk if you owned the stock in your portfolio long before the M&A was ever announced. You may already have a built-in profit from holding the stock for several months or years. And any loss resulting from the abandonment of the deal will likely be temporary.

Further Reading>> How to Invest in stocks

Things to Keep in Mind During an M&A

• The single best advice during an M&A is to keep your cool. Price volatility with an M&A begins on nothing more than rumors of a deal taking place. That makes seeking out M&A deals a high-risk game from the very start. If M&A announcements carry a risk of not happening, rumors have an even bigger risk.
• Most of the gains in the stock of the target company usually come from the announcement of the M&A. But that's not always the case. Even on the deal's announcement, the stock may trade at a discount to the acquisition price, adjusting for the risk that the transaction may never take place.
• Look at both companies' financials and consider analyst reports to determine if the deal is likely to be profitable on a long-term basis. Profitability makes the M&A more likely to happen. And it provides more protection against short-term volatility.
• Also, a declining stock market negatively affects the value of stocks in M&A deals. In a rip-roaring, take-no-prisoners bear market, the stock's values in both the acquiring company and the target company could fall even in what is obviously a solid deal.
• If you are already holding the stock of a target company and it results in a substantial gain, it may be prudent to sell your position. There could indeed be greater profits in waiting until the deal consummates. But the risk that it never happens could erase the gains and cause the stock price to fall below its pre-announcement level as the market overreacts to the withdrawal of the offer.

Keep Your Emotions in Check

If you're getting the impression M&A investing is not for the faint of heart, you're thinking in the right direction. Profits can be spectacular, but they're not always easy to identify. Because there are a plethora of reasons an M&A won't be realized, the likelihood of losing money by jumping into a deal in progress is at least as great as making money.

If you decide to invest in M&As, do it with only a small percentage of your portfolio. And do your research. But perhaps most importantly, keep your emotions in check. If you get too greedy, you could lose money.

But if you approach the deal as a long-term investment — even if your intentions are only short term — you'll take a more rational approach to the investment. After all, any investment you make should be based on hard numbers and not on expectations.