Four ways mergers and acquisitions can impact stock prices. (2024)

Mergers and acquisitions (M&A) are complex commercial transactions that can substantially impact the stock values of firms. Understanding the potential Impact of M&A activity on stock prices is crucial for investors looking to make informed decisions about their portfolios.

While M&A activity can often lead to exciting growth opportunities, it can also create uncertainty and risk that can significantly impact the stock prices of the companies involved.

Several factors can influence the direction of stock prices in the wake of an M&A deal, including market reactions, financial performance, competition, and growth potential.

This article will explore four ways M&A deals can impact stock prices. By understanding how M&A deals affect stock prices, you can be prepared for whatever the market throws your way and make informed decisions about responding to these market changes.

What influence does M&A have on Stock Prices?

Mergers and acquisitions (M&A) are common in the business world, with companies seeking to expand their operations and increase their market share. The news of a merger or acquisition deal can trigger a reaction in the stock market, with investors adjusting their positions in response to the information.

Depending on the nature of the agreement and the perceived benefits and risks of the transaction, the stock prices of the firms involved may rise or fall.

Here are four ways in which M&A deals can impact stock prices:

1| Volatility in pre-acquisition transactions.

Pre-acquisition transactions are deals or activities that occur before a merger or acquisition deal is officially announced or completed. Before reporting an official merger or acquisition, the stock prices of potential target firms typically rise.

These activities can include rumors of an upcoming merger, negotiations between companies, or indications of interest from potential buyers. Such actions can create volatility in the stock prices of the companies involved in the transaction.

When rumors of a merger or acquisition surface, it can cause investors to speculate on the potential outcome of the deal and start buying or selling the stocks of the companies involved. It can create a fluctuation in the stock prices of both the acquiring and target companies.

However, you need to be cautious when reacting to pre-acquisition activities such as takeover rumors because if the deal falls through, it can cause a significant drop in the target company's stock price, as was the case with Grubhub when negotiations with Uber became more public, leading to a stabilization of stock prices and a subsequent 3% drop in Grubhub's stock price.

You need to be aware of such activities and understand the factors that can affect the direction of stock prices to make informed investment decisions.

2| Impact the target company.

When a company becomes a target for a merger or acquisition (M&A) transaction, it can significantly impact its stock price.

The impact on the stock price can depend on various factors, including the terms of the deal, the industry trends, and the target company's financial performance before and after the agreement.

The acquisition frequently increases the target firm's stock price since the acquiring company pays more for the target shares to gain the shareholders' approval.

As a result, the selling company's stock price increases due to the premium paid, which opens the door to more potential investors.

A case in point isSalesforce acquisition of Slack. When the deal was announced, the stock price of Slack soared by more than 37%, reflecting investor confidence in the deal. While salesforce saw the acquisition as a strategic move to expand its workplace communication and collaboration market presence, investors saw significant growth potential for both companies.

However, this might only be true in some cases.

Suppose the market perceives the deal as undervaluing the target company or investors perceive the target company as compelled to engage in the transaction due to financial difficulties or external pressures. In that case, it can be perceived as unfavorable, leading to a potential decrease in the stock price.

Furthermore, the stock price may fall if the market believes the target company could have gotten a better deal elsewhere.

Upon announcing the deal, Whole Foods' stock price surged by 29%, reflecting the market's positive perception of the acquisition.

However, some analysts and investors later criticized the deal, arguing that Whole Foods could have gotten a better deal elsewhere. Some shareholders also argued that the deal undervalued Whole Foods and that the company was forced to engage in the transaction due to financial difficulties and external pressures.

As a result, the stock price of Whole Foods started to decline after the initial surge, and it ultimately settled at a price lower than the acquisition price.

3| Impact on the acquiring company's stock price.

Upon announcement of a purchase, the purchasing company's stock tends to decline for a short period since it pays a premium with cash or debt. This can happen for these two obvious reasons:

When the company pays cash for an acquisition. Usually paying with cash scares investors because the company cash reserves reduces. Investors may also be concerned that the acquiring company is overpaying for the target company, which could strain its finances and negatively impact its stock price.

When acquiring companies use debt to finance M&A deals. This increases the company's debt-to-equity ratio and puts pressure on the company's credit rating. Investors may view this move as a negative sign, leading to a decline in the acquiring company's stock price.

In either case, the acquiring company's stock price may initially decline due to the perceived financial risk associated with the deal.

Usually, the stock price decline is only temporary.

Once investors have time to digest the news and assess the deal's potential benefits, the stock price may recover. The perceived strategic value of the acquisition, increased market share, or cost synergies that could enhance the acquiring company's financial performance may drive this recovery.

4| The impact of the market's reaction on stock prices after a merger.

The stock prices of both the acquiring and target companies may go up if investors perceive an M&A deal to be favorable. This is likely to happen when the market views the deal as strategic, with the potential to increase market share, expand the product line, or enhance the financial performance of both companies.

For example, in 2019, United Technologies Corporation (UTC) announced plans to merge with Raytheon Company.UTC's stock price increased by 2.3% on the day the merger was made public, and Raytheon's stock price rose by 3.3% as the market reacted positively to the news. Investors saw the merger as a strategic move that could improve the companies' competitive positions and create cost synergies.

What happens when the market perceives an M&A deal as unfavorable? Your guess is as good as mine. The stock prices decline for both companies.

Similarly, adverse reactions can occur if investors view the deal as overpriced, risky, or unlikely to generate the expected benefits.

One instance where stock prices were adversely affected is the case ofHewlett-Packard's (HP) acquisition of CSC.In 2016, HP announced its intention to acquire the technology services company for $8.5 billion. However, the market reacted unfavorably, with HP's stock price falling 1.6% on the day of the announcement. Investors considered the deal to be overpriced and questioned whether it would deliver the expected benefits.

As seen from the above cases, positive reactions can boost stock prices, while adverse reactions, on the other hand, can lead to declines in stock prices.

How does a reverse merger impact stock?

A reverse takeover occurs when a private corporation purchases a publicly traded company. The owners of the private company become controlling shareholders of the public corporation and run the business.

Announcing a reverse merger may initially increase the publicly traded company's stock price due to the anticipation of the union.

However, the impact of a reverse merger on the stock price of the publicly traded company can vary depending on the private company's perceived value and growth potential. If investors perceive the private company as having high growth potential and a solid business model, the stock price of the publicly traded company may continue to rise.

When perceived as risky or unproven, the stock price of the publicly traded company may decline.

Additionally, suppose the publicly traded company's shareholders are unhappy with the merger terms or have concerns about the private company's financials. In that case, the stock price may also decline.

Should you buy a stock before a merger or acquisition?

Deciding whether to buy stock before a merger or acquisition can take time and effort. Several factors determine it, including the companies involved, the terms of the transaction, and the market's reaction to the news.

Analyzing the deal terms and understanding how they will impact the target and acquiring companies is essential. For example, suppose the acquiring company is paying a high premium for the target company. In that case, it may be a red flag that the acquisition won't be profitable in the long run.

Again, if the acquisition necessitates the acquiring company incurring substantial debt, this could impact the company's financial health and future growth prospects.

The timing of investment can also be important. If you buy stock early enough, you may take too much risk if the deal falls through. Conversely, if you wait too long, you may miss out on potential gains. It's essential to find a balance between timing and risk management.