Q: Why do investors get so excited when companies get bought out?
A: First, a quick definition of two types of mergers:
1. Horizontal — This is when two similar companies merge.
2. Vertical — This is when companies in different stages of the “supply chain” merge. An example would be if a paper mill buys a timber company.
Vertical mergers tend to be very company-specific and trigger less industrywide stock market speculation. There are a number of reasons to be both excited and wary when talks of horizontal mergers surface. When you see an industry perform well in the stock market after a merger announcement, one major reason is speculation that more mergers will follow. This is theoretically positive for three reasons:
1. Typically, buyout prices (the price you would receive as an existing shareholder when your company is purchased) tend to be at a premium to the market price of the company. That price is equal to the number of shares outstanding (float) multiplied by the price per share; essentially it’s the price at which you can sell your stock.
2. Horizontal mergers tend to be positive for an industry because, once completed, there are fewer companies in the industry. This turns companies into “price-setters” as opposed to “price-takers.” In other words, the more companies selling the same or similar products, the less power each of them has to increase their prices. As the number of companies selling declines, the “supplier power” increases. In other words, profitability has the potential to increase as competition is reduced.
3. “Synergy” (from the Greek “synergo”) is the word used to describe what occurs when parts together equal more than their sum individually. In the context of mergers/acquisitions, it is typically used to describe the cost savings that occur when similar companies combine.
Typically there are redundancies in the cost structure that can be eliminated. There may also be “economies of scale,” which describes the increasing profitability of larger volume.
While any one merger likely has very specific reasons for exciting investors, those reasons are more than likely founded in one or more of the above concepts.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. John C. DeMoss, CFA, is president of DeMoss Capital. Submit questions to his attention by writing to Business Editor John Vass Jr., Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by e-mailing him at jvass@timesfreepress.com.