Companies can grow either by increasing sales organically or through acquisition. Numerous studies have been conducted about the effect of acquisitions on both the target company and the acquiring company. These studies show that the stock of the acquiring company usually goes down immediately following an acquisition announcement, while the stock of the target company, or company being acquired, tends to go up. This is largely due to the premium the acquiring company has to pay on the target's shares.
After an acquisition is announced, it's common for the acquiring company's stock price to drop while the target company's stock price will rise. Rarely, the acquiring company's stock price will actually go up.
The Incentive to Sell
The most common reason for the increase in price of the target company, and decrease in price of the acquirer, is the market premium the acquiring company must pay on the target company's stock. The shareholders of the target company need an incentive to sell their shares, and that incentive comes in the form of more money. This means the acquiring company typically pays a premium to the target company's stock price.
For example, if a target company trades at $10 per share, the acquirer will probably have to pay a good deal more than $10 per share to convince the target company to sell. The higher the premium, the more the acquiring company expects to benefit from the deal. After the deal is made public, the price of the target company typically continues to trade near the buying price until the acquisition closes.
The Price of an Acquisition
While the stock price of the acquired company usually goes up, the stock price of the acquiring company usually goes down. This is mainly because the premium paid for the target's shares is more than the company is worth, at least on paper. The acquiring company might need to pay additional cash or take on more debt to make up for the difference.
This downward scenario can be further exacerbated by market sentiment. If investors think the target is overpriced based on inflated price-to-earnings or other metrics, they might push the stock price of the acquiring company down even further.
Price Rises for Acquiring Firm
In rare instances, the stock price of the acquiring firm may also go up after a buyout is announced. This usually happens when investors believe the acquiring company received a bargain on the price of the target company. If the acquiring company has a particular weakness and/or a poor brand name that will be helped by the goodwill and reputation of the target firm, this might also push the stock price of the acquiring firm higher.
Long-Term Stock Prices
While studies suggest that the price of the target company will go up immediately following a buyout announcement -- and the price of the acquirer will go down -- these studies are primarily focused on short-term pricing. A good management team, coupled with a good integration strategy, can significantly improve the share price of the acquiring company in the long term.
However, there are no guarantees that any deal, even with the best of management teams, will result in higher long-term stock prices. It's up to the acquiring company's management team to pull enough value out of the acquisition. If the management team struggles or has difficulty with the transition and integration, the deal could push the acquiring company's shares down even further over the long term.