The deal where Yahoo is buying Tumblr got me thinking about a question that I get asked whenever there is a big merger or buyout between companies. Often, when one company buys another company, the buying company’s stock price goes down in reaction to the news. Why does the acquiring company stock price go down so often?
Stock Price Reaction to Buying Another Company
Investor reaction to deal of Yahoo buying Tumblr was understandably muted. First, Tumblr is not a publicly traded company, so there is no way for its stock price to react at all. Second, at a reported price of $1 billion the acquisition isn’t exactly a blockbuster deal in terms of size. However, when one publicly traded company buys another, there is often an immediate dip in the share price of the acquiring company.
Before we get started on exploring why the buying corporation’s stock goes down, it is important to remember that stocks do not trade in a vacuum. There are millions of people buying and selling stocks, with millions of different objectives, millions of different time frames, and millions of different investment philosophies. At any one time, any of those competing motivations can affect the price of a company’s stock.
However, all other things being equal, the drop in the company stock price that is buying out the other company is a simple matter of balance sheet math.
In a typical corporate buyout, the acquiring company pays a “premium” for the company being bought out. For example, if FinanceGourmet were a publicly traded company with a stock price of $30 per share, and my freelance writing business, ArcticLlama were buying it, then ArcticLlama would pay more than $30 per share. The amount above the $30 share price is called the premium
Why Corporations Pay a Premium to Buy
Theoretically speaking, a company’s value at any point in time is the price of its stock multiplied by all the shares of stock. So, if FinanceGourmet has 10 million shares and it trades for $30 per share, then the value of the company is $30 million.
Why doesn’t Arctic Llama just buy Finance Gourmet for $30 million, then?
The idea is that if the company is already worth $30 million, then selling gives the shareholders of FinanceGourmet nothing. Why should they sell? Instead, ArcticLlama will offer $35 per share, for example. That gives a $5 per share profit for current investors and provides the motivation for agreeing to sell. The bigger the premium, the more likely a transaction will be approved by shareholders and the board, all things being equal.
Now, the catch is that if FinanceGourmet is only worth $30 million, but ArcticLlama is paying $35 million. For the shareholders of ArcticLlama, this is the same thing as losing $5 million. If there were no other factors at play, then the price of ArcticLlama’s shares would drop by the same amount. For longer-term investors, there is the issue of how well the merger or purchase will play out. Deals seen as most likely to succeed will result in a smaller drop in share price since investors believe that they will get the purchase premium back and more. Deals seen as less likely to succeed may see a higher drop as investors worry that not only is the premium a lost asset, but there might also be further costs down the line from the purchase.
On the other side of the coin, the acquiring company’s shares usually rise to an price very near the price offered for the buyout. Since someone going to pay $35 per share for the company very soon, why would an investor be willing to sell their shares for anything less?
Since most merger and buyout news is announced while the markets are closed, the stock of the company being bought will usually open for trading at a price near, but not equal to the buyout price. The gap between the purchase price and the current price per share of the target company represents the risk that the deal might not go through for some reason. The greater the gap, the riskier the deal is seen to be by investors.