Why does the buyer's share price fall on a takeover?Medium

Partly because somebody is selling it mechanically from the first minute, and partly because paying a premium is a transfer of value that has to be earned back.

3 min read · 477 words

It happens often enough that people treat it as a rule. It is not a rule, but there are three real reasons, and they are worth separating because only one of them is a judgement about the deal.

One: somebody is selling it mechanically

If the buyer is paying in its own shares, merger arbitrage funds do the same trade on the day: buy the target, sell the buyer in the ratio's proportion. That selling is automatic, it arrives within minutes of the announcement, and it has nothing to do with anybody's opinion of the transaction.

The size of it is roughly the size of the deal, so on a large share-funded acquisition it is a lot of selling into one afternoon.

Two: a premium is a transfer

The buyer is paying more than the market price for the target. That difference goes to the target's shareholders on day one. For it not to be a loss to the buyer's shareholders, the combination has to be worth more than the two halves by at least the premium — and it has to be worth it after the cost of achieving it and after tax.

The synergy calculator makes the arithmetic explicit: a premium paid once has to be earned back by annual savings, discounted, for years. When the market does that sum and doubts the answer, the buyer's shares are where the doubt shows up.

Three: issuing shares says something

A buyer choosing to pay in its own shares rather than cash is choosing to hand over a share of the outcome. There is a long-standing reading of that: a company is more willing to spend its shares when it thinks they are dear than when it thinks they are cheap. Whether or not that is true in a particular case, some investors price it.

Cash deals do not carry this, which is one reason the average reaction to a cash offer is different from the average reaction to a share offer.

What it does not mean

• It is not a verdict on the target. The target's shares are up; the two moves are not two opinions about the same thing.
• It is not permanent. The arbitrage selling reverses when the deal completes or breaks, and the shares go back to tracking the business.
• It is not a measure of how bad the deal is. Day-one moves are a poor predictor of what an acquisition eventually delivers, because the thing being judged has not happened yet.

The number to look at instead

Whether the buyer's earnings per share rise or fall on the arithmetic of the deal — see accretion and dilution. It is a crude test and everybody runs it, which is exactly why it moves prices. It is not the same as whether the deal is a good idea, and the page says why.