When One Company Buys Another …

Who’s better off?

Bank of America announced today that it will acquire the biggest credit card company in the country, MBNA, for $35 billion. After details of the proposed merger were made public, the companies’ stock prices went in opposite directions: Bank of America’s stock has fallen in value, while MBNA’s shares have jumped. In situations like this, whose stock does better—the target of a takeover or the company that made the offer?

The target. In order to take over MBNA, Bank of America must buy the company’s stock from its investors. Since investors expect a merger will increase profits, they typically demand a higher price for their stock than that at which it’s currently trading. According to the terms announced today, Bank of America would pay out the equivalent of $27.62 for each share of MBNA, a 31 percent premium over its market value.

Over the past couple of decades, successful mergers have yielded average “takeover premiums” of about 35 percent. That means that when a deal is finalized—the MBNA-Bank of America acquisition should go through by the end of the year—each of the targeted company’s shareholders will make a lot of money. Early reports indicate that MBNA stock went up 25 percent on the news, as investors realized that—should things work out as planned—they would receive a fat premium down the road. The gap between the initial jump (25 percent) and the reported premium (31 percent) means that investors think there’s some risk that the deal won’t be consummated at the terms originally announced.

What about the company that made the offer? In theory, the bidder should increase in value too, since it will also prosper off the “synergy” from the merger. But on average, the company’s stock actually goes down a bit on the news. One reason for this is that the acquiring company is often much bigger than the company it’s taking over. If the expected value of the merger gets split across the two, the bigger company will see a much smaller percentage increase in value, and the boost in total value might not be as apparent.

Second, investors tend to worry that the acquiring company has overpaid for its target. Stock analysts have already described the terms of Bank of America’s deal as “a very rich price” and a “huge premium.” In order to complete mergers, acquiring companies often have to take on more debt or issue more stock. And if the market thinks that a company is spending too much—or borrowing too much—they’ll lose confidence.

The extent of this effect depends on the nature of the buyout. The buyer can use cash, stock, or some combination thereof to complete a takeover. The more stock the buyer offers, the more nervous investors get. If a company dumps a lot of its own stock into a takeover bid, it might mean that the stock is overvalued. When America Online made its offer to buy Time Warner in 2000, it offered stock in place of cash—in part because AOL stock was riding so high on the Internet bubble.

Next question?

Explainer thanks B. Espen Eckbo of Dartmouth’s Tuck School of Business and Martijn Cremers of the Yale School of Management.