The Walt Disney Company (DIS) bought out Marvel Entertainment, Inc. (MVL) in a deal valued at $4 billion in 2009. The purchase price was originally a mix of $30 in cash and .745 of a share of Disney for each share of Marvel. The closing prices at the time of the deal meant that Marvel shareholders would have received $49.3998 per share in value for their stock at closing. However, prior to the merger’s completion the share price of Marvel Entertainment, Inc was only $48.37 – a full point below the merger value.
This happens regularly in mergers but why does this discount exist and is there a way traders can take advantage of it?
One of the things we look for when watching for a market bottom is an increase in merger and acquisition (M&A) activity. This merger – along with several others – in the second quarter of 2009 were a big tip that the bull market was likely to re-emerge. Similarly, when deal-activity begins to slow it is a signal that prices in the market may begin to move lower. M&A activity is common at a market bottom because lower stock prices are attractive to potential acquirers as they look to consolidate competitors and grab more market share.
[VIDEO] How Mergers and Acquisitions Affect Stock Prices
Stock Prices Can Change Even After A Merger Is Announced
A common question relative to M&A activity and its affect on stock prices is why the acquisition target’s stock price does not equal the value the acquirer will be paying. In other words – if company A is buying Company B’s stock for $10 a share in a few months, why doesn’t Company B’s stock equal $10 immediately following the announcement?
Uncertainty Can Lower Prices
The differential between an M&A target’s acquisition price per share and its current trading price accounts for the uncertainty around the merger. If the purchase never actually happens, the target’s stock will likely drop significantly. In the video, I will cover another case study of a stock that was going through a deal of its own at the time of recording.
Hostile Takeovers Are Even More Uncertain
The more uncertain the actual merger is, the wider this delta or differential will be. For example, if the target company is being subjected to a hostile or unsolicited takeover the difference between the acquisition stock price and the current stock price will be very wide as management works to fend off the acquirer or attract a “white knight” to rescue it from the larger firm.
Sometimes the Acquisition Target’s Stock Will Rise Above the Takeover Offer
This can happen when traders believe that there is likely to be another bidder that will offer more for the firm. This is a more unusual situation but it will happen from time to time when the deal would give the winning bidder a significant competitive advantage.
Think Before Trading
It may be tempting to take advantage of the differential by buying the target’s stock and shorting the proper ratio of the acquirer’s stock. That strategy has a very poor risk/reward ratio as the downside can be many times the possible upside. Long Term Capital Management (the trillion dollar hedge fund bailed out by the Fed in the late 1990′s) famously built a problematic portfolio of highly-leveraged versions of this trade.
Options May be a Better Alternative
Alternatively, buying long term puts on the target’s stock may be another way to approach the opportunity. This strategy is extremely speculative but the upside could be very large should the merger not occur. If you decide to test a strategy like this it would be a good idea to start with paper trading. Option premiums can be extremely inflated before a merger is consummated, which will make losses much larger.