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Virtually every share on the stock exchange list is a potential takeover target, but this does not mean that such a takeover will actually take place in the new future. Therefore trying to pick stocks which will become takeover targets within a reasonable timeframe is not as easy as some investors seem to think.

An intriguing question is whether a successful bidding company is going to have an increased or a decreased share price as a result of the takeover.

The table below set out an example which shows why, other things been equal, most takeover bids lead to an increase in earnings per share (and thus eventually to an increase in the share price).

(1)

(2)

(3)

(4)

(5)

PE ratio

10

5

7.5

7.5

Earnings per share

22.5

10

10

30

Market price

225

50

75

225

Column (2) refers to the bidder’s existing (“old”) shares
Column (3) refers to the target’s shares before the bid
Column (4) refers to the target’s shares after the bid, which had to be made at a 50% premium – this led to a ratio of one bidder share for every three target shares
Column (5) refers to the bidder’s “new” shares issued as the takeover consideration on the one-for-three basis

If the sizes of the two companies are roughly equal then the bidding company will have on issue one “new” share (eps 30) for every “old” share (eps 22.5), giving a weighted average eps of 26.25, showing that the bid had the desired effect of boosting the eps.

The effect is slightly less dramatic if the bidder is much larger than the target – for example, 10 times larger. Then the bidding company will have on issue one “new” share (eps 30) for every ten “old” shares (eps 22.5), giving a weighted average eps of 23.18.

The boards of bidding companies expect to improve their performance as a result of being able to ginger up the management of the target company after its acquisition. They also hope to make better use of its capital, possibly through asset sales. They in addition expect to make savings from the integration process itself – for example, there will be only one board of directors instead of two, one managing director instead of two, one chief financial officer instead of two, one accounting system instead of two, and so on, all resulting in lower costs.

In short, companies making takeover bids expect to receive benefits in terms of assets and benefits in terms of earnings, as well as benefits from the increased market perception.

Some bidding companies regard a takeover quite correctly as a cheap way to enter a new market without incurring heavy establishment costs. Some companies expect to get benefits from the horizontal integration and the vertical integration, which can result from a successful takeover bid.

Other motivating factors might be to get some greater diversification and to have the opportunity to make a pure investment that stands up on its own merits.

Sometimes unlisted companies may make takeover bids in order to acquire a backdoor listing. At other times the attraction is the plant and equipment of the target or it is valued for the quality of its personnel. Sometimes the aim is merely to get hold of the target’s cash.

On occasions there are other reasons for making a takeover bid, such as to resolve economically a dispute between the two companies.

A company that has for many years been active in making takeovers for diversification reasons as well as for increased profitability is Wesfarmers Ltd. Recently it was in the news for its massive takeover of Coles and it is well known for its ownership of the Bunnings hardware business. But Wesfarmers subsidiaries acquired in earlier times are involved in industrial distribution, coal mining, LPG processing and distribution, fertilisers and chemicals, and general insurance. Smaller activities are involved in forest products and road and rail freight

Henry Jones IXL is a company dating back to 1891. However, it was a sleepy enterprise with massive underutilised assets, leading to its being acquired by interests associated with John Elliott in 1974.

An intriguing question is what happens to the share price of a bidding company after it has made a successful takeover. It is difficult to get meaningful statistical evidence on this subject because share price movements in a company can be swamped by movements in the market as a whole and by changes in economic conditions. These can mask the effect of a particular acquisition.

The performance of a bidding company may be good, bad or indifferent for reasons quite unconnected with the takeover, particularly as companies making takeover bids are often active on many other fronts. Consolidated profit figures could also be misleading because a newly acquired subsidiary’s results are consolidated for only part of a year.