Investors can learn a lot about how management views the value of their firm, and the synergies expected to be realized from a merger or acquisition based on how the company pays. The payment method provides a candid assessment from the acquirer’s perspective of the relative value of a company’s stock price.

M&A Basics

Mergers and acquisitions (commonly referred to as M&A) is the general term used to describe a consolidation of companies. In a merger, two companies combine to form a new entity; whereas during an acquisition, one company seeks to purchase another. In the latter situation, the acquiring company is making the purchase and the target company is being bought. There are many types of M&A transactions: a merger can be classified as statutory (the target is fully integrated into the acquirer and thereafter no longer exists), consolidation (the two entities join to become a new company) or subsidiary (target becomes a subsidiary of the acquirer). During the process of an acquisition, the acquirer may try to purchase the target in a friendly takeover. or acquire a target that does not want to be purchased in a hostile takeover. (To learn more, see Mergers And Acquisitions: Understanding Takeovers . )

There are several types of mergers. A horizontal merger is an acquisition of a competitor or related business. In a horizontal merger, the acquirer is looking to achieve cost synergies, economies of scale and gain market share. A well-known example of a horizontal merger was the combination of auto manufacturers Daimler-Benz and Chrysler. A vertical merger is an acquisition of a company along the production chain. The goal of the acquirer is to control the production and distribution process, and gain cost synergies via integration. A hypothetical example of a vertical merger is a car company purchasing a tire manufacturer. The integration can be backward (acquirer purchases supplier) or forward (acquirer purchases distributor). A milk distributor’s purchase of a dairy farm would be a backward integration. Alternatively, a dairy farm’s purchase of a milk distributor illustrates a forward integration.

A conglomerate merger is the purchase of a company completely outside of the acquirer’s scope of core operations. Consider General Electric, one of the world’s largest multinational conglomerates. Since its founding in 1892 by Thomas Edison, GE has purchased companies in a wide range of industries (i.e. electronics, aviation, entertainment and finance). General Electric itself was formed as a merger between Edison General Electric and Thomson-Houston Electric Company. (For more on how mergers should affect your investing decisions, read The Merger – What To Do When Companies Converge .)

Method of Payment is Revealing

These different types of M&As can be evaluated by investors to understand management’s vision and objectives. An acquirer might pursue a merger or acquisition to unlock hidden value, access new markets, obtain new technologies, exploit market imperfections or to overcome adverse government policies. Similarly, investors can assess the value and method of payment an acquirer offers for a potential target. The choice of cash, equity or financing provides an inside look into how management values their own shares, as well as the ability to unlock value through an acquisition.

Cash, Securities or a Mixed Offering

Firms have to take many factors into consideration (such as the potential presence of other bidders, the target’s willingness to sell and payment preference, tax implications, transaction costs if stock is issued and the impact on the capital structure) when an offer is put together. Once the bid is presented to the seller, the public can glean a lot of insight into how insiders of the acquiring company view the value of their own stock, the value of the target and the confidence that they have in their ability to realize value through a merger. (For more on valuing a company’s worth, read What Investors Can Learn From Insider Trading .)

A company can be purchased using cash, stock or a mix of the two. Stock purchases are the most common form of acquisition.

The greater the confidence that management will be able to realize benefits of an acquisition, the more they will want to pay for stocks in cash. This is because they believe the shares will eventually be worth more after synergies are realized from the merger. Under similar expectations, the target will want to be paid in stock. If paid in stock, the target becomes a partial owner in the acquirer and will be able to realize the benefits of the expected synergies. Alternatively, the less confident an acquirer is about the firm’s relative valuation. the more they will want to share some of the risk of the acquisition with the seller. Thus, the acquirer will want to pay in stock.

Stock as a Currency

Market conditions play a significant role in M&A transactions. When an acquirer’s shares are considered overvalued. management may prefer to pay for the acquisition with an exchange of stock-for-stock. The shares are essentially considered a form of currency. Since the shares are deemed to be priced higher than what they are actually worth (based on market perception, due diligence. third party analysis etc.), the acquirer is getting more bang for their buck by paying with stock. If the acquirer’s shares are considered undervalued. management may prefer to pay for the acquisition with cash. By thinking of the stock as equivalent to currency, it would take more stock trading at a discount to intrinsic value to pay for the purchase.

The Bottom Line

Of course, there may be additional factors as to why a firm would choose to pay with cash or stock, and why the acquisition is being considered (i.e. purchasing a firm with accumulated tax losses so that the tax loss can be recognized immediately, and the acquirer’s tax liability is lowered dramatically).

The payment method of choice is a major signaling effect from management. It is a sign of strength when an acquisition is paid for with cash; whereas stock payment reflects management’s uncertainty regarding potential synergies from a merger. Investors can use these signals to value both the acquirer and the seller. (For another look at analyzing an M&A deal, check out Accretion / Dilution Analysis: A Merger Mystery .)