Why Do Stock Prices Increase After a Takeover?

Depending on the circumstances, investors who own shares of a company that gets bought out by another firm may experience a quick jump in their share prices. That is because investors, by way of a vote, have the final word on whether or not a takeover deal is ultimately approved. Unless the takeover offer is essentially part of a desperation sale, investors are likely to reject the deal unless the offer reflects a premium that is at least as high as the price at which shares of the stock are currently trading. As a result, takeover companies usually offer to buy a company for a price that is higher than where the current market value of the target company is trading.

Overview

When a buyer takes over a target company, it may use shares of its own stock to help finance the deal in addition to using cash or debt. If this is the case, once the takeover has been announced, shares of the target company will systematically rise to a level that is near the price per share that the acquiring company has offered to pay, which should be higher than the market value of the target company prior to the deal.

Confidence

Even when a buyer finances a takeover with shares of its own stock, shares of the target company may continue to trade independently for months until the deal is finalized. When the stock price rises to a level that is close to but slightly below what the buyer is offering to pay, investors are demonstrating confidence that the deal will be finalized. If the target company's stock price surpasses the price the buyer has offered to pay for each share, investors are indicating that they believe the target company may receive a higher bid from another buyer.

Takeover Rumors

Stock prices not only tend to rise once a takeover has formally been announced, but they can also increase on speculation that a takeover deal is imminent. When rumors of a possible takeover of technology company Dell surfaced, the stock immediately added 7 percent in a single day, according to a 2012 "Wall Street Journal" article. At the time, the stock was trading for under $10 per share, but the potential buyers were considering acquiring the company for $13 to $14 per share.

Investor Sentiment

It could be that stock prices rise following a takeover deal because it puts investors in a good mood. Investor sentiment plays a part in stock market activity. When takeovers occur, corporations are demonstrating that the economy is strong enough for them to spend their cash or obtain some type of bank financing. In 2011, following three years of few takeover deals amid an economic recession, merger activity began to increase. Investors responded to the optimism by purchasing shares of the companies involved in takeover, which sent the stock market higher by 2 percent, according to a 2011 CNN Money article.