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Many investors are obsessed with trying to beat the market, which leads them to take more risk than necessary and also makes them vulnerable to brokers with a seductive pitch.Thinkstock

Have you ever wondered why a stock does what it does after an acquisition is announced?

Valuing an acquisition can be somewhat baffling. Even with a good acquisition, shares of the acquisitor company typically fall after the announcement. Let's examine why that is the case, and how you can make money on the transaction.

Publicly traded companies typically trade at a discount to their private market value. When a company is taken private or bought in whole by another company, the target company's premium over the share price should reflect private market value over public market value. A premium of 15- to 20-per cent is considered a benchmark, but the premium is frequently greater than that. The additional premium may reflect the fact that the target was already undervalued, for any number of reasons.

The acquisitor company shares decline on the news of the proposed acquisition, primarily to an expected dilution of pro-forma earnings. If the payback time (time until the earnings are positively impacted) is relatively short (under two years), and the acquisition is deemed to be a good strategic fit, the share price decline will tend to more moderate.

When I was an analyst on Bay Street and an acquisition was announced involving a stock I covered, my job was to arrive at a fair value and make a prediction on share price, based on whether the market had been efficient in reacting to the news. I had a very short window in which to make these assessments – essentially from the time the stock was halted to the time it reopened for trading, usually the next morning.

Typically I would value the two companies separately, and make adjustments for synergies and financing. You can try this yourself.

1. Value the acquisitor
Construct the valuation based on forecasted earnings and cash flow. As an analyst. I would use various multiples and corroborate these results with a discounted cash flow model. You can use consensus numbers to come up with estimates.

2. Value the target
If it is a public company, add a 15- to 20-per cent premium for control. Keep in mind that the stock may already have moved up on rumours of the impending takeover, which means part of the control premium has already been reflected in the stock price. If the target is private, you won't have earnings estimates. In that case, simply discount management estimates using a probability factor of at least 25 per cent to be conservative.

3. Adjust for synergies
Synergies are typically bottom-line adjustments calculated as redundant costs which can be eliminated when the two companies merge. However, true synergies can also include other, less predictable factors which affect top line and margins. For example, if the target company adds market share to the acquisitor company, this could open the door to unit price increases and a subsequent margin improvement. On the other hand, the converse could happen – competition could respond to the new threat by cutting prices, leading to a price war and margin impairment. This is where you will need to exercise your own critical thinking in making your assessment.

4. Adjust for write-offs
If there are any write-offs associated with the acquisition, these must be included in any asset value calculation. Beware of golden parachutes, and be sure to quantify their impact.

5. Adjust for management
Confidence in management is a function of past history. The key indicator I would use is Return on Capital Employed (ROCE). If the ROCE is higher than a group of peer companies, management is deemed to be an incremental positive factor. In addition, if management of the acquisitor already has a history of making good acquisitions, you can assume the current acquisition is probably a continuation of that trend. If the target is a turnaround situation, you can assume a one-time severance cost to be included in your calculation for write-offs.

6. Adjust for financing costs
Financing the acquisition will change the capitalization of the company, as well as the net earnings. Be sure to adjust the pro forma income statement to reflect this.

When you're all done, apply a probability factor
Apply a probability for the deal going through, and apply a discount based on the time estimated for the deal to go through. The target company will trade very near the target price, after the acquisition is announced, absent of any mitigating factors. For example, if the target is being acquired at $10 per share and is trading at or near that price after the announcement, the market is saying that the deal will go through, and soon. If it's trading at $9, the market is skeptical, and/or the time to closing is long enough to incur meaningful carrying costs. On the other hand, if the stock is trading at $11, the market expects a higher bid is in the works. For example, the market may expect a bid may of $12, with a probability of 92 per cent, or a bid of $15 with a probability of 73 per cent, or anything in between. Remember – all forecasts must be probability weighted.

Following these six steps will not only take some of the mystery out of the effects of mergers and acquisitions on a stock's price, but it will give you an idea of what the market is thinking and the opportunity to react appropriately, ultimately increasing your odds of realizing a profit.

Steven Holt is a former top-ranked equity research analyst and director of equity research. He is currently an investment consultant specializing in consumer goods and services businesses. Email: holtcap@gmail.com