What Is an Acquisition Premium?

An acquisition premium is a figure that’s the difference between the estimated real value of a company and the actual price paid to acquire it. An acquisition premium represents the increased cost of buying a target company during a merger and acquisition (M&A) transaction.

There is no requirement that a company pay a premium for acquiring another company; in fact, depending on the situation, it may even get a discount.

Understanding Acquisition Premiums

In an M&A scenario, the company that pays to acquire another company is known as the acquirer, and the company to be purchased or acquired is referred to as the target firm.

Reasons For Paying An Acquisition Premium

Typically, an acquiring company will pay an acquisition premium to close a deal and ward off competition. An acquisition premium might be paid, too, if the acquirer believes that the synergy created from the acquisition will be greater than the total cost of acquiring the target company. The size of the premium often depends on various factors such as competition within the industry, the presence of other bidders, and the motivations of the buyer and seller.

How Does An Acquisition Premium Work?

When a company decides that it wants to acquire another firm, it will first attempt to estimate the real value of the target company. For example, the enterprise value of Macy’s, using data from its 2017 10-K report, is estimated at $11.81 billion. After the acquiring company determines the real value of its target, it decides how much it is willing to pay on top of the real value so as to present an attractive deal to the target firm, especially if there are other firms that are considering an acquisition.

In the example above an acquirer may decide to pay a 20% premium to buy Macy’s. Thus, the total cost it will propose would be $11.81 billion x 1.2 = $14.17 billion. If this premium offer is accepted, then the acquisition premium value will be $14.17 billion – $11.81 billion = $2.36 billion, or in percentage form, 20%.

Arriving at the Acquisition Premium

You also may use a target company’s share price to arrive at the acquisition premium. For instance, if Macy’s is currently trading at $26 per share, and an acquirer is willing to pay $33 per share for the target company’s outstanding shares, then you may calculate the acquisition premium as ($33 – $26)/$26 = 27%.

Using our price-per-share example, let’s assume that there was no premium offer on the table and the agreed-upon acquisition cost was $26 per share. If the value of the company drops to $16 before the acquisition becomes final, the acquirer will find itself paying a premium of ($26 – $16)/$16 = 62.5%.

Acquisition Premiums in Financial Accounting

In financial accounting, the acquisition premium is known as goodwill—the portion of the purchase price that is higher than the sum of the net fair value of all of the assets purchased in the acquisition and the liabilities assumed in the process. The acquiring company records goodwill as a separate account on its balance sheet.

Goodwill factors in intangible assets like the value of a target company’s brand, solid customer base, good customer relations, healthy employee relations, and any patents or proprietary technology acquired from the target company. An adverse event, such as declining cash flows, economic depression, increased competitive environment and the like can lead to an impairment of goodwill, which occurs when the market value of the target company’s intangible assets drops below its acquisition cost. Any impairment results in a decrease in goodwill on the balance sheet and shows as a loss on the income statement.

An acquirer can purchase a target company for a discount, that is, for less than its fair value. When this occurs, negative goodwill is recognized.

What Is an Acquisition?

An acquisition is when one company purchases most or all of another company’s shares to gain control of that company. Purchasing more than 50% of a target firm’s stock and other assets allows the acquirer to make decisions about the newly acquired assets without the approval of the company’s other shareholders. Acquisitions, which are very common in business, may occur with the target company’s approval, or in spite of its disapproval. With approval, there is often a no-shop clause during the process.

We mostly hear about acquisitions of large well-known companies because these huge and significant deals tend to dominate the news. In reality, mergers and acquisitions (M&A) occur more regularly between small- to medium-size firms than between large companies.

Understanding Acquisitions

Companies acquire other companies for various reasons. They may seek economies of scale, diversification, greater market share, increased synergy, cost reductions, or new niche offerings. Other reasons for acquisitions include those listed below.

As a Way to Enter a Foreign Market

If a company wants to expand its operations to another country, buying an existing company in that country could be the easiest way to enter a foreign market. The purchased business will already have its own personnel, a brand name, and other intangible assets, which could help to ensure that the acquiring company will start off in a new market with a solid base.

As a Growth Strategy

Perhaps a company met with physical or logistical constraints or depleted its resources. If a company is encumbered in this way, then it’s often sounder to acquire another firm than to expand its own. Such a company might look for promising young companies to acquire and incorporate into its revenue stream as a new way to profit.

To Reduce Excess Capacity and Decrease Competition

If there is too much competition or supply, companies may look to acquisitions to reduce excess capacity, eliminate the competition, and focus on the most productive providers.

To Gain New Technology

Sometimes it can be more cost-efficient for a company to purchase another company that already has implemented a new technology successfully than to spend the time and money to develop the new technology itself.

Acquisition, Takeover, or Merger?

Although technically, the words “acquisition” and “takeover” mean almost the same thing, they have different nuances on Wall Street.

In general, “acquisition” describes a primarily amicable transaction, where both firms cooperate; “takeover” suggests that the target company resists or strongly opposes the purchase; the term “merger” is used when the purchasing and target companies mutually combine to form a completely new entity. However, because each acquisition, takeover, and merger is a unique case, with its own peculiarities and reasons for undertaking the transaction, the exact use of these terms tends to overlap in practice.

Acquisitions: Mostly Amiable

Friendly acquisitions occur when the target firm agrees to be acquired; its board of directors (B of D, or board) approves of the acquisition. Friendly acquisitions often work toward the mutual benefit of the acquiring and target companies. Both companies develop strategies to ensure that the acquiring company purchases the appropriate assets, and they review the financial statements and other valuations for any obligations that may come with the assets. Once both parties agree to the terms and meet any legal stipulations, the purchase proceeds.

Takeovers: Usually Inhospitable, Often Hostile

Unfriendly acquisitions, commonly known as “hostile takeovers,” occur when the target company does not consent to the acquisition. Hostile acquisitions don’t have the same agreement from the target firm, and so the acquiring firm must actively purchase large stakes of the target company to gain a controlling interest, which forces the acquisition.

Even if a takeover is not exactly hostile, it implies that the firms are not equal in one or more significant ways.

Mergers: Mutual, But Creates a New Entity

As the mutual fusion of two companies into one new legal entity, a merger is a more-than-friendly acquisition. Mergers generally occur between companies that are roughly equal in terms of their basic characteristics—size, number of customers, the scale of operations, and so on. The merging companies strongly believe that their combined entity would be more valuable to all parties (especially shareholders) than either one could be alone.

Evaluating Acquisition Candidates

Before making an acquisition, it is imperative for a company to evaluate whether its target company is a good candidate.

• Is the price right? The metrics investors use to value an acquisition candidate vary by industry. When acquisitions fail, it’s often because the asking price for the target company exceeds these metrics.
• Examine the debt load. A target company with an unusually high level of liabilities should be viewed as a warning of potential problems ahead.
• Undue litigation. Although lawsuits are common in business, a good acquisition candidate is not dealing with a level of litigation that exceeds what is reasonable and normal for its size and industry.
• Scrutinize the financials. A good acquisition target will have clear, well-organized financial statements, which allows the acquirer to exercise due diligence smoothly. Complete and transparent financials also help to prevent unwanted surprises after the acquisition is complete.

Example of Acquisitions

AOL and Time Warner and AT&T

AOL Inc. (originally America Online) was the most publicized online service of its time, and had been extolled as “the company that brought the internet to America.” Founded in 1985, by the year 2000 AOL had grown to become the United States’ largest internet provider. Meanwhile, the legendary media conglomerate, Time Warner, Inc. was being labeled an “old media” company, given its range of tangible businesses like publishing, and television, and an enviable income statement.

In 2000, in a masterful display of overweening confidence, the young upstart AOL purchased the venerable giant Time Warner (TWX) for $165 billion; this dwarfed all records and became the biggest merger in history. The vision was that the new entity, AOL Time Warner, would become a dominant force in the news, publishing, music, entertainment, cable, and Internet industries. After the merger, AOL became the largest technology company in America.

However, the joint phase lasted less than a decade. As AOL lost value and the dot-com bubble burst, the expected successes of the merger failed to materialize, and AOL and Time Warner dissolved their union:

• In 2009, AOL Time Warner dissolved in a spin-off deal.
• From 2009 to 2016, Time Warner remained an entirely independent company. 
• In 2015, Verizon Communications, Inc. (NYSE: VZ) acquired AOL for $4.4 billion.

Then, in October 2016, AT&T (NYSE: T) and Time Warner (TWX) announced a deal in which AT&T will buy Time Warner for $85.4 billion, morphing AT&T into a media heavy-hitter. In June 2018, after a protracted court battle, AT&T completed its acquisition of Time Warner.

Certainly, the AT&T-Time Warner acquisition deal of 2018 will be as historically significant as the AOL-Time Warner deal of 2000; we just can’t know exactly how yet. These days, 18 years equals numerous lifetimes—especially in media, communications, and technology—and much will continue to change. For the moment, however, two things seem certain:

1. The consummation of the AT&T-Time Warner merger already has begun to reshape much of the media industry.
2. M&A enterprise is still alive and well.

What Is the Acid-Test Ratio?

The acid-test ratio, commonly known as the quick ratio, uses a firm’s balance sheet data as an indicator of whether it has sufficient short-term assets to cover its short-term liabilities.

Understanding the Acid-Test Ratio

In certain situations, analysts prefer to use the acid-test ratio rather than the current ratio (also known as the working capital ratio) because the acid-test method ignores assets such as inventory, which may be difficult to quickly liquidate. The acid test ratio is thus a more conservative metric.

Companies with an acid-test ratio of less than 1 do not have enough liquid assets to pay their current liabilities and should be treated with caution. If the acid-test ratio is much lower than the current ratio, it means that a company’s current assets are highly dependent on inventory.

This is not a bad sign in all cases, however, as some business models are inherently dependent on inventory. Retail stores, for example, may have very low acid-test ratios without necessarily being in danger. The acceptable range for an acid-test ratio will vary among different industries, and you’ll find that comparisons are most meaningful when analyzing peer companies in the same industry as each other.

For most industries, the acid-test ratio should exceed 1. On the other hand, a very high ratio is not always good. It could indicate that cash has accumulated and is idle, rather than being reinvested, returned to shareholders, or otherwise put to productive use.

Some tech companies generate massive cash flows and accordingly have acid-test ratios as high as 7 or 8. While this is certainly better than the alternative, these companies have drawn criticism from activist investors who would prefer that shareholders receive a portion of the profits.

Calculating the Acid-Test Ratio

The numerator of the acid-test ratio can be defined in various ways, but the main consideration should be gaining a realistic view of the company’s liquid assets. Cash and cash equivalents should definitely be included, as should short-term investments, such as marketable securities.

Accounts receivable are generally included, but this is not appropriate for every industry. In the construction industry, for example, accounts receivable may take much more time to recover than is standard practice in other industries, so including it could make a firm’s financial position seem much more secure than it is in reality.

The formula is:

$\begin{aligned} &\text{Acid Test} = \frac{ \text{Cash} + \text{Marketable Securities} + \text{A/R} }{ \text{Current Liabilities} } \\ &\textbf{where:} \\ &\text{A/R} = \text{Accounts receivable} \\ \end{aligned}$​Acid Test=Current LiabilitiesCash+Marketable Securities+A/R​where:A/R=Accounts receivable​

Another way to calculate the numerator is to take all current assets and subtract illiquid assets. Most importantly, inventory should be subtracted, keeping in mind that this will negatively skew the picture for retail businesses because of the amount of inventory they carry. Other elements that appear as assets on a balance sheet should be subtracted if they cannot be used to cover liabilities in the short term, such as advances to suppliers, prepayments, and deferred tax assets.

The ratio’s denominator should include all current liabilities, which are debts and obligations that are due within one year. It is important to note that time is not factored into the acid-test ratio. If a company’s accounts payable are nearly due but its receivables won’t come in for months, that company could be on much shakier ground than its ratio would indicate. The opposite can also be true.

Acid-Test Ratio Example

A company’s acid-test ratio can be calculated using its balance sheet. Below is an abbreviated version of Apple Inc.’s (AAPL) balance sheet as of Jan. 27, 2022, showing the components of the company’s current assets and current liabilities (all figures in millions of dollars):

What Is the Accumulation/Distribution Indicator (A/D)?

The accumulation/distribution indicator (A/D) is a cumulative indicator that uses volume and price to assess whether a stock is being accumulated or distributed. The A/D measure seeks to identify divergences between the stock price and the volume flow. This provides insight into how strong a trend is. If the price is rising but the indicator is falling, then it suggests that buying or accumulation volume may not be enough to support the price rise and a price decline could be forthcoming.

The Accumulation/Distribution Indicator (A/D) Formula

$\begin{aligned}&\text{MFM} = \frac {(\text{Close} – \text{Low} ) – ( \text{High} – \text{Close} ) } {\text{High} – \text{Low} } \\&\textbf{where:}\\&\text{MFM} = \text{Money Flow Multiplier} \\&\text{Close} = \text{Closing price} \\&\text{Low} = \text{Low price for the period} \\&\text{High} = \text{High price for the period} \\ \end{aligned}$​MFM=High−Low(Close−Low)−(High−Close)​where:MFM=Money Flow MultiplierClose=Closing priceLow=Low price for the periodHigh=High price for the period​

$\begin{aligned}&\text{Money Flow Volume} = \text{MFM} \times \text{Period Volume} \\ \end{aligned}$​Money Flow Volume=MFM×Period Volume​

$\begin{aligned}&\text{A/D} = \text{Previous A/D} + \text{CMFV}\\&\textbf{where:}\\&\text{CMFV} = \text{Current period money flow volume} \\ \end{aligned}$​A/D=Previous A/D+CMFVwhere:CMFV=Current period money flow volume​

How to Calculate the A/D Line

1. Start by calculating the multiplier. Note the most recent period’s close, high, and low to calculate.
2. Use the multiplier and the current period’s volume to calculate the money flow volume.
3. Add the money flow volume to the last A/D value. For the first calculation, use money flow volume as the first value.
4. Repeat the process as each period ends, adding/subtracting the new money flow volume to/from the prior total. This is A/D.

What Does the Accumulation/Distribution Indicator (A/D) Tell You?

The A/D line helps to show how supply and demand factors are influencing price. A/D can move in the same direction as price changes or in the opposite direction.

The multiplier in the calculation provides a gauge for how strong the buying or selling was during a particular period. It does this by determining whether the price closed in the upper or lower portion of its range. This is then multiplied by the volume. Therefore, when a stock closes near the high of the period’s range and has high volume, it will result in a large A/D jump. Alternatively, if the price finishes near the high of the range but volume is low, or if the volume is high but the price finishes more toward the middle of the range, then the A/D will not move up as much.

The same concepts apply when the price closes in the lower portion of the period’s price range. Both volume and where the price closes within the period’s range determine how much the A/D will decline.

The A/D line is used to help assess price trends and potentially spot forthcoming reversals. If a security’s price is in a downtrend while the A/D line is in an uptrend, then the indicator shows there may be buying pressure and the security’s price may reverse to the upside. Conversely, if a security’s price is in an uptrend while the A/D line is in a downtrend, then the indicator shows there may be selling pressure, or higher distribution. This warns that the price may be due for a decline.

In both cases, the steepness of the A/D line provides insight into the trend. A strongly rising A/D line confirms a strongly rising price. Similarly, if the price is falling and the A/D is also falling, then there is still plenty of distribution and prices are likely to continue to decline.

The Accumulation/Distribution Indicator (A/D) vs. On-Balance Volume (OBV)

Both of these technical indicators use price and volume, albeit somewhat differently. On-balance volume (OBV) looks at whether the current closing price is higher or lower than the prior close. If the close is higher, then the period’s volume is added. If the close is lower, then the period’s volume is subtracted.

The A/D indicator doesn’t factor in the prior close and uses a multiplier based on where the price closed within the period’s range. Therefore, the indicators use different calculations and may provide different information.

Limitations of Using the Accumulation/Distribution Indicator (A/D)

The A/D indicator does not factor in price changes from one period to the next, and focuses only on where the price closes within the current period’s range. This creates some anomalies.

Assume a stock gaps down 20% on huge volume. The price oscillates throughout the day and finishes in the upper portion of its daily range, but is still down 18% from the prior close. Such a move would actually cause the A/D to rise. Even though the stock lost a significant amount of value, it finished in the upper portion of its daily range; therefore, the indicator will increase, likely dramatically, due to the large volume. Traders need to monitor the price chart and mark any potential anomalies like these, as they could affect how the indicator is interpreted.

Also, one of the main uses of the indicator is to monitor for divergences. Divergences can last a long time and are poor timing signals. When divergence appears between the indicator and price, it doesn’t mean a reversal is imminent. It may take a long time for the price to reverse, or it may not reverse at all.

The A/D is just one tool that can be used to assess strength or weakness within a trend, but it is not without its faults. Use the A/D indicator in conjunction with other forms of analysis, such as price action analysis, chart patterns, or fundamental analysis, to get a more complete picture of what is moving the price of a stock.