The difference between the price paid for the firm being purchased and the current market value of the firm
In mergers and acquisitions (M&A), the difference between the price paid for the firm being purchased, i.e., the target firm, and the assessed market value of that firm is known as the acquisition premium.
In other words, the acquisition premium, also known as the takeover premium, is the extra amount paid by an acquiring company, i.e., the acquirer, in addition to the estimated real value of all identifiable assets of the target company.
In financial accounting, the acquisition premium is called, which is recorded as an intangible asset on the acquirer's after the transaction.
Opposite a tangible asset such as equipment and factories, an intangible asset is referred to as an identified item with no physical substance. Brand name and intellectual property (IP) like trademarks and copyrights are .
In terms of calculation of goodwill in accounting, it equals the value that exceeds the target company's assets:
Goodwill = P - (A - L)
P = Purchase price of the target company
A = Fair market value of the target company's assets
L = Fair market value of the target company's liabilities
Note that the core idea of goodwill and acquisition premium is the same. However, we use different formulas to calculate them solely because these two words are referred to and used by professionals in different business realms (you will learn how to calculate the premium in the section below).
It is worth noting that a firm is not required to pay a premium when purchasing another company; depending on the circumstances, the acquiring company may even receive a discount on the final deal price.
Microsoft paid $196 per share, including a 50% takeover premium on LinkedIn's share price, since they anticipated the deal would positively impact Microsoft's revenue and competitive position.
Why Pay The Premium?
The fact that an acquiring company is willing to pay a higher price than the market value of the target company may not make sense intuitively.
It is worth noting, however, that the target company's current pricing reflects what it is worth in the eyes of the market. On the other hand, an acquirer may place a higher value on the target company than the market, owing to the strategic value the target company may provide.
The following are the reasons explaining why an acquiring company pays a premium:
1. Expected Synergy
The most common reason for a merger or an acquisition is the generation of synergies, in which the combined value of two enterprises is greater than the sum of their individual parts.
In general, there are two forms of synergies - hard synergies and soft synergies. Soft synergies indicate revenue hikes via improved, cross-selling, and increased pricing power, while hard synergies refer to cost .
When the acquirer expects a high potential financial benefit from a deal, they will be willing to pay more premium.
2. Stronger Position in the Market
When an industry is more consolidated, businesses in that industry may have fewer rivals.
A merger or an acquisition offers the consolidated firm a stronger position in the market, allowing it to manage more areas of the supply chain, minimizing dependency on third parties.
When two firms join together, their combined operations and customer base provide the merged entity with a stronger position in the market. Hence, the acquirer may pay a premium in exchange for a stronger position in the market.
3. Increased International Presence
A merger or an acquisition can be used as a strategic instrument to expand a company's international market reach.
Less regulation and more consistent accounting standards in the international market will make a deal a more prevalent basis for future M&A deals for the acquirer, who consequently might be willing to pay a premium to secure the target company.
4. Diversified Portfolio
From a company's perspective, diversification can be viewed as a portfolio of investments in other companies.
Diversifying a company's cash flows into different industries through M&A transactions can mitigate the cash flow fluctuation for the acquiring company. As a result, the acquiring company might pay extra to join the target firm.
5. Competitive Advantage
An acquirer may seek competitive advantages or secure resources that it now lacks from the target firm through a merger or an acquisition.
Specific competencies or resources, like a(R&D) team, a profit-generating sales staff, or other distinctive talents, are examples of competitive advantages or unique resources.
These advantages and resources may encourage the acquiring company to pay more.
6. Outbidding Other Bidders
Sometimes, the target company is very desirable. For instance, Facebook had to compete with Twitter on its offer before acquiring Instagram for $1 billion in cash and stock.
Twitter allegedly offered $525 million to Instagram as the company felt that Instagram's product nicely aligned with Twitter's business, and the company had been planning to have more presence in the media space.
To block the Twitter deal, Mark Zuckerberg paid what at the time seemed like an astounding sum of $1 billion for the photo-sharing start-up, which had only 13 employees at the time.
However, in less than ten years, Instagram has emerged as a crucial pillar of Facebook's expansion. As a result, if there are other bidders for the target company, the acquirer may need to pay a significant premium to outbid them.
7. Tax Reduction
In some circumstances, it may be favorable for an acquirer to purchase or merge with a company that has substantial tax losses so that the acquirer may rightfully reduce its tax obligation.
Suppose the perceived value of any of the aforementioned reasons is greater than the market value of the target company. In that case, the acquirer may be encouraged to participate in an M&A transaction to buy the target company with an extra takeover premium.
To calculate the acquisition premium, the acquirer must determine the true value of the target business, which can be calculated by using either thevaluation.
Calculating the premium using the target company's share price:
- Calculating the difference between the price paid per share for the target firm in the current deal and the target's current stock price: (DP -SP)
- Dividing the difference (DP - SP) by the target's current stock price to get a percentage amount:
AP = (DP – SP)/ SP * 100
AP = Acquisition/Takeover Premium
DP = Deal Price per share of the target company
SP = Current Share Price of the target company
Calculating the premium using the enterprise value:
Calculating the difference between the price paid by the acquiring company and the pre-merger value of the target company.
AP = PT - VT
AP = Acquisition/Takeover Premium
PT = price paid for the target company in the current deal
VT = Pre-merger value of the company
Take the example of LVMH's acquisition of Tiffany & Co., in which the Paris-based luxury goods conglomerate, LVMH, acquired the American jeweler Tiffany & Co. for $15.8 billion or $131.5 per share in January 2021.
At the time of the initial announcement of the acquisition in October 2019, the deal was supposed to be $16.2 billion ($135 per share), and Tiffany's stock price was around $92.7 per share.
With the official announcement of the deal, the stock price of Tiffany jumped by 6.2% to $98.5 per share approximately. However, the deal was renegotiated due to Covid-19 and Tiffany's poor performance, and the final price of $15.8 billion was signed in January 2021.
Assuming the stock price is $98.5 per share, we can calculate the acquisition premium LVMH paid.
According to the formula, the acquisition premium is:
AP = (DP – SP)/ SP * 100
AP when the deal was $16.2 billion or $135 per share:
AP = (135 – 98.5)/ 98.5 * 100
AP1 = 37% per share
AP of the final deal of $15.8 billion or $131.50 per share:
AP = (131.5 – 98.5)/ 98.5 * 100
AP2 = 33.5% per share
For the method using the enterprise value, let us take a hypothetical merger of two companies, X Co. and Y Ltd. The enterprise value of Y Ltd. is $12.5 million, and X Co. is offering a 15% premium.
Price Paid for Y Ltd:
PT = $12.5 million + 15% of $12.5 million
PT = 12.5 * 115/100 = $14.375 million
Pre-merger Value of Y Ltd (VT) = $12.5 million
According to the formula,
AP = PT - VT
AP = $14.375 million - $12.5 million = $1.875 million
- In a merger or an acquisition, the difference between the price paid for a target firm and the assessed market value of that firm is known as the acquisition premium.
- The acquisition premium is also known as the 'takeover premium' or 'goodwill.'
- There are two ways to calculate the acquisition premium using either the enterprise value or equity valuation. Despite the differences in the formulas, the two methods share the same logic: the acquirer must determine the true value of the target business first.
- The acquirer (acquiring company) pays for the takeover premium owing to the following reasons:
- The expected benefits from synergies
- Stronger market power
- Increased international presence
- Competitive advantages
- Desire to outbid other buyers
- Tax reduction