An acquisition premium is the difference between the estimated real value of a company and the actual price paid to acquire it. This premium represents the additional cost incurred during a merger or acquisition (M&A) transaction to secure the purchase of a target company. It’s not always necessary to pay a premium, as companies might also obtain a discount under certain circumstances.
Understanding Acquisition Premiums
In the context of M&A transactions, the company initiating the purchase is known as the acquirer, and the company being acquired is referred to as the target firm. Acquisition premiums are often paid to secure the deal and preemptively outbid competitors.
Reasons for Paying an Acquisition Premium
Typically, an acquiring company pays an acquisition premium to:
- Facilitate the deal quickly and prevent competitors from acquiring the target.
- Capitalize on anticipated synergies, where the combined entity is expected to be more valuable than the sum of its parts.
Factors influencing the size of an acquisition premium include industry competition, the presence of multiple bidders, and the motivations of both the buyer and seller. In some cases, a company’s troubled circumstances, such as falling stock prices or industry uncertainties, might lead to no premium or even a discount.
How Does an Acquisition Premium Work?
When considering an acquisition, the first step for the interested company is to estimate the real value of the target firm. For instance, if Macy’s has an enterprise value of $11.81 billion, an acquirer may decide to offer a 20% premium, proposing a total purchase price of $14.17 billion. If accepted, the acquisition premium equates to $2.36 billion, representing a 20% markup.
Arriving at the Acquisition Premium
The acquisition premium can also be calculated using the stock price of the target company. Suppose Macy’s shares trade at $26 each, and an acquirer offers $33 per share. This computes to an acquisition premium of 27%:
($33 - $26) / $26 = 27%
Even without an intentional premium, changes in the target company’s stock price can result in a de facto premium. If the acquisition is agreed upon at $26 per share but Macy’s stock drops to $16 per share before the deal concludes, a 62.5% premium arises:
($26 - $16) / $16 = 62.5%
Key Takeaways
- An acquisition premium reflects the difference between the estimated real value of a company and the price paid to acquire it in an M&A transaction.
- The acquisition premium appears as “goodwill” on the balance sheet.
- Paying a premium isn’t mandatory; some acquisitions may occur at a discount.
Acquisition Premiums in Financial Accounting
In accounting terms, the acquisition premium is recognized as goodwill. Goodwill reflects the acquisition price exceeding the combined net fair value of the target company’s assets and assumed liabilities. It factors in intangible assets such as brand value, customer relationships, employee relations, and proprietary technology. If intangible asset value declines due to negative events, goodwill impairment occurs, which decreases balance sheet goodwill and is reported as a loss on the income statement.
Alternatively, acquiring a company for less than its fair value results in negative goodwill recognition.
By understanding acquisition premiums, companies and investors can navigate the complexities of M&A transactions more effectively, ensuring informed decision-making regarding potential investments.
Related Terms: mergers and acquisitions, enterprise value, goodwill, synergy, target company, premium.
