A storm is brewing in the stock market, and it has nothing to do with the failure of Trumpcare.
Right now U.S. corporations are sitting on nearly $2 trillion in cash here at home. And according to Capital Economics, American firms have another $2.5 trillion stashed overseas.
Combine that with low interest rates and tepid earnings growth and you’ve got the perfect recipe for merger mania this year.
But what should you look for in a takeover target, and more importantly, which companies make the grade?
Senior Analyst Jonathan Rodriguez breaks it all down for you below:
Why Takeovers Are Such a Big Deal
If you’ve followed the financial news over the last few years, you’ve likely seen a lot of coverage on mergers and acquisitions.
And if you weren’t following closely, you might wonder why M&A is such a hot topic.
Well, in the wake of the financial crisis of 2008 — and fueled by ultralow interest rates — corporate earnings took off in a way not seen since the dot-com boom of the 1990s.
But after years of eye-popping earnings growth, the gravy train finally hit a speed bump in 2015. A slowdown in consumption overseas, particularly in China and Europe, hit multinational corporations hard here in the U.S.
But many firms were already hoarding mountains of cash and had access to even more easy money with cheap credit.
So what do you do as a loaded company when growth slows down and you’re not sure when it’s going to pick up again?
You create growth by acquiring your rivals and pocketing their cash flow.
What followed in 2015 was a record-breaking year for M&A.
Around the world, $4.3 trillion of merger deals were made, according to Dealogic.
The Early Bird Gets the Worm
Now, you might be wondering what this means for the average shareholder.
In short, if you happen to be one of the fine people holding shares of a takeover target, you could be in line for a big payday.
Acquiring companies will often pay for targets in cash, stock and/or debt. And they can offer investors a premium to the current share price anywhere from 20–60%.
For instance, semiconductor giant Intel Corp (NASDAQ:INTC). announced a deal this month to purchase Israeli tech firm Mobileye (NYSE:MBLY) N.V. for $15.3 billion. Intel offered to buy Mobileye shares at $63.54 in cash, which represented a 34% premium to the latter’s closing price the day before the announcement. On March 13, the day news of the deal broke, shares gained 28%.
As you can see, the rewards of owning a hot takeover target before it’s scooped up are big and can come swiftly.
How to Snag Your Pot of Takeover Gold
As you can imagine, the criteria for an acquisition vary based on the kind of business a company operates.
But many takeover targets display similar traits:
For starters, look for companies with a high cash balance and low level of debt. Acquiring firms love to see a high cash balance in targets. After all, the acquirer is going to pocket the loot once the deal goes through.
In fact, a company’s enterprise value (EV) can be a very useful figure for investors hunting for M&A gold. EV is simply a firm’s market capitalization plus debt, minus cash and it represents a company’s theoretical takeover price.
Investors can also divide this number by a company’s earnings before interest, taxes, depreciation and amortization (EBITDA) to give them an even more powerful tool. EV/EBIDTA, better known as the enterprise multiple, allows investors to compare a target with other firms on a relative basis. Some analysts even consider EV/EBITDA to be a superior measure of earnings than the price-earnings ratio.
In the context of takeovers, though, the lower an enterprise multiple, the better a value the target is.
Above all, a company sporting a valuation below that of the broader market (i.e., price-earnings, price-to-sales, etc.) is more likely to be acquired than a company with an excessive valuation.
Bottom line: The combination of slow growth, low interest rates and high corporate cash balances will likely fuel a resurgence of mergers and acquisitions this year. And keeping a keen eye out for “cheap” companies with lots of cash and little debt could make you rich in the event of a takeover.