Any company preparing to acquire another is going to pay a premium to do so. What is an acquisition premium and why is it such a given? Most companies see it as the cost of doing business. They want to appease the board of directors at the target company, so they agree to pay a sum above and beyond the value of the company. Think of it like the “buy it now” option on auction websites—you pay more, but you get what you want without all the runaround. 

The acquisition premium has broader ramifications beyond what a company is willing to pay to acquire another. It affects investor sentiment, the share prices of both companies and more. Understanding the role of acquisition premium beyond the buying process can help you make more informed investing decisions—especially if you hold shares of the acquirer, acquiree or both companies. 

Acquisition Premium Defined

The acquisition premium is the difference between the value of the target company and what an acquirer agrees to pay for it. Here’s an example:

Company A wants to acquire Company B. According to its most recent 10-K filing, Company B is worth approximately $20 billion. Company A is willing to pay a 10% premium to acquire them—meaning it will pay $22 billion. 

Often, the acquisition premium manifests in the share price of the company. Using the example from above, let’s say Company B’s share price was at $20 pre-acquisition. Once the news breaks, the stock is liable to rise 10% to $22, to match the new valuation based on the premium Company A is willing to pay.

It’s important to note that the acquisition premium can be anything or nothing. It’s a representation of what the acquiring company is willing to pay for the target company. They may choose not to buy at a premium—or, they may overbid and put too much of a premium on the acquisition. The market will react accordingly. 

Is the Acquisition Premium Good or Bad?

Depending on which side of the acquisition your investment interests are on, the premium paid can be objectively good or bad.

If you hold shares of the acquirer, those shares will likely lose value on the announcement of an acquisition. This happens due to the acquisition premium—it’s effectively a big expense that weighs on the company’s balance sheet. The larger the premium paid, the more your shares are likely to shed value. The market tends to react harshly to acquisition premiums it deems too high to justify the value of the transaction. 

If you’re a shareholder for the target company, acquisition premium can become a lucrative driver of wealth for you. The share price of most companies will shoot up to the premium amount as soon as it’s announced, which can mean instantly gaining significant wealth in a very short time period. For example, if you hold 100 shares of a stock worth $50 per share and it shoots up 20% due to an acquisition, you’ll gain $1,000 on your holdings. 

For outsiders who don’t hold any shares, the acquisition premium represents an opportunity. Since most target companies see a boom in share price and acquirers tend to suffer an immediate loss, straddling is common. Traders open a position before the acquisition becomes official, then capitalize after it goes through. While a proven strategy, it also carries a lot of risk, since the details of an acquisition aren’t always concrete.

What is “Goodwill?”

In the world of corporate accounting, the acquisition premium a company pays is often recorded as “goodwill” on the balance sheet. Goodwill represents the intangible benefits of a company that justify its value. For example, if a company has a strong brand presence, an acquiring company may cite that as part of the reason for paying a premium. 

Goodwill also works to cushion a company against an acquisition gone bad. A goodwill write-down can represent the loss of intangible benefits after an acquisition. For example, if Company A acquires Company B largely because of its brand prevalence and that brand begins to underperform, it may write down some of the goodwill premium to lessen the impact on its balance sheet. 

Revisions and write-downs against goodwill are a sign that the acquirer overpaid for the target company. This doesn’t tend to sit well with investors, and the stock usually faces turbulence as a result. 

How to Evaluate Acquisition Premium

Analysts evaluate whether an acquisition premium is reasonable or unreasonable based on the expected ROI from an acquisition. Why is Company A acquiring Company B? What do they get out of the deal? How does it affect long-term prospects? Analysts will look at everything from the target company’s IP and assets, to its market capitalization and revenues, to debt and leadership. If they feel that the premium justifies the acquisition of these things, it’s considered a reasonable (or justifiable) premium. 

If the numbers just don’t add up and the acquirer is overeager, it could result in a premium that’s too high. This is further exacerbated if the acquirer brings on debt to finance the acquisition or offers an ROI timeline that’s too protracted to justify the spend. 

Keep Acquisition Premium in Mind

What is an acquisition premium? Depending on which side of the fence you’re on, it could be a boon to your portfolio or the catalyst behind the red you’re seeing. Ultimately, it’s the cost of doing business to acquire a company that will (hopefully) unlock new value and growth opportunities in the future.

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It may seem like an overpay today, but if the acquisition works out, it could end up being a small price to pay for major ROI. You may want to consider this when determing your next investment strategy.