Pocket Higher Profits By Spotting the Next Takeover Target

Investors lucky enough to hold shares in a company before it's acquired by another can snag some hefty profits - and this year has been one of the hottest on record for deals.

Global merger and acquisition (M&A) activity in the first quarter topped $799.8 billion, the most since 2007's pre-crash frenzy, according to a recent report in Forbes magazine. Looking forward, most M&A analysts now predict well more than $3 trillion in takeover activity for all of 2011.

The question is, how can you spot a likely takeover target before the announcement of a potential deal hits the news?

Hunting Takeover Targets from the Top Down

There are a couple of ways to identify potential buyout candidates - one sort of a "top-down" approach and the other more of a "bottom-up" analysis.

In the "top-down" approach, you first identify companies with resources sufficient to engineer a major buyout. If the news stories don't tip you off, most stock screeners can help you find firms with high cash holdings or a high level of free cash flow, a frequent indicator that a company can afford to do a deal. Also look for low levels of existing debt and a stock price that's been moving steadily upward or has hit a series of new highs - a condition that will facilitate stock-denominated acquisitions.

For a clue to smaller deals, look for strong regional companies that appear ready to expand into a new geographic area or go national, as well as firms with an existing line of products or services that has a "hole" in it. It's usually easier to buy an existing sales base in a new region than to build your own while competing with those already there.

Same with a new product or service - buying an existing firm with the product you want is almost always cheaper and quicker than developing your own. (A hypothetical example might be a successful small-appliance maker that! doesn't have a microwave. Far easier to buy a specialty company that makes a good microwave than invest in the technology, plant and sales networks needed to create a new brand.)

Finally, check out resource-intensive companies - e.g., those in oils, minerals, metals and the like - that might find it cheaper to buy a company with existing reserves than explore for new ones of their own.

Once you've identified some potential buyers and the needs they have, go on the search for companies that would fill those needs - and that also offer attractive valuations. If you find a small company that looks like it might be a bargain for a richer, hungrier giant, then its stock could be a bargain for you, too - not to mention a potential bonanza.

Up From the Bottom

Conversely, with the "bottom-up" approach, you start by trying to identify companies that are attractive takeover targets in their own right, without respect to a specific potential buyer. There are a number of items you can look at in making such a determination, beginning with a ratio based on a couple of purely financial factors.

Consider the The Enterprise Value (EV)-to-EBITDA Ratio. This is a favorite of accountants because it takes in most financial aspects in a single formula.

The calculation begins by finding the company's "Enterprise Value," which is its market capitalization (shares outstanding x share price), plus the value of its preferred or closely held stock (if any), plus its outstanding debt, minus any excess cash or cash equivalents. (The excess cash is particularly important because, while not in the same league as the old leveraged buyouts [LBOs], cash in a deal can help a buyer offset the cost of acquiring the company.)

The second step is to determine the "EBITDA," which is "Earnings Before Interest, Taxes, Depreciation and Amortization," a figure nearly always found in the financial statistics section of any of the quote se! rvices, such as Google Finance. Once you have it, you divide it into the Enterprise Value, and that gives you the ratio (some websites actually report the ratio itself).

What those numbers tell you, in short, is how effective the company is at generating profits relative to its size (or worth). Since most potential buyers target companies that provide large profits relative to their size, you want to look for a relatively small EV/EBITDA ratio.

Once you get beyond the numbers, there's a wide assortment of other elements that can make a company attractive to potential corporate buyers (or private equity buyout firms). Without going into a lot of detail, some key things to look for include:

• Top management or research staff - A company moving into a new region or new product line might buy a company just to get the experts needed to succeed in that market.
• A unique product - As mentioned earlier, it's often cheaper to buy a successful existing product than it is to develop a competing product of your own. This is particularly true if the product in question has a strong or widely recognized brand name.
• A specific service specialty - Same logic as with the unique product.
• An established sales or distribution network - Ditto.
• Dominance in a desirable market or geographic area - A buyout provides quick, cost-effective growth for the acquiring company.
• A company up against a growth ceiling - Sometimes a successful small company could grow rapidly if only it could get financing. Setting itself up for a takeover is one way to attract the needed money.
• Excess debt that a larger company could refinance - Sometimes servicing debt is the difference between a loss and profitability, and a buy! out coul d erase the debt service that's stifling growth.
• A history of increasing shareholder value - Stockholders of a potential corporate buyer are unlikely to look favorably on a deal if the target company hasn't done well by its own stockholders in the past.
• A clean legal history - This is more of a concern in some industries than others - pharmaceuticals and toxic materials, to name just a couple. Nobody wants to buy a lawsuit waiting to happen - especially one that might be triggered by a sudden shot at deeper pockets.
• Potential for increased efficiencies of scale - Combining two entities can often reduce overall costs, thus increasing operating margins - and profits.

Having listed all those positive attributes, it should also be noted that takeovers sometimes occur even when the target company is burdened by bad characteristics. This usually goes back to the issue of executive ego - cases where the strong leaders of an acquiring company are certain they can turn a weak business around by using better management techniques and providing superior leadership.

News and Related Story Links:

• Money Morning: How to Profit from Hottest M&A Activity Since 2007 (video)
• Money Morning: Mergers & Acquisitions Are Set to Accelerate in 2011 Following Their Best Start in a Decade
• Money Morning:
  U.S. Companies Spending Record-High Cash Piles on Everything But Jobs
• Money Morning: Stock Exchange Mergers: The Real Story
• Money Morning Archives: Investors' Hopes Riding on Surge in M&A Activity
• Wikipedia:Mergers and acquisitions
• Wikinvest: Acquisition! s
• Investopedia:
  Trademarks of a Takeover Target
• Wikipedia: Encyclopedia entry: Free cash flow
• Wikinvest: Enterprise Value to EBITDA
• Big Fat Finance Blog: M&A Activity - and Risks - Expected to Increase

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