These 9 stocks could be the next takeover targets
2015 has been a huge year for deal activity, with world-wide mergers and acquisitions up 36 percent compared with the first 5½ months of 2014, according to Thomson Reuters. And the deal talk has heated up in the past week, with the major health insurance firms clamoring to complete tie-ups, and energy company Williams (WMB) rejecting an offer from Energy Transfer Equity (ETE).
So if the rampant dealmaking continues, which companies could be next to get a suitor?
Since smaller companies are more likely to get acquired than giants, it's worth starting off by looking only at companies with market values ranging from $500 million to $2 billion.
Then, one must think like an acquirer. While stock investors typically look at valuation measures like price-to-earnings ratios or a stock's dividend yield, a potential pursuer looks at a company differently, from what's known as a "control perspective" in the valuation context.
The price one is paying for a company's expected earnings, or the size of the dividend checks that company sends out, has paramount relevance for an individual investor. That's because the investor must more or less accept the company's operations and corporate structure as is. But if an investor is acquiring control over a company, that party can completely revamp a company's operations-changing its management, shifting its capital structure, or combining operations with other portfolio companies, among many other maneuvers.
That's why investors in prospective M&A candidates should perform valuation analysis in the context of a company's core operations.
One way to do this is to examine a company's free cash flow yield. That's a valuation measure that compares a company's cash flow per share (a broad measure of how successfully a company is generating income) to its market price per share.
A second way to get inside the mind of a potential buyer is to look at a metric known as enterprise multiple, which we get by taking a company's enterprise value (essentially, the market value of a company's shares plus the market value of its debt, minus its cash and investments) and dividing it by its earnings before interest, taxes, depreciation, and amortization (EBITDA). The lower a company's enterprise multiple, the less investors are paying for a business in terms of its earnings, and thus the better value it may be.
However, even if a company has an attractive valuation on both a free cash flow yield and enterprise multiple basis, a high degree of leverage will make an acquisition less attractive. Also, a high debt-to-equity ratio may also be taken as a sign of poor corporate health (though cross-industry or even cross-company capital structure comparisons are difficult to make).
With all this in mind, CNBC screened for small- and mid-cap companies with free cash flow yield above 6, an enterprise multiple below 6, and total debt as a percentage of equity below 30 percent. Using data and screening technology from FactSet, the following nine names emerged.
Naturally, knowing whether a company will get taken out is impossible (or, if possible, trading on that knowledge illegal). And most stocks, of course, do not get acquired, which makes betting on possible takeout targets a bit akin to buying a lottery ticket.
However, if the M&A spree continues, investors in many companies are sure to be surprised with sudden riches. And for those who want to be counted among that group, looking at control-oriented metrics like free cash flow yield may be the best place to start.
Correction: An earlier version of this article provided an incorrect definition of enterprise value. However, the enterprise multiples used in the screen and given in the table were correct and have not been changed.
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