When I was thinking of things to write about, I remembered the episode of The Office where Michael is invited to Ryan's business school class for the day. While Michael is in the classroom, one of the other business students asks him how far his Herfindahl index has dropped as a result of a recent merger. (Over the course of this explainer, it will become apparent that that student was incorrect-- mergers will increase this index, not decrease it.) This is completely real, and it's actually something that can significantly impact which stocks are available on the market and how much those stocks are worth. One of the ways that businesses grow, and therefore the value of their stocks go up over time, is by buying other companies.
In general, there are two directions in which it makes sense to buy a company. If you buy a company vertically relative to yours, then the company you bought is somewhere else on the same supply chain that your company is on. Either you bought the company that you make stuff for, which is either the end product itself or is bought by someone else who uses that and adds to it, and that might be the end product, or it might be bought by someone else to add on to it, and so on. But eventually, you end up with the end product, wherever your step is in the chain of production of that thing.
The other way that acquisitions can happen is horizontally. When you buy horizontally, you're buying a competitor-- someone who has established a system that is similar to yours to make a product that is similar to yours, but until the merger, you're working against each other to maximize your profit at their expense and vice versa.
Whenever one company wants to buy another publicly traded company, the government needs to get involved to make sure that the purchase is legal. For more than a hundred years now, there have been laws on the books that define what it means to be anti-competitive: that is what it means to create an unfair advantage in the markets as a result of something that you do, whether that's with how you price things or how you buy up your competitors or your suppliers, and a whole host of other reasons.
The index that the business student asks about (incorrectly, but never mind that) in that episode of The Office measures how concentrated a particular market is.
If the number is 0, then there are an infinite number of sellers who each have an infinitely small amount of the market selling an identical product, and no one individually has any control over the price.
If the number is 10,000, then there exists a monopoly, and one firm has total control over an entire market.
Agencies like the SEC look at this number before they approve or reject mergers. If a merger goes through and you own the buyer, the stock of the buyer will probably rise because now the buyer has access to the technology and processes, and infrastructure of the company that it bought, making it easier to do the things that make a business profitable and it increases stock prices in the long run.
But if a government decides not to allow a merger on the grounds that the index would become too high after that merger, and you own stock in the prospective buyer, your stock will probably fall because the market was expecting the prospective buyer to succeed, but now they faltered, and now they're going to miss out on the intellectual property and the infrastructure and everything else that makes it easier to make bigger profits and to drive the stock price up.
The government typically tries to keep this number below 2,500 after a merger, which in general shouldn't increase the number by more than 200. If either of these things happens, the government is much more likely to rule that the market would be too concentrated and that there would be too few players in the market which individually have too much power, which means the merger is anti-competitive, and so it would not be allowed to go through.
Calculating this index is actually a relatively simple process. Simply take the percentage of the market share of each firm in that market, ignore the fact that that number is a percentage Square it, and add that number for every firm in the market.
So let's look at the two theoretical edge cases, and then something much closer to the middle:
Let's say that in your country, there is one producer of bananas. Because there's only one producer of bananas, that producer of bananas has 100% of the market. So the Herfindahl index is 100², which is the theoretical maximum limit of 10,000.
If, on the other hand, you live in a place where everyone has banana trees in their backyard, everyone sells those identical bananas, and all these banana buyers have to set their price to exactly what everyone else is charging, then the index value is the other theoretical limit of 0, because 0 + 0 + 0 + 0... and so on, is 0.
Now let's find something not at the extremes. Let's say now that in your country there are five producers of bananas.
Now let's suppose we own a considerable amount of stock in producer E, and producer e wants to buy producer A. So the executives of producers E and A go to the government and say that they want to merge. You and the other people who own producer e stock or excited by this prospect because gaining access to the infrastructure and client base of producer A would make your revenues and profits much greater, and so the stock price would rise in the newly merged producer E if that were to come to fruition.
But the government knows its own rules, and it calculates the index before and after the merger.
Before the merger, remember, the index was 2,195.1.
If the government were to allow this merger to go through as planned, they calculate that the index would jump to 3,650.4.
After a merger, the index can't be more than 2,500, and the merger can't cause the index to rise by 200 points or more. The government knows this, so they declined to authorize the merger because the merger would increase the index by about 1300 more points than is allowed at once, to a value more than 1100 points above the maximum allowed.
When the government hands down its decision disallowing the merger of the two companies, stock in both E and A Falls because now neither company will be allowed to work together as a single new company E having behind itself the full strength of the previous companies E and A.
This example was entirely hypothetical, but that doesn't mean at all that cases like this have not happened in the real world in the past, or that cases like this will not happen in the future.
It's not every day that this number matters to the average consumer or even to the average investor, but it's always a good thing to know and to keep at the back of your mind to understand why a company that you're interested in may or may not be allowed to merge with a company it wants to merge with, and what that decision will do to the stock of the company if you like and you have a position in.
In general, there are two directions in which it makes sense to buy a company. If you buy a company vertically relative to yours, then the company you bought is somewhere else on the same supply chain that your company is on. Either you bought the company that you make stuff for, which is either the end product itself or is bought by someone else who uses that and adds to it, and that might be the end product, or it might be bought by someone else to add on to it, and so on. But eventually, you end up with the end product, wherever your step is in the chain of production of that thing.
The other way that acquisitions can happen is horizontally. When you buy horizontally, you're buying a competitor-- someone who has established a system that is similar to yours to make a product that is similar to yours, but until the merger, you're working against each other to maximize your profit at their expense and vice versa.
Whenever one company wants to buy another publicly traded company, the government needs to get involved to make sure that the purchase is legal. For more than a hundred years now, there have been laws on the books that define what it means to be anti-competitive: that is what it means to create an unfair advantage in the markets as a result of something that you do, whether that's with how you price things or how you buy up your competitors or your suppliers, and a whole host of other reasons.
The index that the business student asks about (incorrectly, but never mind that) in that episode of The Office measures how concentrated a particular market is.
If the number is 0, then there are an infinite number of sellers who each have an infinitely small amount of the market selling an identical product, and no one individually has any control over the price.
If the number is 10,000, then there exists a monopoly, and one firm has total control over an entire market.
Agencies like the SEC look at this number before they approve or reject mergers. If a merger goes through and you own the buyer, the stock of the buyer will probably rise because now the buyer has access to the technology and processes, and infrastructure of the company that it bought, making it easier to do the things that make a business profitable and it increases stock prices in the long run.
But if a government decides not to allow a merger on the grounds that the index would become too high after that merger, and you own stock in the prospective buyer, your stock will probably fall because the market was expecting the prospective buyer to succeed, but now they faltered, and now they're going to miss out on the intellectual property and the infrastructure and everything else that makes it easier to make bigger profits and to drive the stock price up.
The government typically tries to keep this number below 2,500 after a merger, which in general shouldn't increase the number by more than 200. If either of these things happens, the government is much more likely to rule that the market would be too concentrated and that there would be too few players in the market which individually have too much power, which means the merger is anti-competitive, and so it would not be allowed to go through.
Calculating this index is actually a relatively simple process. Simply take the percentage of the market share of each firm in that market, ignore the fact that that number is a percentage Square it, and add that number for every firm in the market.
So let's look at the two theoretical edge cases, and then something much closer to the middle:
Let's say that in your country, there is one producer of bananas. Because there's only one producer of bananas, that producer of bananas has 100% of the market. So the Herfindahl index is 100², which is the theoretical maximum limit of 10,000.
If, on the other hand, you live in a place where everyone has banana trees in their backyard, everyone sells those identical bananas, and all these banana buyers have to set their price to exactly what everyone else is charging, then the index value is the other theoretical limit of 0, because 0 + 0 + 0 + 0... and so on, is 0.
Now let's find something not at the extremes. Let's say now that in your country there are five producers of bananas.
- Producer A controls 24.5% of the banana market.
- Producer B controls 17.8% of the banana market.
- Producer C controls 12.6% of the banana market.
- Producer D controls 15.4% of the banana market.
- And producer E controls 29.7% of the banana market.
Now let's suppose we own a considerable amount of stock in producer E, and producer e wants to buy producer A. So the executives of producers E and A go to the government and say that they want to merge. You and the other people who own producer e stock or excited by this prospect because gaining access to the infrastructure and client base of producer A would make your revenues and profits much greater, and so the stock price would rise in the newly merged producer E if that were to come to fruition.
But the government knows its own rules, and it calculates the index before and after the merger.
Before the merger, remember, the index was 2,195.1.
If the government were to allow this merger to go through as planned, they calculate that the index would jump to 3,650.4.
After a merger, the index can't be more than 2,500, and the merger can't cause the index to rise by 200 points or more. The government knows this, so they declined to authorize the merger because the merger would increase the index by about 1300 more points than is allowed at once, to a value more than 1100 points above the maximum allowed.
When the government hands down its decision disallowing the merger of the two companies, stock in both E and A Falls because now neither company will be allowed to work together as a single new company E having behind itself the full strength of the previous companies E and A.
This example was entirely hypothetical, but that doesn't mean at all that cases like this have not happened in the real world in the past, or that cases like this will not happen in the future.
It's not every day that this number matters to the average consumer or even to the average investor, but it's always a good thing to know and to keep at the back of your mind to understand why a company that you're interested in may or may not be allowed to merge with a company it wants to merge with, and what that decision will do to the stock of the company if you like and you have a position in.
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