Some of you may remember Sun Microsystems. It was one of the high-flyers during the late 1990s tech boom.

But by March of 2009, Sun’s shares were languishing under $5. Rumors abounded that the one-time tech darling was looking for a suitor.

After all, while Sun’s dominance had faded in recent years, the core server business remained a market leader.

Its Internet software, including the widely used Java programming language, might be a valuable asset to some larger technology firms.

In late March, sources close to both parties leaked news of late-stage negotiations between Sun and tech giant IBM (NYSE: IBM), itself a major player in servers and software.

While terms of the deal were unclear, it appeared IBM was looking to pick up Sun for around $9 per share.

Investors who owned the stock in mid-March before the deal was announced made a near-80% gain quite literally overnight as news of the negotiations broke.

But the story didn’t finish with IBM. A few weeks later, the IBM deal fell through as the company tried to lower its acquisition price and Sun’s board balked at the lower offer.

The word was that another buyer was waiting in the wings with a slightly sweeter payout for the company.

Sure enough, in late April, software giant Oracle took advantage of the confusion to offer Sun $7.4 billion in an all-cash deal, a premium to IBM’s bid.

Now, Sun’s best days were behind it. But none of that mattered. The former tech darling had something other companies coveted. And they were willing to pay for it.

Gains of this magnitude are common when it comes to mergers and takeovers. The average takeover premium in the U.S. over the long run is about 24% — but there are plenty of example where investors made more.

And much of that gain comes in the first few days after a takeover is announced.

Here are a few key criteria to I look for when searching for takeover plays…

5 Traits Of Possible Takeover Targets

1) Fundamentally Strong Firms

Sometimes, companies or private equity firms will take over another firm that has weak fundamentals. Companies with weak fundamentals often see their share prices decline in value — a decline in price makes them cheaper and easier to purchase.

At first glance, such a deal might look nonsensical — after all, why take over a firm that’s performing poorly? There are several possible motivations for such a deal. The acquirer may believe that current management is not making the right decisions and that by replacing management, the company’s prospects could improve.

Alternatively, the acquirer may feel that the company doesn’t have adequate access to the cash needed to fund growth and there is an opportunity to improve prospects by infusing capital.

Nonetheless, the problem with buying a fundamentally weak firm is that you could wait months for a bid, or a bid might never emerge. Stock in the potential target firm could continue sliding while you wait for a deal.

After all, picking takeover targets is never an exact science; if a deal does not emerge, then you do not want to get stuck holding a stock that will not perform well on its own.

2) Industries with Deal-Making Activity

Often, particular industry groups will see an unusually large amount of deal-making activity over a period of time — deal binges of this sort can last for several years.

A classic example in the recent past is the healthcare industry. Many of the largest pharmaceutical companies face a wave of patent expirations every few years.

This is when branded drugs lose patent protection they’re almost immediately subject to competition from generics.

While such drugs can remain profitable, profit margins can plummet. And since most pharmaceutical companies rely on just a handful of blockbuster drugs for their earnings and growth, patent expirations can be a major obstacle.

To offset this weakness, many pharmaceutical firms have been acquiring other drug makers or smaller biotechnology firms with promising pipelines of new drugs.

Because many of the big pharmaceutical companies have high credit ratings and large free cash flow, it’s relatively easy for these firms to finance even multi-billion dollar deals. In fact, it’s not uncommon to see triple-digit premiums.

That makes the healthcare industry fertile ground to search for potential takeover targets.

3) Low Debt Levels

When a company is acquired, the acquiring firm must assume all the target’s debt obligations. In other words, the acquirer has to buy out both shareholders and bondholders or continue to make interest and principal repayments on bonds.

Companies with a great deal of debt are harder to take over — all that debt leads to additional expenses for the acquirer.

This is not a big deal if the acquiring firm is much bigger and can assume all the obligations easily. However, many companies remain leery of taking on too much debt in light of last year’s credit crunch.

One of the key metrics to watch when looking for potential takeover targets is enterprise value (EV) to earnings before interest, taxation, depreciation, and amortization (EBITDA). Enterprise value is equal to the total value of a company’s outstanding shares plus the total outstanding debt minus any cash balances.

Acquiring firms must not only buy out existing shareholders, but they also must assume the target firm’s debts; EV is a good measure of the price an acquirer needs to pay in a takeover. Meanwhile, EBITDA is a measure of a firm’s earnings power.

Pure earnings figures include a large number of non-cash charges such as depreciation. These accounting charges have no real effect on a company’s ability to generate cash; EBITDA is a purer measure of profitability.

EV/EBITDA compares the total value of a firm’s stock and debt to its earnings power; the lower the ratio, the cheaper the stock, and the more likely it is to be a prime acquisition target.

4) Strong Cash Flows

Bondholders and bank lenders typically prefer to lend money to companies that generate copious free cash flows. Reliably cash-generative businesses can carry higher debt loads than more cyclical businesses; potential debt investors are more willing to finance such firms.

This is particularly true when it comes to private equity acquirers. Private equity firms can use the strong cash flows of the target firm to support the large debt burden needed to complete the transaction.

5) Valuable Assets

It’s just common sense. Businesses with unique, one-of-a-kind assets will probably be more desirable to potential buyers.

Case in point… Google paid $12.5 billion for Motorola Mobility strictly to gain control of its valuable patent file. Other companies have been coveted for their real estate, their brand names, or even their manufacturing capabilities.

In short, look for companies with strengths that aren’t readily available – and that others find desirable.

Closing Thoughts

If you can identify stocks that are likely takeover candidates, then you stand to post big gains when a deal is ultimately announced. That’s what my premium advisory, Takeover Trader, is all about.

And if you think it sounds impossible to identify takeover targets before deals are actually announced, think again… Keep this in mind, and you just might be surprised.

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