Stock Market Valuation and Mergers

In recent years, few business topics have commanded as much research and media attention as mergers and acquisitions, perhaps because of the sheer volume of M&A activity: the value of U.S. merger activity equaled around 16% of GDP in 1999 (Bengt Holmstrom and Steven Kaplan, 2001), and the value of M&A worldwide reached a peak of $3.5 trillion in 2000 (Economist, January 27, 2001).

Over the past 40 years, economic theory has provided many rationales —positive and negative — for why firms choose to engage in mergers and acquisitions. For example, acquirers may be seeking to improve efficiency or create market power, or be reacting to deregulation; in other cases, diversification or empire building may be the goal — possibly spurred by managerial hubris. Indeed, empirical research has shown that most of these theories can explain certain types of merger activity, though some theories appear to be more relevant for particular time periods. That is, the 1960s were characterized by diversifying mergers, the 1980s are referred to now as the decade of market discipline, and the 1990s were dominated by deregulation.

Much of the academic and anecdotal research has focused on this crucial question: Do mergers and acquisitions create value? Interestingly, the answer is not clear. Whether acquisitions create value depends on various factors: how value improvements are measured (using short-run or long-run stock performance, or accounting measures of profit, efficiency and so on); the participant examined (bidder, target or the combined entity); the type of deal (tender offer versus merger, or diversifying versus focus-enhancing); the method of payment (cash versus stock versus mixed); the type of target (public, private or subsidiary); and the bidder’s, the target’s or the market’s valuation.

Measures of Value Creation

There are three popular ways to measure whether mergers create value. The first measure — the short-run stock performance of the acquirer, the target or the combined entity surrounding the acquisition announcement — is the most widely used in studies. Many view short-run stock performance as the most reliable evidence of value creation because in an efficient capital market, stock prices quickly adjust to new information and incorporate any changes in value that the acquisitions are expected to bring. Rather than considering actual stock returns occurring over a few days, these studies focus on abnormal returns. That is, they deduct the return investors could have earned by investing in the market as a whole.