Corporate acquisitions using overpriced shares of stock rarely do much to cushion the decline the shares eventually suffer, according to a new study.
The study, which appeared in the November/December issue of the American Accounting Association’s journal, The Accounting Review, found that such acquisitions are hardly a bargain, despite conventional wisdom, and often presage lagging returns over the long term. On the contrary, they frequently lead to large write-offs of goodwill, along with lawsuits from groups of shareholders.
“Academics and practitioners often argue that when a firm’s shares are overpriced, it is beneficial to current shareholders to acquire businesses, and even overpay for them, as long as the overpayment is lower than the bidder's share overpricing,” wrote the study's authors, Feng Gu of the State University of New York at Buffalo and Baruch Lev of New York University. “We show that this is not the case. Corporate acquisitions with overpriced shares—many leading to goodwill write-offs—exacerbate the post-acquisition negative returns beyond the overpricing correction."
A goodwill write-off, the authors argue in their study, is not, as managers often claim, "just a byproduct of a rational use of overpriced shares to acquire sometimes overvalued targets." Instead, it is "a very consequential event...an important indication of a flawed investment strategy."
The authors cite the case of eBay's 2005 purchase of Skype for $2.6 billion, in which half the payment consisted of company stock that had risen at about three and a half times the rate of the S&P 500 within the previous two years. The authors noted that "things soon turned ugly for the online auctioneer, and on Oct. 1, 2007 [eBay] announced a massive goodwill write-off of $1.43 billion...related to the Skype acquisition. Meg Whitman, eBay's highly respected CEO, retired soon thereafter in January 2008, and commentators attributed this in part to the Skype debacle."
"Similar stories have become depressingly frequent," said Gu, who noted that the percentage of U.S. firms reporting goodwill in their financial statements rose from approximately 25 percent in 1990 to about 33 percent in 2000 to approximately 50 percent in 2009.
[IMGCAP(1)]The study found that eBay’s experience occurred more generally as well. “eBay’s chain of events from overpriced shares through stock-financed acquisitions and ultimately to substantial goodwill write-offs is, in fact, a general phenomenon,” said the study authors.
Lev and Gu found, when they divided their sample into quintiles, from least to most overpriced, the stock payment among the most overpriced group resulted on average in a 17 percent increase in goodwill on their books, compared to a 4 percent increase among the least overpriced companies, suggesting the extent to which the former group tends to overpay.
In contrast, among cash-paying companies, no such disparity in goodwill increase is seen.
The most overpriced companies acquired with stock also wrote off up to 13 times more goodwill than the least overpriced companies did. The likelihood of write-off-related lawsuits when stock was used to pay for the acquisition increased from near zero among the latter group to as much as 40 percent among the former.
[IMGCAP(2)]What accounts for such negative results? According to the study, “They are not automatic outcomes of acquisitions with overpriced shares...We document that weak corporate governance enhances the association between share overpricing on one hand and acquisition intensity and the consequent goodwill write-offs on the other. Apparently, effective [corporate] directors check managers' urge to use overpriced shares to acquire companies in order to justify and prolong the overpricing. Many such acquisitions are overvalued and strategically incompatible with the bidders.”
In other words, the pressure to maintain inflated stock values pushed managers into making acquisitions that had little to do with any clear management strategy. Driving the purchases instead were "the incentives of overvalued firms to acquire businesses, whether to exploit the overpricing for shareholders' benefit or to justify and prolong the overpricing by maintaining the facade of growth."
The study’s findings came from data on thousands of companies that made one or more significant acquisitions of other companies between 1990 and 2006. Companies in the sample made an average of 1.35 purchases over the entire 17-year span, for a total of 7,055 acquisitions at an average cost of roughly one-fourth of the bidding company’s assets.
Gu and Lev combined three widely used measures to determine the extent to which purchasing companies were overpriced at time they made the acquisition: the industry-adjusted price-to-earnings ratio of their stock; the amount of discretionary accruals (non-cash earnings items) in their financial reports; and the amount of stock issued by the bidding companies in the five years preceding the acquisition. The caliber of the companies’ governance was assessed through standard measures of shareholder rights and the extent of managerial ownership stakes.
The professors found that acquisitions with overpriced shares reduced bidding companies’ profitability by one-third in the year following the purchase and had a significant negative impact on the companies’ stock performance over the following three years beyond what they would experience through a natural correction of overpricing. In the first post-acquisition year, for example, “the bidders suffer an extra negative abnormal return of 4.5 percent on an annual basis relative to similarly overpriced non-acquirers.”
Lev, whose research on the hazards of mergers and acquisitions spans 40 years, sees the study's findings as potentially valuable to investors, auditors and regulatory agencies.
“For investors, the combination of overpriced shares and company acquisitions financed by stock should be a red flag,” he said. “Even relatively unsophisticated investors can gauge stock overpricing in short order by checking industry-adjusted price/earnings ratios on the Internet. If a stock appears to be overvalued, and the firm makes a big acquisition substantially with stock, the lesson of this study is: Proceed with great caution.”
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