Merger activity seems to rise in step with the market. Academic papers suggest this may be due to bidders exploiting overvalued shares, a pro-cyclicality of merger economies of scale or available capital for deals, or simply the behavioral pressures of a “me too” mindset among CEOs. But this positive association is not altogether intuitive, as practitioners and academics alike ask “why do we not see merger waves during bear markets in which acquirers are bargain-hunting for undervalued firms.”
In our working paper “Merger Activity, Stock Prices, and Measuring Gains from M&A” we offer a fresh take on the positive correlation between the two. Rather than explaining why bidders are more active when prices are higher, we propose it is their activity that in part drives up market valuations. To arrive at this hypothesis, we begin with the well-known fact that rumors about a specific target lead to run-ups in its share price. Similarly, it is also known that prices tend to rise for firms in an industry that is considered “in play.” We expand these intuitions to the broader market, suggesting that as deal activity increases, markets assign all firms higher probabilities of getting acquired at significant premiums. In a rational market, this option (of being acquired) then becomes more valuable, and prices rise accordingly.
We first model firm prices—and thereby the aggregate market when summing across all firms—as incorporating expectations of: i) the present value of their future (standalone) dividends, ii) the possibility of being acquired, and iii) the likely premium obtained in such a deal. Using historical trends about merger activity and conservative estimates of the other parameters involved, we find that 10-15% of a typical firm’s total value, and therefore of the market as a whole, can be attributed to general merger anticipation. We call this portion of the price the “embedded merger premium,” and note that it exists in a firm’s price long before any deal- or industry-specific merger rumors. At today’s prices, this embedded merger premium is responsible for trillions of dollars of the observed aggregate market value of U.S. publicly traded firms.
The model also shows how increases in merger activity lead to rational increases in stock prices. As trends in merger activity are highly persistent—with spikes in deals predicting higher future merger activity—a jump in announced deals increases the value of the option to be acquired, and prices rise accordingly. In some specifications of the model, the beginning of a merger wave leads to a double-digit jump in stock prices across the market. Thus, we believe a significant portion of the link between deals and prices can be attributed to the former rationally increasing the latter, rather than targets somehow becoming more attractive when they are more expensive.
We next test the model’s predictions on a large data set of U.S. deals over the last 25 years. Although we are unable to observe the embedded merger premium directly, our results are very supportive of our theoretical hypotheses. First, we look at how markets respond to changes in deal activity, and find that aggregate price increases far exceed anything than can be explained by the specific deals themselves. Depending on the regression design, we find that each dollar of deal premium announced is associated with between $10 and $50 of increase in value across all listed firms. Such increases not only dramatically exceed that of the deal itself (in which each dollar of premium or synergy essentially leads to a $1 increase), but likely exceed any story that tries to contain these gains within the affected industry or industries.
Subsequent tests verify that deal announcements have a positive effect on the stock prices of firms far beyond any measure of relatedness. When we split deal announcements and subsequent returns by industry, we find that the effect of deals on firms outside that industry are as large as those within the industry when measured as percent returns. As any industry comprises a small subset of the overall market, this implies that the effects outside the industry are actually much larger than those within it when we measure the impact in dollar terms. We run additional tests to verify that our results continue to hold across a variety of measures of deal activity, and also across a number of different ways of measuring the relatedness of firms. We conclude the empirical evidence is highly consistent with markets reacting positively to deal announcements, and the likely explanation is that traders increase valuations by increasing the likelihood they put on subsequent deals across the broader market.
In addition to these insights about the link between merger activity and aggregate stock prices, our paper offers one final important takeaway to those interested in the M&A realm. Specifically, we note that if prices already include a significant premium associated with the anticipation of a buyout, then traditional event study methods of measuring the gains or synergies from deals dramatically understate the associated benefits. By measuring the gain from a deal as the difference between what is offered and the price prior to the deal, previous studies omit the portion of the gain that was embedded in the price long before any deal-specific rumors. Although this portion was already in the target’s price, it must be accounted for to correctly measure how much mergers add to a firm’s standalone value. This is necessary simply to get an accurate measure of the direct gain, and still understates the indirect value a healthy M&A market creates by pressuring firms managers to perform or get ousted in a deal.
In conclusion, we offer a new take on the old assertion that stock prices drive merger activity. Rather than presume that bidders find higher-priced targets more attractive, we propose that it may be the bidder interest driving up prices in the first place.
 Goel, Anand M., and Anjan V. Thakor, 2010. Do Envious CEOs Cause Merger Waves? The Review of Financial Studies 23:487-517.
The preceding post comes to us from Benjamin Bennett, Assistant Professor of Finance at the Ohio State University, and Robert Dam, Assistant Professor of Finance at the Leeds School of Business, University of Colorado. The post is based on their paper “Merger Activity, Stock Prices, and Measuring Gains from M&A,” which is available here.