In a new paper, “Worthless Companies,” I explain how companies with worthless assets can have substantial equity value on efficient markets and debt that trades near par, so long as an irrational bidder may acquire the company.
Consider a firm with a market value of more than $1 billion. The firm has sales under $1 billion and has never been profitable. The firm describes its mission as, “to make incredible home cooking accessible to everyone,” and its business is to sell ready-to-prepare meals. Or consider a firm with a market value of more than $8 billion with revenues of just over $1 billion. The firm is not profitable and describes its mission as, “to be the traveler’s first and independent source of information for finding the ideal hotel at the lowest rate.”
Companies like these — with large market capitalizations and no profits, especially in new and largely unproven businesses — raise many interesting questions for investors, scholars, and practitioners. The large market values suggest high asset values. At the same time, someone sympathetic to the possibility of rampant irrationality in the financial markets might see the values as evidence of “animal spirits.”
My new paper considers another possibility: Worthless companies can trade for large positive values in efficient and rational markets. (I do not assert here that any of the firms used as examples above are worthless.) A worthless company, as I use the term here, has assets of no value. The accounting equation, assets equal liabilities plus equity, suggests that the debt and equity of a worthless company should also have no value. Instead, however, the possibility of an irrational acquisition of the worthless company by another company can cause the debt and equity of the worthless company to trade at positive and potentially large values. Irrational acquisitions may occur, for example, because the acquiring company’s managers are excessively optimistic, they are engaged in blind empire-building, or opinions about the target’s value vary widely. Each explanation has substantial support in the financial economics literature.
A robust finding in the mergers and acquisitions literature highlights the very different effects of tender offer announcements on the stock of acquirers and targets. “Extensive empirical evidence supports the view that takeovers are beneficial to the shareholders of target firms,” wrote Professor Gregg Jarrell of the University of Rochester and Annette Poulsen of the University of Georgia nearly 30 years ago. “Virtually every study has found that these shareholders receive large premiums, averaging about 30%, for their shares. The wealth effects on shareholders of acquiring firms, however, are much more puzzling. Researchers measuring these wealth effects have found them to average close to zero and to be negative for some categories of offers.” Those effects still exist, and the worthless companies hypothesis may help in understanding them.
The worthless company hypothesis may also help explain why target company debt can deter takeovers, and why target company bonds earn significantly higher returns within the two-month period following the announcement of a deal. Those returns are larger when the target’s rating is below the acquirer’s and when the merger will decrease target risk or leverage.
Importantly, the possibility of worthless companies does not require that anyone other than the potential bidder believe that the target’s assets have value. In that case, the securities in the model are not mispriced, even though their worth is based only on the probability that an irrational bidder will acquire the company. To the extent that short sellers believe the securities are worthless because the assets have no value, the value of their short trades will much lower than expected. The poor performance of many short sellers with otherwise compelling cases against the underlying business of certain firms may be due, at least in part, to the failure to recognize the fact that worthless companies can support valuable securities in the presence of a potentially irrational acquisition.
An alternative possibility for arbitrage against the effects of the irrational bidder is to attack it directly. If it is possible to acquire a position in the bidding firm’s equity at this price and then influence the bidding company to abandon the acquisition, the value of the bidding firm’s equity will rise. If the acquisition has already been announced, but an arbitrageur can acquire a position and influence the bidder to abandon it, then the bidder’s equity will rise. However, if potential irrational acquirers are very large, this may be infeasible, both because the cost of acquiring influence may be too high, and because the impact of the irrational acquisition on value may be small relative to the other idiosyncratic risks of the position in the acquirer. Of course, if the irrational acquirer is privately held or controlled, there may be no possibility of arbitrage.
The worthless companies hypothesis also demonstrates the risk of assuming that assets always equal liabilities plus equity. In determining the balance sheet solvency of a company, for example, it is common to compare the market value of the company’s debt and equity (its assets) to the face amount of its debt. The company is considered solvent if that market value exceeds the face value of the debt. The possibility that security prices in an efficient market reflect the probability of an irrational acquisition casts doubt on this method.
The possibility of worthless companies may explain widespread disagreement in capital markets about the value, if any, of a number of high profile start-ups (so-called “unicorns”) and the bad performance of some prominent short sellers with strong cases against the underlying businesses supporting their short trades.
This post comes to us from J.B. Heaton, a lawyer in Chicago and a founder of analytics firm Conjecture. It is based on his recent article, “Worthless Companies,” available here.