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Contrary to conventional wisdom, corporate acquisitions with overpriced shares are generally a losing proposition, study finds

A major corporate acquisition is announced, and, as frequently happens, the stock price of the acquiring firm drops. Is that likely a good buying opportunity for investors?

Surprisingly not, if the bidding company pays substantially in overpriced stock, a new study finds. While conventional wisdom has it that purchasing with overvalued shares prevents or cushions the decline that such shares are normally destined to sustain, it actually makes the fall worse.

The study, in the current issue of The Accounting Review, published by the American Accounting Association, finds that, in general, such acquisitions are harbingers of lagging returns over the long run and frequently lead to big goodwill write-offs and shareholder lawsuits.

"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," write 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."

As an accounting term, goodwill represents the amount a firm pays in excess of the fair value of a company it acquires, in anticipation of earnings-enhancing synergies. A goodwill write-off, the authors argue, is not, as managers often claim, "just a byproduct of a rational use of overpriced shares to acquire sometimes overvalued targets." Quite the contrary, it is "a very consequential event...an important indication of a flawed investment strategy."

As an example, the authors cite the case of eBay's 2005 purchase of the Internet phone company 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 observe that "things soon turned ugly for the online auctioneer, and on October 1, 2007 it 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," comments Prof. Gu, who notes that the percentage of U.S. firms reporting goodwill in their financial statements rose from about 25% in 1990 to about 33% in 2000 to about 50% in 2009. Further, in the words of the study, "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."

Profs. Lev and Gu found that, when they divided their sample into quintiles from least to most overpriced, the payment in stock among the most overpriced group resulted on average in a 17% increase in goodwill on their books compared to a mere 4% increase among the least overpriced firms, suggesting the extent to which the former group tends to overpay. (Among cash-paying firms no such disparity in goodwill increase is seen.) The most overpriced firms also write off as much as 13 times more goodwill than the least overpriced firms do, and the likelihood of write-off-related lawsuits when stock is the acquisition currency increases from near zero among the latter group to as much as 40% among the former.

What accounts for such sorry 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 sum, pressures to maintain inflated stock values push managers into acquisitions that have little to do with any clear management strategy. Driving the purchases instead are "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 derive from data pertaining to thousands of companies that made one or more significant acquisitions of other firms over the period 1990 through 2006. With companies in the sample making a mean of 1.35 purchases over that entire 17-year span, there were a total of 7,055 acquisitions at an average cost of roughly one fourth of the bidding firm's assets. Profs. Gu and Lev combined three widely used measures to determine the extent to which purchasing firms were overpriced at buying time -- 1) the industry-adjusted price-to-earnings ratio of their stock; 2) the amount of discretionary accruals (non-cash earnings items) in their financial reports; and 3) the amount of stock issued by bidding companies in the five years preceding the acquisition. The caliber of companies' governance was assessed through standard measures of shareholder rights and 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 its 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% on an annual basis relative to similarly overpriced non-acquirers."

Prof. Lev, whose research on the hazards of mergers and acquisitions spans 40 years, sees the study's findings as potentially valuable to investors, as well as to auditors and regulatory agencies. "For investors, the combination of overpriced shares and company acquisitions financed by stock should be a red flag," he comments. "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 in stock, the lesson of this study is: Proceed with great caution."

The study, entitled "Overpriced Shares, Ill-Advised Acquisitions, and Goodwill Impairment," is in the November/December issue of The Accounting Review, published six times a year by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA and its specialty sections include Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Auditing: A Journal of Practice & Theory, and The Journal of the American Taxation Association.

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