Relevance of Misvaluation to the Intensity and the Value Effects of

As discussed in the above section, misvaluation related takeover motives can explain why the relationship between takeove rs and misvaluation occurs. These motives can further quantify such a relationship by shedding light on the activity and the value creation of corporate takeovers in the presence of misvaluation. Related literature is reviewed in this section, including research towards examining the relevance of misvaluation to both the intensity and the value effects of takeovers.

Transaction intensity refers to the fluctuations in total takeover activities. Such fluctuations, presented by takeover waves, have persisted in the market for corporate control over the past several decades. The trend of mergers clustering during high stock market valuation periods has been rationalized by the theoretical models formalized by Shleifer and Vishny (2003) and Rhodes-Kropf and Viswanathan (2004).

The Shleifer and Vishny (2003) model, as previously mentioned, regards positively perceived synergies and potential earning growth during high valuation periods as the motives driving a firm to engage in the takeover market. Furthermore, targets are willing to accept these overvalued offers due to their managers‘ self-concerns. These two motives, from both a bidder ‘s and a target‘s perspective, suggest a relation between high takeover intensity and high valuation. This model

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elucidates the acquisition experiences in the US market, particularly the conglomerate merger wave in 1960s and the merger surge in the second half of the 1990s. Both of these takeover movements took place during a period of rising stock market valuations.

This relation is later confirmed by the Rhodes-Kropf and Viswanathan (2004) model. As above discussed, it regards hyped synergy-estimates as the driving force of a firm‘s involvement in the takeover market. According to it, the mis-estimated synergies, which increase with market valuation, lead to active merger activities during high market valuation periods.

More systematic empirical evidence is provided by Rhodes-Kropf et al. (2005). They deconstruct misvaluation into three components: the firm-specific pricing deviation from short-run industry pricing (firm-specific error), sector-wide, short-run deviation from long-run pricing (time series sector error), and long-run sector pricing to book (long-run value to book). Concerning a sample of US mergers and acquisitions announced from 1978 to 2001, they examine the relevance of misvaluation to the intensity of takeovers. Their empirical findings, based on a probit regression analysis, indicate that merger intensity is positively correlated with the firm-specific error and the time series sector error.

To summarize, several theoretical models have been applied to explain takeover intensity in the presence of misvaluation. Although these theoretical models and the takeover motives underlying them are different, they all suggested a relation between high takeover intensity and high valuation / overvaluation.

Compared with the theoretical implications on transaction intensity, the effects of misvaluation on merger performance are presented with more mixed empirical results (as shown in Table 3.1). Literature on the value effects of misvaluation is reviewed in the paragraphs below.

Mergers, motivated by the low finance costs in the presence of overvaluation, are likely to be associated with high takeover premiums. This is beca use bidders, once overvalued, are capable of offering a higher premium due to their loose capital constraints. These high premiums, in turn, lead to low returns for acquiring firms (Dong et al., 2006).

This relationship between overvaluation and low bidder s‘ gains can also be explained by the information asymmetry surrounding bidding firms. As suggested by Ali et al. (2003), a market correction follows the arrival of new public corporate information. Therefore, a takeover announcement is expected to alert investors to a bidder‘s pre-existing misvaluation and thus cause partial corrections to this prior- mispricing. Accordingly, lower bidder announcement-period returns should correspond to bidders‘ overvaluation (Dong et al., 2006).

In line with this research, Draper and Paudyal (2008) report that undervalued bidders outperform their overvalued counterparts in the short-run. This is because, with the existence of information asymmetry between an undervalued bidding firm and investors, a corporate takeover releases information to the market and consequently attracts investors to reappraise the bidder‘s previously undervalued equity. This, in general, raises the bidder‘s stock price around the announcement

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period.

However, this widely documented empirical result, which overvalued bidders tend to underperform, is questioned by Ang and Cheng (2006). They point out that there are differences between the market price corrections to overvaluation and the evidences of underperformance. Accordingly, a methodology of comparing the difference in short-run returns between acquirers and non-acquiring firms, which are on a similar scale of overvaluation, is employed in their study. In line with the prediction of the Shleifer and Vishny (2003) model, they posit that takeovers serve the best interests of shareholders from overvalued bidding firms, since their abnormal returns are higher than their counterparts from non-acquiring firms. In particular, when the rationality condition21 is applied, these acquirers capture positive abnormal returns both around the announcement periods and in the long-run.

In all these aforementioned studies (Ang and Cheng, 2006; Dong et al, 2006; Draper and Paudyal, 2008), misvaluation is measured at a firm level. However, when this line of research is developed to a market valuation context, different empirical results are presented.

Concerning the Canadian takeover market, Tebourbi (2005) provides evidence that acquisitions announced in a booming stock market generate positive announcement abnormal returns to bidders. Investors‘ behaviour is then used to rationalize this positive effect. More specifically, investors tend to be over-optimistic during a high valuation period, which gives rise to a high announcement period return

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for a bidding firm following high recent returns in the stock market.

Similar empirical results are documented by Bouwman et al. (2006), who report that short-run stock returns, long-run stock returns and long-run operating performances of low-market and high- market acquisitions, are fundamentally different. More specifically, announcing acquisitions in a high market period generates significantly higher announcement returns to acquiring firms than low- market acquisitions. However, these bidders‘ gains do not persist beyond the takeover announcement period, as they are followed by significantly lower long-run abnormal returns and poorer long-run operating performances. ‗Managerial herding‘ is then employed to explain the underperformance of high- market acquisitions. It suggests that, if a large number of firms are involved in mergers and acquisitions, subsequent firms will follow the trend while ignoring their own motives and not fully considering the valuations of this investment decision. Therefore, the underperformance of high- market acquisitions is primarily driven by the low stock returns to firms acquiring later in a high- market merger wave.

This negative long-run effect of high market valuation is also reported by Rosen (2006). He attributes these market reactions to the influences of investor sentiment. Specifically, ―when investor expectations are based more on optimistic expectations than reality, the short-run boost in price caused by a merger announcement is reversed in the long-run as the track record of the merger becomes known‖ (p.1016).

To summarise, different components of misvaluation shape takeovers in different ways. The firm-component of misvaluation is in general inversely related to bidders‘

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gains; the industry- and market-components of misvaluation drive up bidder ‘s announcement returns. Although several theories or hypotheses have been suggested to theorize the valuation effects of misvaluation, it is only the information asymmetry hypothesis that can comprehensively rationalize the driving force of each compo nent of misvaluation. At a market or industry level, a high market valuation breeds overestimated synergies due to information asymmetry (Rhodes-Kropf and Viswanathan, 2004). These overestimated synergies can temporarily enhance bidders‘ gains. At a firm-specific level, corporate takeovers release information to the market and consequently attract investors and analysts to reappraise bidders‘ values. If a bidding firm is previously undervalued, its share price can be bidded up through this revaluation process (Draper and Paudyal, 2008).