Thursday, October 3, 2013

Selecting the Form of Payment: Signaling and Overvaluaton

Selecting the form of payment in an acquisition is a function of many factors.  What post-acquisition ownership structure is desired?  What are the tax consequences?  How much cash does the acquiring firm have?  Is the acquiring/target firm stock overvalued?  What are the legal ramifications for this form of payment? What does the target desire?

These are but a few of the payment related factors to consider in selecting form of payment.  We'll discuss just one aspect here - the concept of signaling and overvaluation.  Firm's that use stock to acquire other firms tend to experience a small drop in the market value of their shares.  Similar results are found for firms issuing equity.  

What explains the loss of market value?  The evidence is consistent with  the Signaling Hypothesis, which suggests that the use of stock is because the acquiring firm's managers believing that their stock is overvalued.  

Consider the following scenario - you are CEO of a firm whose shares are trading at $30.  You believe, however, that the shares are worth $20.  Thus, the shares are overvalued by 50%.  Now eventually, the market may 'wise up' and revalue your shares.  As a way to create value for existing shareholders you consider exchanging the overvalued equity for hard assets of another firm.  In this way you 'lock - in ' the excess value even if shareholders recognize your current overvaluation.

Now consider using shares for acquisitions.  Would you do so if you thought the shares were undervalued?  Probably not, you'd be giving away value.  Thus the prevailing wisdom is that firms using stock don't think it is undervalued.

Empirical evidence, showing stock drops on the order of 3% at the announcement of a stock deal, are consistent with this idea.

We'll discuss these and other ideas in great detail in Amsterdam, just over two months from now(see side note or click here)

All the best,


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