Thursday, July 23, 2015

Apple Profits Surge 38%; Price Drops 7%

The headline above, paraphrasing results in today's WSJ drives home a reality of the market.  It is not enough to outperform your past, you must outperform expectations. In an efficient market, past performance and future expectations are already discounted (i.e., reflected in price).  What matters is how you perform relative to those future expectations.  Indeed, in the case of Apple, sales of iphones were 35% higher than the same quarter a year before.  And sales more than doubled in China.  Not enough.  The market expected more.

A firm's stock price will always be forward looking, reflecting future expectations.  Deviations from those expectations, either up or down, will move the stock price.  Thus, prices move based on new not historic information.

So how does this relate to mergers.  In pricing a deal bidders (should) establish a walk away price based on their expectation about the present value of future cash flows once a target is under their control.  That walk away price represents the maximum the acquiring firm should pay.  But what is the minimum price the bidder can get away paying?

For a publicly traded firm, this minimum is generally above the prevailing stock price.  But here is where expectations come to play.  What if the prevailing stock price anticipates acquisition.  In this case the market price of the target is already inflated.  It doesn't represent the value of the target's assets in place but the value of those assets under new management.  Bidders need to be aware of this when setting bid premia.  Flatly paying a fixed premia over an inflated market price raises bidder cost, giving a bonus over values already incorporated in target prices due to the bidder's subsequent actions.  

Yet this is precisely what one influential analysis of bid premia implies.  Bill Schwert, in his paper Mark Up Pricing in Mergers and Acquisitions finds little correlation between previous run-ups and subsequent premia, implying that the runup (anticipation) is an added cost to the bidder.  Note that this does not necessarily imply that this is optimal or sub-optimal practice as we don't know the lowest price at which the bidder actually could have purchased the target.

It does imply, at least to me, the importance of keeping deals quiet before a bid is made.  It also suggests a psychological element to target shareholder behavior.

All the best,


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