The Real Effects of Financial Markets

The following post comes to us from Alex Edmans and Itay Goldstein, both of the Department of Finance at the University of Pennsylvania, and Wei Jiang, Professor of Finance at Columbia University.

In our paper, The Real Effects of Financial Markets: The Impact of Prices on Takeovers, forthcoming in the Journal of Finance, we provide evidence on the real effect of financial markets. Using non-fundamental shocks to market prices — occurring due to non-discretionary trades by mutual funds that face liquidation pressure from investors’ outflows — as an instrumental variable, we show that market prices affect takeover activity. A non-fundamental decrease in the stock price creates a profit opportunity for acquirers, and increases the probability that the firm will be taken over. Using an instrument for price changes is essential for identifying this effect since market prices are endogenous and reflect the likelihood of an upcoming acquisition. This may explain the weak relationship between prices and takeover activity found by prior literature. By modeling the relationship between prices and takeovers as a simultaneous system that accounts for anticipation, and identifying using an instrument, we find a significantly stronger effect of prices on takeovers than previous research.

The research question that we are aiming to answer is whether a low market valuation makes a firm a takeover target. In theory, if acquisition prices are related to market prices, acquirers can profit from taking over a firm, whose market value is low relative to its peers — either due to mispricing or mismanagement — and restore it to its potential. However, existing empirical studies on takeovers fail to systematically uncover a meaningful relationship between market valuations and takeover probabilities. These results cast doubt on the received wisdom that market valuations create a takeover threat that forces managers to improve firm performance. We argue that these insignificant results arise because there is a fundamental challenge in finding a relation between market prices and takeover activity in the data, since the relationship can go in both directions. While markets may exhibit a trigger effect, in which a decrease in market valuation due to mispricing or mismanagement induces a takeover attempt, there is also an anticipation effect which leads to reverse causality from takeover activity to market valuations: forward-looking prices are inflated by the probability of a future takeover.

We adopt a new approach that consists of two major deviations from the existing literature. First, prior literature studies the effect of raw valuations (such as price-to-earnings or market-to-book ratios) on takeover likelihood. However, a low raw valuation may not indicate underperformance and thus the need for a corrective action, as it may be driven by irremediably low quality — for example, because the firm is mature and in a competitive industry. We thus construct a “discount” measure of the difference between a firm’s current market valuation and its potential value. This discount aims to measure undervaluation due to mismanagement or mispricing, and thus the value that an acquirer can create by restoring a firm to its potential. Hence, it has a theoretical link to the likelihood that a firm becomes targeted by a bidder. We estimate the potential value using tools from the literature on stochastic frontier analysis, based on the values of other firms in the industry or with similar basic fundamentals. Second, we employ an instrumental variable: a variable that directly affects the market price, but affects takeover probability only via its effect on the market price. We construct a measure of price pressure induced by mutual funds sales that are not due to informational reasons, but mechanically induced by flows by their own investors. We find that our measure causes significant price changes, followed by slow reversal that ends with full correction only after about two years.

Our analysis uncovers a statistically and economically significant effect of market prices on takeover probabilities. First, our discount measure exhibits a more significant correlation with takeover probabilities than the valuation measures used previously in the literature: an inter-quartile change in the discount is associated with a one percentage point increase in takeover probability in the following year. Second, by using our instrument to account for endogeneity, the trigger effect rises substantially: an inter-quartile change in the discount causes a seven percentage points increase in takeover probability in the following year. This is both statistically significant and economically important relative to the 6.2% unconditional probability that an average firm receives a takeover bid in a particular year.

Our findings have a number of implications for takeover markets. First, the trigger effect implies that financial markets are not just a side show. They have a real effect on corporate events such as takeovers, and thus on firm value. Interestingly, the active role of financial markets implies that any factor that influences prices can also influence takeover activity (and other real actions). Therefore, mispricing (e.g. due to market frictions or investor errors) can have real consequences by impacting takeovers. Indeed, for identification purposes, our paper uses non-fundamental changes in prices to establish the active role of the financial market. Second, regarding the anticipation effect, our results demonstrate the illusory content of stock prices. While researchers typically use valuation measures to proxy for management performance, a firm’s stock price may not reveal the full extent of its agency problems, as it may also incorporate the expected correction of these problems via a takeover. Our results thus challenge the common practice of using Tobin’s Q or stock price performance to measure management quality. By breaking the correlation between market valuations and takeover activity into trigger and anticipation effects, our analysis enables us to ascertain the extent to which future expected takeovers are priced in. Third, considering the full feedback loop — the combination of the trigger and anticipation effects — our results suggest that the anticipation effect could become an impediment to takeovers — the anticipation of a takeover boosts prices, deterring the acquisition of underperforming firms. Moreover, it may also allow managers to underperform in the first place since they are less fearful of disciplinary acquisitions.

More broadly, our results contribute to the growing literature that analyzes the link between financial markets and corporate events. While corporate finance typically studies the effect of prices on firm actions and asset pricing examines the reverse relation, our paper analyzes the full feedback loop — the simultaneous, two-way interaction between prices and corporate actions that combines the trigger and anticipation effects. We show that prices both affect and reflect real decisions. One important strand of this literature concerns the link between financial market efficiency and real efficiency. While most existing research suggests that the former is beneficial for the latter, our results point to an intriguing disadvantage of forward-looking prices — they may deter the very actions that they anticipate.

The full paper is available for download here.

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