Acquirer Reference Prices and Acquisition Performance

David A. Whidbee is Professor and Omer L. Carey Chair in Financial Education at Washington State University; Qingzhong Ma is Assistant Professor at California State University, Chico; and Wei Zhang is Assistant Professor at California State University, Chico. This post is based on their recent article, forthcoming in the Journal of Financial Economics.

How do investors adjust their estimates of a stock’s value in response to an acquisition announcement? Rationally, the acquirer’s new stock price should reflect the synergistic gains associated with the merger, the premium paid to target company shareholders, the method of payment, and other value-relevant information associated with the acquisition. But what if the acquirer’s stock value is already difficult to estimate or there is limited information available about the target company? Is it possible that investors rely on heuristics under these circumstances? Specifically, we are interested in whether investors are influenced by readily available salient reference prices, even if those reference prices are fundamentally irrelevant.

In our article, Acquirer Reference Prices and Acquisition Performance, we find evidence that at least some investors are indeed influenced by the acquirer’s 52-week high price when assessing the valuation implications of an acquisition announcement. Specifically, in a large sample of acquisitions of both public and private targets, we find that acquirers with pre- announcement stock prices well below their 52-week high prices earn significantly higher announcement period abnormal returns than acquirers with stock prices at or near their 52-week highs. We call this the reference price effect. It suggests that acquirers with stock prices well below their 52-week high prices are perceived by investors as being undervalued relative to acquirers with stock prices at or near their 52-week highs.

The reference price effect and the impact of 52-week high prices on perceived valuation levels are rooted in anchoring, the well-known psychological phenomenon first documented by Tversky and Kahneman (1974). Anchoring describes the common tendency of individuals to be influenced by numeric anchors when estimating unknown numbers even if the anchor is irrelevant. For example, it is well known that buyers and sellers anchor on list prices for homes and cars, so those list prices influence ultimate transaction prices. This anchoring phenomenon is considered one of the most robust findings of experimental psychology and it has been used to explain a variety of empirical results. Recent work by Baker, Pan, and Wurgler (2012), for instance, documents a tendency for offer prices to cluster around target-firm 52-week high prices in acquisitions of public targets. Our results suggest the 52-week high price also influences investors’ perceptions of valuation levels of acquirers in mergers and acquisitions.

Consistent with the anchoring phenomenon being more important in circumstances involving less information or more uncertainty, the reference price effect is more pronounced in acquisitions of private targets and when there is more uncertainty regarding the impact of the acquisition on the acquirer’s value (when the acquirer’s stock price is more volatile, there are fewer analysts following the acquirer, in acquisitions of relatively large targets, and acquisitions involving non-cash forms of payment). The reference price effect is also more pronounced in acquirers with relatively large individual investor ownership, suggesting that less sophisticated investors are more likely to be influenced by 52-week high prices. These results hold even after controlling for a host of firm and deal characteristics and they survive a battery of robustness checks.

We consider several potential rational explanations, but conclude that none can adequately account for our results. For example, it is possible the reference price effect can be explained by some overlooked fundamental factor associated with acquisitions. Other possibilities include investors anticipating the acquisition for some of our acquirers, managers with high stock prices becoming overconfident and making poor acquisition decisions, or high stock prices protecting managers from monitoring. In all of these potential explanations, the reference price effect should be permanent. In reality, however, long-horizon returns exhibit a reversal of the short horizon return pattern: acquirers with pre-announcement stock prices well below their 52-week high prices tend to earn lower long-horizon abnormal returns than acquirers with pre-announcement stock prices that are at or near their 52-week high prices. This suggests the reference price effect is driven by an irrational behavior bias.

Our results add to the evidence that valuation level perceptions influence investor reaction to acquisition announcements and deal outcomes. Rhodes-Kroph et al. (2005) and Dong et al. (2006) document that perceived valuation levels influence investor reaction to acquisition announcements and deal outcomes. However, their analysis focuses on conventional measures of valuation levels (current stock prices relative to book values or estimated fundamental values). Our results, on the other hand, indicate that the 52-week high also influences investor perceptions of valuation levels in mergers and acquisitions.

In fact, our analysis of bid premiums and target-firm announcement period returns indicates that perceived valuation levels based on 52-week high prices do not just influence investor reaction to acquisition announcements, but can also influence merger negotiations. When there is greater uncertainty concerning acquirer valuation levels or when non-cash forms of payment are involved, acquirer’s with current stock prices close to their 52-week high prices tend to pay higher offer premiums, and this carries over into announcement-period abnormal returns for target firms. When there is little uncertainty concerning acquirer valuation levels or in cash deals, on the other hand, offer premiums tend to be influenced more by target-firm 52-week high prices. We find little consistent evidence that the acquirer’s 52-week high price influences the method of payment, the likelihood of the acquisition being a tender offer or hostile, or the deal’s success. Rather, our results suggest that these deal outcomes are not affected by 52-week high prices because firm managers have significant say over these outcomes, and managers are less likely to be influenced by irrelevant reference prices due to their sophistication and access to value-relevant information.

Overall, our results indicate that investors and merger negotiations are influenced by salient reference prices when assessing the valuation implications of an acquisition announcement, even if those reference prices are fundamentally irrelevant. Because this influence is irrational and driven by anchoring, a behavioral bias, its influence on announcement period abnormal returns is ultimately corrected in the long run.

The complete article is available here.

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