Valuation Waves and Merger Activity: The Empirical Evidence1

Merger intensity spikes in times of high market valuations (i.e., when average M/B ratios are at their highest). This is especially true for stock-based mergers, supporting recent theories by Rhodes-Kropf and Viswanathan (2002) and Shleifer and Vishny (2003). To explore whether this is the result of correlated valuation errors or behavioral mispricing we decompose M/B into three components: firm-specific deviation from short-run industry valuations; short-run industry deviations from long-run values, and long-run value to book. The fact that high M/B buys lower M/B is driven mostly by firm-specific deviations from short-run industry average pricing. However, both targets and acquires are priced above their long-run industry average. When we find differences between bidders and targets in long-run valueto-book, we find that low buys high. We also find that the industry-specific component of M/B is highly positively correlated with merger intensity, and correlated with the use of stock. However, long-run value-to-book is uncorrelated with cash merger intensity and negatively correlated with stock merger intensity, leading to little overall correlation between long-run value-to-book and merger activity. One interpretation for these findings is as follows: relatively over-valued firms buy relatively under-valued firms in times when the industries of both firms are over-valued; stock acquisition intensity increases with the over-valuation of the industry, while cash merger intensity does not; and finally, mergers involve cash when high Q buys lower Q but industry over-valuation leads to mergers in which low Q buys high Q. These findings support recent theories but also provide new findings that current theories are unable to explain. VALUATION WAVES AND MERGER ACTIVITY: THE EMPIRICAL EVIDENCE First Draft: September, 2002 This Draft: March 15, 2003