By Kara Sherrer
Many studies have demonstrated a connection between company earnings and stock prices. When a public company announces increased earnings, the stock price rises accordingly. However, the situation becomes more complicated when one company has announced its intentions to merge with or acquire (M&A) a second target company — but the deal hasn’t gone through yet. In this interim period, it’s unclear which company (and, by extension, which shareholders) will eventually reap the target company’s profits.
New research from Rita Nevada Gunn, Assistant Professor of Accounting, explores exactly this scenario in a paper entitled How Do Investors Respond to Targets’ Interim Earnings? Alongside co-authors Spencer Pierce and Miles Romney of Florida State University, Gunn examined 1,728 unique transactions where the target company made at least one earnings announcement during the waiting period.
The authors found that the target companies’ stock prices positively correlate to their earnings during this interim period, but only if the merger or acquisition bid is unsuccessful. In other words, investors only price the target company’s interim earnings into its stock price only if the deal falls through, suggesting investors can at least partially anticipate the outcome of the deal.
In cases where the merger or acquisition was successful, the authors did not find that the stock prices were affected by unexpected interim earnings at the time of announcement. However, the authors did find that target companies’ interim earnings predicted future returns of the combined firm following deal completion, suggesting the investors respond inefficiently to the earnings news. This finding contradicts the earnings management explanation from prior studies, which predicts that firms with higher earnings should exhibit more negative returns after deal completion.
“The finding that acquiring shareholders do not efficiently process the earnings of the firm they are in the act of acquiring (the target firm) is interesting because the target firm earnings are both publicly announced and predictive of the earnings of the combined firm after the transaction completes,” says Gunn. “This means the market is not incorporating relevant information into their prices.”
The deals studied were large, public events with deal announcements and other documentation made available, so the authors argue that it is unlikely the investors did not have the information needed to respond effectively to these potential M&As. The authors find that the mispricing they document is due to investors struggling to integrate the economic effects of the acquisition into the valuation of the combined firm rather than being unaware of the acquisition.
This study adds to the literature on determinants of M&A deal outcomes and factors impacting earnings-return relations.
The study, How do investors respond to targets’ interim earnings?, has been accepted in the November 2023 issue of The Accounting Review.