Valuation waves and merger activity: The empirical evidence

To test recent theories suggesting that valuation errors affect merger activity, we develop a decomposition that breaks the market-to-book ratio (M/B) into three components: the firm-specific pricing deviation from short-run industry pricing; sector-wide, short-run deviations from firms' long-run pricing; and long-run pricing to book. We find strong support for recent theories by Rhodes-Kropf and Viswanathan [2004. Market valuation and merger waves. Journal of Finance, forthcoming] and Shleifer and Vishny [2003. Stock market driven acquisitions. Journal of Financial Economics 70, 295-311], which predict that misvaluation drives mergers. So much of the behavior of M/B is driven by firm-specific deviations from short-run industry pricing, that long-run components of M/B run counter to the conventional wisdom: Low long-run value to book firms buy high long-run value-to-book firms. Misvaluation affects who buys whom, as well as method of payment, and combines with neoclassical explanations to explain aggregate merger activity.