Companies Bought with Overpriced Shares are Bad Investments, Study Finds

By Jacqueline Molik Ghosen

BUFFALO, N.Y. -- Contrary to conventional wisdom, corporate acquisitions made with overpriced stock are often a losing proposition, according to a study in the current issue of The Accounting Review.

“In general, such acquisitions are harbingers of lagging returns over the long run,” says Feng Gu, associate professor of accounting and law in the University at Buffalo School of Management.

Gu and his co-author, Baruch Lev of New York University, studied thousands of companies that made one or more significant acquisitions of other firms from 1990 through 2006.

“Academics and practitioners often argue that when a firm’s shares are overpriced, it is beneficial to current shareholders to acquire businesses, and even overpay for them, as long as the overpayment is lower than the bidder’s share overpricing,” Gu says. “We show that this is not the case.”

The authors found that corporate acquisitions with overpriced shares exacerbate the negative returns beyond the overpricing correction.

This situation can often lead to big goodwill write-offs and even shareholder lawsuits. Goodwill is the accounting term for the amount a buyer pays in excess of the acquisition’s fair value in the time before it realizes hoped-for earnings benefits from merger and acquisition synergies. When the earnings do not occur, the loss is called a goodwill write-off.

The authors found that the most overpriced companies acquired with stock wrote off up to 13 times more goodwill than the least overpriced companies did. In addition, the likelihood of write-off-related lawsuits when stock is used as the acquisition currency increases from near zero to as much as 40%.

As an example, the authors cite the case of eBay’s 2005 purchase of the Internet phone company Skype for $2.6 billion, in which half the payment consisted of company stock that had risen at about three and a half times the rate of the S&P 500 within the previous two years. In less than two years, eBay announced a massive goodwill write-off of $1.43 billion, related to the Skype acquisition. The resignation of Meg Whitman, eBay’s highly respected CEO, is often partly attributed to the Skype debacle.

“Similar stories have become depressingly frequent,” Gu says, noting that that the percentage of U.S. firms reporting goodwill in their financial statements rose from about 25% in 1990 to about 50% in 2009.

“For investors, the combination of overpriced shares and company acquisitions financed by stock should be a red flag,” the authors conclude.

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