Overvaluation, Diminishing Profitability, and Acquisitions

Abstract

We find that a firm is more likely to engage in acquisitions when its private information, measured by changes in purchase obligations, predicts that future profitability will fall and thus that its shares are overvalued in the current stock market. Overvalued acquirers are as likely to pay with stock as non-overvalued acquirers, suggesting that these firms do not necessarily take advantage of overvalued stock. Such acquisitions are followed by increases in profitability and generate positive announcement returns that are similar in magnitude to those generated by non-overvalued acquirers. In addition, bidding-period returns on overvalued acquirers are higher than those on similarly overvalued non-acquirers. Being an overvalued acquirer is not associated with executive compensation structure or ownership, suggesting that these acquisitions are less likely to be driven by managers' private incentives. The results suggest overall that managers engage in acquisitions to boost profitability when their private information predicts diminishing profitability rather than to take advantage of overvaluation and that such acquisitions benefit shareholders.

Keywords: Overvaluation, Information Asymmetry, M&A, Profitability

JEL Classification: G30, G32