Rising stock prices influence bigger mergers

Weekly Corporate Growth Report, Oct 25, 1999

In the past 20 years, the most dramatic wave of corporate consolidation has occurred. In 1992, announced deals had a total volume of $58 billion as compared to the $2.7 trillion in 1998. The five largest deals in history have all occurred within the past 18 months. MCI WorldCom's recent $115 billion acquisition of Sprint is the largest transaction in history.

M&A activity has created companies of unprecedented size and global reach. The combinations are based on the belief that size is important, and market leaders' premium stock market valuations have enhanced that belief. In addition, high stock prices have simultaneously pressured companies to maintain trading multiples through deals.

Furthermore, a relaxed antitrust environment, especially in the telecommunications industry, has enabled companies to respond to the technical revolution through combinations. Weak commodity prices have influenced mergers in natural resource industries. A global perspective of competition and easier international trade have enabled manufacturing sectors such as airplanes and automobiles to become truly global, resulting in previously unimaginable combinations and cross-border alliances.

Continually rising stock prices are influencing bigger mergers. The rise in stock prices can be explained by the strong stock market. Stock values usually represent the minimum for merger prices. As a result, no company expects to purchase another for less than it is trading on the public market. In the mid-1990's, the average P/E ratio in the U.S. was 18 times trailing earnings. Today, that ratio is at 30 times trailing earnings. In addition, the average premium paid by an acquirer has risen from 30.0% to 45.0%.

As prices and premiums rise, risks for the buyer also increase. The premium represents a transferred value that can only be compensated for by improved results at the combined company.

In "The Synergy Trap," Mark Sirower analyzed 168 deals completed between 1979 and 1990. His study concluded that unfulfilled expectations from synergies ruined shareholder value in two-thirds of the deals. BusinessWeek magazine's and Mercer Management Consulting's analysis of 150 deals between 1990 and 1995 revealed that half of them yielded negative returns to shareholders. Another study by PricewaterhouseCoopers L.L.P. for CFO magazine analyzed deals between 1994 and June 1997 and discovered that one year after the deal, the average acquirer's stock was 3.7% lower than other's in its industry.

Creating a larger company by paying higher stock prices does not necessarily result in huge gains. In fact, deals for an excellent company involving stock prices that are too high may ultimately ruin the effects of the company's future business developments. Companies that avoid M&A activity usually perform better in the stock market than acquirers.

(Source: Wall Street Journal)