Merger Synergies and Analyst Forecasts

How do analysts respond to company forecasts during mergers?

Dr Ahmad Ismail from the American University of Beirut analyses over 2,000 U.S. takeovers to find out. His research shows that analysts are more likely to revise earnings upwards when companies forecast large cost-saving synergies, and when led by level-headed CEOs. These revisions often predict real market gains, pointing to a clear investment signal.

Read more research: researchgate/Ahmad-Ismail

Transcript

Hello and welcome to Research Pod! Thank you for listening and joining us today. 

In this episode, we look at the work of Dr. Ahmad Ismail, finance professor at the American University of Beirut - in particular his contribution to understanding how stock market analysts assess news coming from companies that are planning a corporate  takeover. This is a crucial subject  because… 

in the lifecycle of a public company - that’s an enterprise with shares trading on an open stock market - the biggest event that can happen - other than liquidation, is a merger with another company. This major strategic move can be the making of both of them, but it can be the breaking of them.

Mergers are highly complex, high risk undertakings. The potential returns are also high, and that, of course, is why they happen - making this kind of corporate event particularly interesting to stock market investors.

Companies planning a merger – particularly the takeover of a smaller company – used to calculate behind closed doors. But in recent years, there’s been an increasing amount of news coming out before a deal is done – particularly from companies looking to make an acquisition - releasing forecasts of the merger’s expected benefits, which are usually either cost savings or increased revenues.

These benefits are called “merger synergies”, and broadcasting these internal synergy calculations alongside a deal announcement amounts to an invitation for stock market investors to buy into the acquiring company ahead of the merger, in anticipation of an uplift in earnings. 

The release of these positive news stories raises the crucial question of reliability… do these positive predictions turn out to be true, and are they correctly assessed by the markets? 

Dr. Ismail’s team looked at merger and acquisitions in the United States over a twenty-three-year period, focusing on cases where the completed merger transferred full control to a buying company. This identified a group of over two thousand deals to investigate.

The team then collected earnings forecasts from the analyst community for all of these – forecasts made before the completed merger but after the acquiring companies’ own forecasts were released – to identify whether equity analysts subsequently upped their earnings forecast, and if so, by how much.

Old analyst recommendations are readily available to view on “The Institutional Brokers Estimates System”. Dr Ismail’s team looked at the system’s records of longer term, two-year ‘earnings per share’ forecast revisions, rather than the more commonly studied short-term ‘earnings per share’ forecasts, so that the study could assess the analysts’ ability to assess the sort of structural,  longer-term company performance changes that a merger would create. 

Researchers then examined the two-thousand mergers to find acquiring companies that had released internal forecast data before the deal was made. This meant making manual searches in cashflow projections reported in company statements, in press conferences and in tax filings. This extensive research identified pre-deal disclosures from over five-hundred of the two-thousand-plus mergers, so that’s around a quarter of bidding companies releasing pre-merger calculations.

This research let the team identify the existence of any analyst earnings revisions made after internal merger news was published, and it also provided insight into how specific company information impacted earnings revisions. It also allowed Dr Ismail’s team to see whether the company forecasts were accurate when compared with what actually happened to the company’s stock market valuation after the merger.

The study found that stock analysts did raise their company earnings forecasts for companies which released positive internal data about a planned takeover.

But this wasn’t a blanket rule. 

Further investigation found that it generally took news of really large merger benefits for analysts to revise their earnings forecasts upwards. Larger announced benefits also ended up being associated with more accurate forecasts than more minor advantages, which did not necessarily make an impact on future earnings growth.

Analysts also took far more note of a company’s positive news of a merger where the benefits were driven by planned cost-savings  - but not by promises of revenue increases. This behaviour supports the generally held view that mergers made on the basis of increased revenue opportunities tend to fail far more than cost-cutting mergers. Costs tend to be more transparent to identify and easier to act on, whereas relying on revenue growth tends to be a more speculative strategy.

This important distinction between the rationales of “cost-savings” and” revenue gains” brings the reputation of an acquiring company’s Chief Executive into the mix when it comes to the way that equity analysts approach internal company forecasts. It is widely held that the more gung-ho, overconfident CEOs often fall for the sort of acquisitions that might massively increase revenues.

These “scaling-up” strategies are more often than not delusions of grandeur that end in operational failure and destroy shareholder value. So, Dr Ismail thought it would be instructive to examine the analyst community’s response to different characters of takeover planning CEOs – namely the over-confident versus more level-headed leadership.

Dr Ismail identified the two categories of CEO by finding the publicly available data on company stock options that each ‘chief exec’ held, and screening for the ones holding unexercised options that were highly profitable to cash-in, with the rationale that this identified overconfident CEOs, as a more realistic, level-headed chief-exec would’ve banked the high returns on offer, rather than hanging on for the highly unlikely prospect of even greater profits. This way of revealing overconfidence was developed in the noughties by finance economists Malmendier and Tate. 

Using their stock option behaviour method as a guide, Dr Ismail found that analysts did indeed take far more note of forecast takeover gains made by CEOs who did not fall into the overconfident category.

The study also found that analysts took far more notice of companies with a reputation for good governance. Dr Ismail assessed this quality using an industry-standard benchmark called The Entrenchment Index - made up of six company provisions considered to indicate high management standards - created by Harvard Law Faculty members. And as with the quality of the CEO, analysts did indeed take far more note of company forecasts made by those that passed The Index tests for good corporate governance.

Dr Ismail then went on to investigate the analysts themselves – in particular, how good they were at coming to their own conclusions about a possible merger, and whether analysts with different levels of experience treated the company’s internal figures in different ways.  The study judged an analyst’s experience and skills by looking through their history of forecasts and identifying error levels relative to other analysts. Their forecasts were also assessed for accuracy by calculating the range of projected earnings – with a wider range of outcomes indicating a less confident analyst

Individuals were also ranked simply by the number of years they’d been making forecasts.

This rigorous screening process revealed that the less confident and experienced analysts relied more on internal corporate forecasts than their more confident and experienced peers.

The study lastly turned from the analysts behaviour to the markets, to ask the all-important question – were these positive company earnings updates actually accurate? Did the mergers add to shareholder value as the companies had stated?

To answer this crucial question, the team compared analyst forecast revisions with subsequent market prices and used this data to build contrasting portfolios: one holding acquiring companies whose earnings estimates had been revised upwards after internal forecasts were published, and another with acquiring companies which had not been upgraded – and the portfolio with that stock which had positive analyst earnings updates showed consistently larger excess returns over time.

So, markets did take note of the analyst community’s selection of positively revised stocks. The study also found that a portfolio holding stocks subject to high upwards earnings revisions outperformed a portfolio with lower upwards earnings revisions. Dr Ismail had found a clear outperforming investment strategy –buy and hold acquirer companies that have been revised upwards by analysts following internally generated forecast of high merger synergies – build a stock portfolio holding taking-over companies that have been substantially revised upwards by analysts in response to company news of projected high merger benefits – what Dr. Ismail calls a “high revision, high synergy” investment portfolio.

This is the high practical conclusion to an in-depth academic study that reveals so much about the role of company news and stock analysts’ treatment of that news when it reveals benefits of a planned takeover – a momentous event in a company’s history. 

As Dr Ismail comments, “ our findings confirm the usefulness of management projections and the information role of bidding management and stock analysts. “

That’s all for this episode – thanks for listening. Links to the original research can be found in the shownotes for this episode. And don’t forget to stay subscribed to Research Pod for more of the latest science! 

See you again soon.