Cross-sectional Stock Returns on Fundamental value vs. Market Value in Mergers and Acquisitions: Evidence from Japan


This study looks at the difference between the fundamental value and the market value of firms during the merger and acquisition process, and investigates the role of that difference on the method of payments (cash vs. stock) and on the subsequent stock performance around the merger and acquisition (M&A) announcement date. The number of M&A transactions has dramatically increased since the stock swap and stock transfer schemes were introduced in 1999. We investigate the scenario that managers who specialize in analyzing the corporate value of the firms possibly shorten the value correction time and partially reduce misvaluation in the capital market. The Means of Payment hypothesis suggests that the managers should choose stock payment over cash payment when the acquiror is over-valued in the market. However, we found that Japanese managers more positively use cash payment when the firm has sufficient financial slack (is cash rich). The Misvaluation hypothesis suggests that positive excess returns of the acquiror could be detected around the announcement day of M&A transactions, when the acquiror and/or the target is/are under-valued in the market. We found strong evidence which supports the Misvaluation hypothesis. In calculating the fundamental value of the firms, we employed the Residual Income Model, using financial analysts forecast value of future profits, after controlling the book-to-market ratio. We found strong evidence which supports the Misvaluation hypothesis. In particular, the hedging portfolio strategy supports the long position of the acquiring firms (M&A transactions are categorized as high acquiror’s valuation–high target’s valuation group) and simultaneously holds the short position of the acquiring firms (M&A transactions are conversely categorized as low acquiror’s valuation–low target’s valuation group). This combination shows more persistent and more positive abnormal returns than the long position strategy of simply holding acquired stock after all M&A transactions. However, the simple long position strategy in Japan is still positive, when compared to the US.

Merger and acquisitions, Means of Payment hypothesis, Misvaluation hypothesis, Fundamental value, Residual income model

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