determining value creation through mergers and acquisitions in the banking industry using accounting study and event study methodology

It uses event study methodology and accounting performance techniques to determine the valuation affects of structural changes that are the result of the merger.. The event study methodo

ISSN 1450-2887 Issue 19 (2010)

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Determining Value Creation through Mergers and Acquisitions

in the Banking Industry using Accounting Study and Event

Study Methodology

Manu Sharma

Doctor in Finance, SMC University Switzerland Faculty: University Institute of Applied Management Science

Panjab University, India

Abstract

This research examines mergers and acquisitions in the United States banking industry involving the formation of mega banks It uses event study methodology and accounting performance techniques to determine the valuation affects of structural changes that are the result of the merger When a merger is announced, it often causes abnormal stock price jumps for both the acquirer and Target Company at or around the date of the announcement Acquisitions that concentrate on increasing the diversity of the business earned the highest abnormal returns However, other types of mergers neither create nor destroy shareholder value Stock return alone does not paint the entire picture of the value created by the merger This research study will assess the mergers using accounting performance techniques as well as stock price analysis to understand the likelihood that the value creation is stable, and not simply reactionary on the part of the shareholders

Introduction

Creating value is the primary reason for mergers and acquisitions There are many reasons for wishing

to engage in mergers and acquisitions In some cases, the company might be a good bargain with future potential gains In other cases, one of the companies may be in financial trouble and the merger might

be a way to fix their predicament Even a company that is in financial disrepair maybe a good bargain once the problems are fixed

Sometimes the backing of a larger company is all that the smaller companies need to return to profitability In the case of an acquisition, the purchaser is speculating that the company will be of greater value at some future point in time There are many financially motivated reasons why a company may choose to merge or acquire another company

Large scale mergers eliminate competition and secure a greater market share In some cases, an acquisition may take place so that one company can acquire its competition Regardless of the primary reason for the merger or acquisition, one can be certain that at least one company will benefit from it

In many cases, there will be a mutual benefit and the combined company will be more profitable Some companies were created to be sold, providing quick cash revenue for their owners, as opposed to the long-term gains that are the typical reason for starting a business

Mergers and acquisitions to create the mega banks are quickly changing the structure of the banking industry in the United States There are many questions that need to be answered in the formation of an opinion of whether these changes are good or bad In order to answer this question thoroughly, one must consider all of the effects of on the various players involved in the merger or acquisition Shareholder value is only one aspect of value creation

This study will focus on answering the question of whether mergers and acquisitions create a value for shareholders of both acquirers and targets in mergers involving major banking corporations

It will examine how shareholders react to potential losses and gains through stock price manipulation

This research will attempt to answer the question of whether the creation of a mega bank is a good situation for shareholders This study will focus on five primaries cases to make its determination It will examine the merger of JP Morgan and Chase Manhattan Corp., JP Morgan Chase and Bank One, Bank of America and Fleet Boston, Citicorp and Travelers Group Inc and Pacific Northwest Bancorp., and Wells Fargo & Co It will examine the valuation affects that are a result of these transactions It will also examine social capital and the effects of these mergers and acquisitions

on the communities in which they are located

Event Study and Accounting Study Parameters

An Event study uses transactions data from financial markets to predict the financial gains and losses associated with newly disseminated information For example, the announcement of a merger between two firms can be analyzed to make predictions about the potential merger-related changes to the supply and the price of the product(s) subject to the merger

Investors in financial markets bet their dollars on whether a merger will raise or lower prices A merger that raises market prices will benefit both the merging parties and their rivals and thus raise the prices for all their shares Conversely, the financial community may expect the efficiencies from the merger to be sufficiently large to drive down prices In this case, the share values of the merging firms’ rivals fall as the probability of the merger goes up Thus, evidence from financial markets can be used

to predict market price effects when significant merger-related events have taken place

The majority of previous M&A studies have measured the short-term stock price reaction to merger announcements applying event study methodology Results are consistent with regard to the value effect on the shareholders of the target firm and on the shareholders of the combined firm The shareholders of the bidding firm either lose or slightly benefit from the mergers whereas those of the target firm receive large abnormal returns for selling their shares In most cases, the combined abnormal return is significantly positive

But the analysis of the M& A should be performed based on the long term implication of the merger on the shareholders This necessitates the determination of the period of study which should be long enough after the merger to study its impact on the market Further the impact should not be continuation of the pre merger market change Hence it is necessary to include the pre merger period also in analysis so as to avoid any misinterpretation In our case study we have taken a pre merger period of 2 years and post merger period of 2 ½ years

The contradiction in the acceptance of the merger by the shareholders can be attributed to a number of reasons, such as the recent losses of the acquired bank and the difference in managing style

of the two involved organization This was the case with JP Morgan Chase in a different way It recent failure to cop up with a merger of Chase in 2000 was clearly reflected in the merger of Bank One in

2004 Further as the event study is dependent on individual shareholder and his perspective of the financial institution acquired may vary which results in contradictions with the event study Event studies have become pervasive; there has not been a concomitant refinement in their technique The specification of an event study in terms of a system of abnormal returns and, in particular, emphasizes the possible limitations of using a methodology when misspecification may be present

But event study generally predicts the shareholder’s present and future mentality on the acquisition Further the support of the shareholders for the merger immediately after merger announcement results in high returns which help in paying higher dividends This results in greater support of the shareholders on combined firm in the future This high support was evident with Citicorp which resulted in paying higher dividends by it

The accounting technique gives a measure of the assets, revenue and liability of the two involved banks prior to acquisition and the same of the combined firm after the acquisition Furthermore, accounting studies employ control firms in order to control for economy

The accounting techniques help in accessing the firm’s liability and assets for the future It gives the total assets available for future investments It gives a good account of the total returns of the merged organization in terms of equity and thereby helps in accessing the value created by the merger

It gives the real account of the company’s fortunes in terms of physical without any consideration for the market The company’s future in terms of the revenue available for new investments is accessed only through accounting techniques But in modern public organization the shareholder’s support greatly the company’s future in long term Hence the accounting technique alone cannot predict the value created by the merger

The partial contradictory results of event studies and accounting studies raise an important question which has remained unanswered until now: Can we freely choose between both approaches when analyzing the performance of corporate bank mergers? So far, despite the contradictory results, the two approaches measuring the economic gains of mergers have been employed as substitutes

In most of previous literatures (Healy, Palepu and Ruback (1992)) they find a great relation between the two methods They find a significant positive relationship between the measures of the two and hence they advocate the use of both as substitutes Both the studies predict the future of the organization in different terms, former in terms of shareholders support and the latter in terms of company’s assets and liabilities

Methodolgy

A convenience sample of 20 quarterly time points in the event window from 2 year prior to the merger through to 2½ years after the merger, including the announcement date and the date of completion for each merger: t = {T1 … T20} The event study methodology will utilize stock market abnormal price returns (ASPR) of both the acquiring and target companies to determine if shareholders experienced an abnormal change in stock value, as well as examine the Sharpe Ratio The accounting performance technique will utilize operating cash flows, absolute cash flows as well as returns on equity for both pre- and post-merger periods

Event Study Methodology

Measures for the event study methodology will include computations of abnormal stock price returns

(ASPR) and cumulative abnormal stock price returns (CASPR) and the Sharpe Ratio (SR)

Abnormal Stock Prices Returns

Abnormal returns (ASPR) are the differences between a single stock or portfolio's performance in

regard to the average market performance over a set period of time

For example if a stock increased by 5%, but the average market only increased by 3%, then the abnormal return was 2% (5% - 3% = 2%) If the market average performs better than the individual stock then the abnormal return will be negative The ASPR’s will be computed for each time period in

the event window The cumulative abnormal returns (CASPR) will be calculated over the whole event

window of the study for the acquiring banks pre- and post merger, and for the period prior to the merger for the target banks

The Sharpe Ratio

The Sharpe Ratio, or Sharpe Index, measures the mean excess return per unit of risk in an investment asset or a trading strategy The Sharpe Ratio is defined as:

] [

] [

] [

f

f f

R R Var

R R E R

R E

S

−

−

=

−

=

σ

where R is the asset return, R f is the return on a benchmark asset, such as the risk free rate of return, E[R − R f] is the expected value of the excess of the asset return over the benchmark return, and σ is the standard deviation of the excess return (Sharpe 1994) The Sharpe Ratio is used to characterize how well the return of an asset compensates the investor for the risk taken When comparing two assets

each with the expected return E[R] against the same benchmark with return R f, the asset with the higher Sharpe Ratio gives more return for the same risk The Sharpe ratios for this study will be computed at 2 year prior to the merger, the beginning of the event window; at the announcement and 2½ years after the merger, the end of the event window

Accounting Performance Techniques

The accounting performance techniques will utilize a return on equity (ROE) as the means to measure profit; as well as operating cash flow (OCF) and absolute cash flow (ACF) This method will examine the performance data of the acquirer and the target before the final merger date, which will then be aggregated into a pre-merger measure of the combined firms A comparison of post-merger performance of the acquirers with the pre-merger measure will provide an idea of whether the performance of the firms is in alignment with what could be expected (Bild, et al., 2002)

Return on Equity

Return on Equity (return on average common equity, return on net worth) measures the rate of return

on the ownership interest (shareholders' equity) of the common stock owners ROE is viewed as one of the most important financial ratios It measures a firm's efficiency at generating profits from every dollar of net assets, and shows how well a company uses investment dollars to generate earnings growth ROE is equal to a fiscal year's net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage

sEquity ckholder

AverageSto

Income Net

ROE

'

=

ROE is best used to compare companies in the same industry, in this case, banking

Operating Cash Flows

In financial accounting, operating cash flow (OCF), cash flow provided by operations or cash flow from operating activities refers to the amount of cash a company generates from the revenues it brings

in, excluding costs associated with long-term investment on capital items or investment in securities

OCF = [EBITDA] - Taxes

[Earnings before Interest Taxes Depreciation and Amortization]

Absolute Cash Flows

For the purposes of this study, the absolute cash flows will be computed by summing the cash flow from operations, investments and financing measures This will provide a measure of the net cash in/out for all the time periods in the event window for both the acquiring and target banks pre- and post- merger

Data Analysis

A convenience sample of 20 quarterly time points in the event window from 2 year prior to the merger through to 2½ years after the merger, including the announcement date and the date of completion for each merger: t = {T1 … T20} The event study methodology will utilize stock market abnormal price returns (ASPR) of both the acquiring and target companies to determine if shareholders experienced an

abnormal change in stock value, as well as examine the Sharpe Ratio The accounting performance technique will utilize operating cash flows, absolute cash flows as well as returns on equity for both pre- and post-merger periods

Descriptive Statistics

The following descriptive statistics are based on the historical data retrieved and computed for the study cases The measures shown in Table 1 are the means and cumulative measures for abnormal stock price returns; and Sharpe ratios computed at time periods T1 (2 year prior to the mergers) and T9 (taken at the date of the announcement of the proposed mergers) The Table 2 shows measures for the variable for Event Study Methodology after the merger The Table 3 shows Buyer and Target average measures for the variable for Accounting Performance Techniques before the mergers The Table shows average measures for the variable for Accounting Performance Techniques after the mergers

Table 1:

Note: Abnormal returns (ASPR) are computed from the average differences between a single stock or portfolio's

performance in regard to the average market performance over a set period of time If the market average performs

better than the individual stock then the abnormal return will be negative The cumulative abnormal returns (CASPR)

will be calculated over the whole event window of the study prior to the mergers

Note: The Sharpe Ratio is used to characterize how well the return of an asset compensates the investor for the risk taken

When comparing two assets each with the expected return E[R] against the same benchmark with return R f, the asset with the higher Sharpe Ratio gives more return for the same risk

Table 2: Merger/Acquisition Measures for the variable for Event Study Methodology after the merger

Buyer Merged Banks Mean ASPR CASPR

Sharpe Ratio (T10)

Sharpe Ratio (T20)

Bank Ind

Mean ASPR

Bank Ind Sharpe Ratio (T10)

Bank Ind Sharpe Ratio (T20)

1B: Citi Group -1.32% 12.70% -15.8236 -3.4995 5.83% 0.4114 0.4800

2B: Wells Fargo & Co -0.25% -0.99% 5.2664 0.1552 3.08% 0.5372 0.4370

3B: JP Morgan Chase 1.83% 1.20% -4.6476 21.4012 9.46% 2.7031 0.5250

4B: Bank of America -3.52% -51.77% 7.4924 11.4298 3.66% 0.4739 2.4241

5B: JP Morgan Chase & Co (Bank One) 0.03% -1.01% -3.4121 1.5396 3.90% 0.4488 0.3731

Table 3: Buyer and Target average measures for the variable for Accounting Performance Techniques before

the mergers

B‐Buyer, 

Bank  Industry  Mean ROE

Note: Return on Equity (return on average common equity, return on net worth) measures the rate of return on the

ownership interest (shareholders' equity) of the common stock owners

Note: In financial accounting, operating cash flow (OCF), cash flow provided by operations or cash flow from operating

activities refers to the amount of cash a company generates from the revenues it brings in, excluding costs associated with long-term investment on capital items or investment in securities

Note: The Absolute cash flows (ACF) will be computed by summing the cash flow from operations, investments and

financing measures This will provide a measure of the net cash in/out for the time periods in the even window

Table 4: Merger/Acquisition average measures for the variable for Accounting Performance Techniques after

the mergers

Bank Industry  Mean ROE

The figure 1, figure 2, figure 3, figure 4 and figure 5 shows ASPRs’ values, Sharpe’s ratio values, ROE Values, OCF Values and ACF values on quarterly basis for Acquirers before and after the Merger The figure 6, figure 7, figure 8, figure 9 and figure 10 shows ASPRs’ values, Sharpe’s ratio values, ROE Values, OCF Values and ACF values on quarterly basis for banking industry on quarterly basis for the same time period before and after the Merger

Figure 1: ASPRs’ values for Acquirers before and after the Merger

‐60%

‐40%

‐20%

0%

20%

40%

60%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

A S P R

Event Window

Citi WFC JPMorgan BOA JPM

Figure 2: Sharpe Ratios’ values for Acquirers before and after the Merger

Figure 3: Mean ROE values for acquiring Banks before and after the merger

‐5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

R O E

Event Window

Citi WFC

JP Morgan BOA JPM Bank

Figure 4: OCF values for acquiring Banks before and after the merger

(60,000) (40,000) (20,000)

0  20,000  40,000  60,000 

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

O C F

Event Window

Citi WFC

JP Morgan BOA JPM Bank One

Figure 5: ACF values for acquiring Banks before and after the merger

(10,000) (5,000)

0  5,000  10,000  15,000  20,000 

A C F

Event Window

Citi WFC

JP Morgan BOA JPM Bank  One

Figure 6: ASPR values for Banking Industry for comparable period of Acquirers

‐20.00%

‐15.00%

‐10.00%

‐5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

Event Window

Banking Industry ASPR for Comparable period of 

Acquriers

Bank Ind. Citi Group Bank Ind. Wells Fargo Bank Ind. JP Morgan Bank Ind. BOA Bank Ind. JPM‐Bank  One

Figure 7: Sharpe Ratio values for Banking Industry for comparable period of Acquirers

0.0000 0.5000 1.0000 1.5000 2.0000 2.5000 3.0000 3.5000

1 2 3 4 5 6 7 8 9 1011121314151617181920

Event Window

Banking Industry Sharpe Ratio for  Comparable period of Acquriers

Bank Ind. Citi Group Bank Ind. Wells Fargo Bank Ind. JP Morgan Bank Ind. BOA Bank Ind. JPM‐Bank  One