The purpose of this paper is to investigate whether investors value the future growth from acquisitions and the subsequent realisations thereof accurately.
The paper calculates conventional and adjusted market-to-book ratios and investigates abnormal cumulative returns over 20 quarters after portfolio formation for a sample of Standard & Poor’s 500 firms using a hedge portfolio and regression approach.
Hedge portfolios formed using adjusted market-to-book ratios underperform conventional hedge portfolios over a five-year period. Dividing the hedge into its comprising elements reveals that the underperformance of the adjusted hedge is mainly caused by weaker returns from value firms.
Findings are specific to large firms in a specific setting, and future research is needed to determine if findings are equally applicable to other situations. Findings imply that investors underrate the growth from new acquisitions and overrate the extent to which this has materialised.
The paper highlights that the extrapolation of future growth rates should be carefully considered in any equity valuation of a firm with current or past acquisitions.
This paper shows that inaccurate valuation of the growth of new acquisitions and the realisation thereof is at least partially responsible for the value versus growth phenomenon. It shows that the accounting information could be improved and highlights the importance of extrapolating past growth rates with care.
