Do takeovers create value? A residual income approach on UK data

This paper develops and empirically tests a new methodology for evaluating the financial performance of takeovers. The existing accounting and event study methodologies do not adequately address the key issue of whether takeovers are a positive net present value investment for the acquiring company. Our methodology attempts this by employing the residual income approach to valuation, and comparing the present value of the acquirer's future earnings before the acquisition, with those that actually result following takeover. In contrast to existing methodologies, we explicitly take account of the cost of the acquisition, the acquirers cost of capital, and the earnings which are created beyond the sample period. The methodology is used for evaluating a comprehensive sample of U.K. acquisitions completed during 1985-96. Using the traditional accounting method, we find that acquisitions result in a significant improvement in profitability. However, the residual income approach reveals that on average, acquisitions destroy roughly 30 percent of the acquirer's pre-acquisition value.