Management quality and acquisition performance: New evidence based on firm profitability

Date01 July 2019
Published date01 July 2019
Management quality and acquisition performance:
New evidence based on firm profitability
Qingfeng Liu
| Hui Sono
| Wei Zhang
Department of Finance and Business Law,
College of Business, James Madison
University, Harrisonburg, Virginia
Department of Finance and Marketing,
College of Business, California State
University, Chico, California
Wei Zhang, Department of Finance and
Marketing, College of Business, California
State University, Chico, CA 95929.
Using corporate accounting profitability measures to proxy for management quality,
we report evidence that acquisitions made by higher quality acquirers create greater
shareholder value. More profitable acquirers earn better stock returns over the long
term, although no consistent relationship is found between announcement-period
abnormal returns and firm profitability. More profitable acquirers also preserve
shareholder value by reducing the likelihood of paying stock for acquisitions or over-
paying the targets. Overall, our results provide new support for the hypothesis that
better acquirers make better acquisitions. Our results also convey a clear message to
corporate accounting and financial executives, outside investors, and other profes-
sionals. When firms with poor accounting profitability make acquisitions, it is usu-
ally not good news.
acquisitions, firm profitability, inefficient market reactions, long-run returns, mergers
Do better management teams create greater values for share-
holders in mergers and acquisitions (M&A)? Do firms with
better management quality tend to acquire more or even
overpay during M&A? The first question can be traced back
to Jensen and Ruback (1983) and has since been extensively
studied for decades. Though most of research argues for the
value creation of better management teams, the collective
evidence over time, however, is mixed, and even inconsis-
tent in some cases. Most of the results are based on either
Tobin's Q or its highly correlated market to book (M/B) ratio
as proxies for management quality or management perfor-
mance. Using Tobin's Q as a proxy, for example, Lang,
Stulz, and Walkling (1989) and Servaes (1991) find strong
results that high Q bidders create greater value for bidder
shareholders, supporting the proposition that better manage-
ment performance and better acquisition performance come
together. Using the M/Bratio as a proxy for mispricing and
based on a sample covering longer periods, Dong, Hir-
shleifer, Richardson, and Teoh (2006) report that bidders
with higher M/Bearn lower announcement returns and con-
clude that overvalued acquirers destroy shareholder value in
acquisitions. Management quality, as proxied by higher mar-
ket valuation (over book value), may be subject to market
overvaluation and the market will revalue the firm during
M&A events and price drops. Studies covering more recent
sample periods also report conflicting results.
Such incon-
sistent findings are not surprising because Tobin's Q and M/
Bratios are weak proxies for management quality. We
intend to reconcile the conflicting empirical results and fur-
ther explore whether firms with better management quality
acquire more often and whether they overpay in M&A.
In this article, we propose to use firm accounting profit-
ability to proxy for management quality. We argue that
We appreciate helpful discussions, comments, and suggestions from an
anonymous referee, Mehmet Akbulut, Yinfei Chen, Emily Huang,
Qingzhong Ma, Richard Ponarul, Norkeith Smith, Stephen Treanor, David
Whidbee, and seminar participants at California State University, Chico,
and the Southwestern Finance Association annual meeting at Albuquerque,
NM. All remaining errors are our own.
Received: 15 January 2019 Revised: 1 April 2019 Accepted: 3 April 2019
DOI: 10.1002/jcaf.22388
44 © 2019 Wiley Periodicals, Inc. J Corp Acct Fin. 2019;30:4463.
previous proxies using Tobin's Q or Market-to-Book ratio to
measure management quality contain a market valuation fac-
tor which is subject to market mispricing. Any market
misvaluation will complicate the inference of management
quality on acquirer returns, thus substantially reducing the
empirical power in testing the management quality hypothe-
sis, and contribute to the inconsistent empirical findings in
previous studies. A measure for management quality does
not have to be market value related, however. If it is market
value related, it is valid only if the market is efficient.
To reexamine the role of management quality in acquisi-
tion performance, we adopt new proxies for management
quality that are free from market prices. The proxies we
choose are based on firm profitability. We argue that the
profitability, free from market misevaluation noise, evaluates
the current performance of management and would better
signal their future performance. First of all, in the seminal
paper, Brainard and Tobin (1968) point out that the impact
of Tobin's Q on investment is equivalent to that of the real
returns on physical investment, or profitability.
Lang et al. (1989) justify their use of Tobin's Q as a proxy
for management performance because Tobin's Q is an
increasing function of the quality of a firm's current and
anticipated projects under existing management.Besides,
the increasing trend of executive compensation contingent
on accounting-based performance (see Li & Wang, 2016)
provides further justification. Earlier studies have used prof-
itability related measures to proxy for management quality
to examine value creation at M&A announcement period.
Morck, Shleifer, and Vishny (1990) and Masulis et al.
(2007) use operating income growth to proxy for manage-
ment quality to explain acquirer announcement-period
abnormal returns.
Because the measurement of firm profitability can be
noisy and subject to manipulation prior to acquisitions, we
adopt three proxies: gross, operating, and net profitability.
Novy-Marx (2013) shows that gross profitability has
roughly the same power as B/M ratio predicting cross-
sectional returns. He argues that gross profits-to-assets con-
tributes economically significant information above that of
valuations. Ball, Gerakos, Linnainmaa, and Nikolaev (2015)
show that operating profits-to-assets presents an even stron-
ger link with expected cross-sectional returns. As Novy-
Marx (2013) points out, in comparison to operating and net
profitability, gross profitability is least likely to be subject to
contamination. Compared to Tobin's Q or M/Bratio, the
three profitability measures have the common advantage in
that they are not directly affected by market misvaluation.
In our empirical analyses, we examine not only the
announcement-period abnormal returns, but also the long-
run returns following acquisitions. Many existing studies
rely on announcement-period abnormal returns as a proxy
for acquisition performance (e.g., Masulis et al., 2007;
Morck et al., 1990). The choice of the announcement period
is legitimate under the assumption that investors rationally
react to M&A announcements. Several recent studies cast
doubt on this assumption, however, and show that the
announcement-period returns can be noisy and do not per-
fectly reflect the value implications of the acquisitions
(e.g., Danbolt et al., 2015; Ma et al., 2019). Thus, we exam-
ine both the abnormal returns at the announcement period
and the acquirer abnormal returns over the longer periods
following the announcements. We expect that in a longer
period, market reactions shall settle down and firms show
more consistent results in their management performance.
For a comprehensive sample of M&A deals announced
in the 19812014 period, we report the following findings
based on three proxies for firm profitability: gross, operat-
ing, and net profitability. First, none of the profitability mea-
sures appear to affect significantly the market responses at
the announcement period. Second, the stock returns of
acquirers with higher gross profitability outperform less
profitable ones over the horizon of 13 years. Third, more
profitable acquirers are more likely to pay cash and less
likely to pay stock for the acquisitions. Finally, there is no
strong evidence that acquirers with higher profitability pay
higher premiums for publicly traded targets. The overall
findings are consistent with the joint hypothesis that acquisi-
tions are partly motivated by improving efficiency, that the
market reaction to the M&A announcements is not efficient,
and that the efficiency improvement is only reflected in the
market price over the longer term.
This article adds to the M&A literature by filling a
reemerging gap. Specifically, we retest the important propo-
sition regarding the role of management quality in creating
shareholder value in M&A using profitability measures. This
proposition has been the central argument of the market for
corporate control (see Jensen & Ruback, 1983). Because the
existing empirical tests of this proposition rely on market
valuation, the empirical findings cannot distinguish between
the management quality and misvaluation hypotheses, leav-
ing questionable the validity of the management quality the-
ory. To overcome this challenge, we propose firm
profitability as proxies for management quality.
Our find-
ings suggest that firms with better profitability create more
values for shareholders in acquisitions, but the overvalued
acquirers destroy shareholder value. Our results also high-
light the importance of accounting, in that different account-
ing profitability measures carry different information, with
the cleanest profitability measure (gross profitability) gener-
ating the clearest results.
It is worth noting that firm operating performance as rep-
resented by the GP/A, OP/A, and NP/A measures can reflect
many different firm attributes. For example, firms may have

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