Most bank and thrift acquisitions require the purchaser to pay a price to the seller that exceeds the current market price.
The excess is often referred to as a "control premium," because it represents the value that the purchaser believes it can add by virtue of controlling target organization.
Quantifying the control premium is a challenging and essential part of any acquisition plan. Overly aggressive assessments destroy the acquirer's shareholder value; overly cautious bids will produce a series of rejected offers and management frustration.
We have produced a valuation model that is a superior way to evaluate acquisition pricing. It goes beyond the static analysis methods of accounting measures such as book value and earnings dilution, replacing the subjective judgment of interested parties with objective market-based information.
Managers and directors of financial institutions that are pursuing acquisitions often ask for help from financial advisers, seeking assurance that the terms and pricing of a prospective transaction will enhance shareholder value.
Together they consider, among other things, what effect the acquisition would have on the earnings and book value of the pro forma organization. They also review pricing and terms of similar transactions. And often they perform a discounted cash flow analysis of the target institution.
Despite these efforts, declines in the acquirer's stock price followed almost 60% of financial institution deals announced from April of last year and through May 1995.
Though some try to dismiss the stock market's reactions as "short- sighted" or "inefficient," there is little empirical evidence to support such claims.
Indeed, the reactions of market participants that are not influenced directly by the transaction's incentives, such as advisory fees or higher salaries, are valuable sources of information and guidance.
In our research, it has proven difficult to discern any systematic relationship between dilution of earnings and book value, on the one hand, and the changes in the acquirers' stock prices on the other.
So although these accounting measures are easily accessible, they offer little guidance in assessing the value of an acquisition or the impact it will have on the acquirers' stock price.
These results confirm the findings of a 1990 study by the Bank Administration Institute, which also examined the relationship between acquirers' share-price changes and earnings-per-share dilution.
Similarly, there is little correlation between trailing four-quarter earnings and deal price as a multiple of tangible book value, two measures commonly used to evaluate the pricing of acquisitions.
Managements must be aware that even price/book and price/earnings multiples falling within the range in other acquisitions do not ensure that the acquisition will be value-enhancing for the acquirer's shareholders.
It is easy to see why there is no relationship between these pricing multiple measures and the value of the acquisition.
Many banks and thrifts routinely trade at prices that exceed 200% of book value. If these institutions could be acquired and routine savings realized, an acquirer could easily justify a deal price of 225% of book value.
For example, after announcing that it would pay over 247% of tangible book for Putnam Trust Co. of Greenwich, Conn., Bank of New York racked up a stock price rise of almost 10%
On the other hand, many institutions would be overvalued at 150% of book value, for a variety of reasons. When Co-op Bank of Concord, Mass., agreed to pay just 146% of tangible book for Bank of Braintree, Co-op's stock price fell by over 13%.
These two examples include extremely dissimilar institutions. Clearly, the pricing multiples in peer-group comparisons are more meaningful the more closely the group matches the targeted institution.
However, as the peer group becomes more narrowly defined, there are fewer deals with which to compare.
The new method Northeast Capital has developed for pricing acquisitions eliminates the problems of comparing price-to-book and price-to-earnings multiples.
Our methodology is based on the premise that the current stock price of a potential target reflects the fair value of the institution as it is now operated. Any premium above the market price must be justified by cost reductions or revenue-enhancing synergies.
Premiums over market price that exceed what the market expects the acquirers to realize in savings and synergies will result in negative stock price reactions for the acquiring institutions. Our research shows that as this premium increases (after adjusting for expected cost savings), so does the negative effect on the acquirer's shares.
This methodology has several advantages.
First, because the premium is relative to market value, not book value, we can account for differences in the performances of the target institutions.
Second, statistical techniques known as regression analysis let us extract information from a large set of transactions involving banks and thrifts of any size, from across the country, with performances across the spectrum, and to apply the result to the transaction being contemplated.
The most important advantage of our methodology may be that because it is based on observed market reactions to deal announcements, it allows us to predict how the markets will react to the proposed deal pricing. This is something none of the other pricing techniques offer.
For example, on the basis of the expected savings and the market premiums paid in the First Union/First Fidelity and PNC/Midlantic acquisitions, our model predicted stock price declines of 7.5% and 6.48%, respectively. The actual declines were 6.49% and 6.13%.
There are other results of our research that can be used in conjunction with a discounted cash flow analysis to improve deal pricing.
For example, the market seems to heavily discount management projections of noninterest expense reductions that are often factored into a discounted cash flow analysis.
In addition, other synergistic benefits, such as cross-selling opportunities and higher lending limits, typically produce value for the acquirer equal to one-third of the savings in noninterest expense.
Since the results of discounted cash flow models are very sensitive to assumptions regarding cost reductions and synergies, these results provide a useful benchmark for gauging the credibility of the model inputs and the resulting valuation.
We believe most bank managers and directors will agree that the ultimate test of an acquisition is whether it adds value for their shareholders.
In an acquirer's efforts to determine the appropriate pricing for a proposed acquisition, we believe shareholder value will be enhanced if acquirers remember that:
*Accounting measures and peer-group comparisons offer only very broad guidelines for assessing value.
*If the premium to market price can not be justified by cost reductions and revenue enhancement, the acquirer's stock price will suffer.
For these reasons, it is important that potential acquirers consider the relationship between market premiums, synergies, and stock price behavior when determining acquisition premiums.
Mr. Loomis is president and Mr. Jones is an associate of Northeast Capital and Advisory Inc., an investment banking firm based in Albany, N.Y.