M&A Research: Event Studies

Most empirical studies utilize the statistical method called event studies.

Event analysis is conducted to evaluate and quantify the impact of a major catalyst incident or event on a company’s market value. Although it is mostly used in empirical financial research, experts in other disciplines, Such as accounting, management, and forensic economics have also been utilizing event studies.

The underlying principle is, relevant events may quickly cause a change in the market value of the firm depending on the efficiency of the market. Thus, the more rational a market, the more accurate the response will be. For example, researchers may examine whether investors think the merger would generate or kill value in announcing a fusion of two business entities. The basic concept is to identify the anomalous return due to the case being analyzed by accounting for the return resulting from the market as a whole’s price fluctuation. Another example is the analysis of stock market reactions to incidents. Such as market disruption or devastating incidents around the economy.

M&A Research and Event Studies

In M&A research, event studies try to measure the effectiveness of an M&A-related occurrence on the value of the companies involved. Such events include the announcement of a takeover bid or the implementation of specific takeover defense. To recap, a merger or an acquisition can be defined as a combination of two firms. Where the bidder usually pays a premium depending upon the synergies involved.

Cumulative abnormal returns, or CARs, are being measured in such a phenomenon. It is defined by measuring the difference between the expected value produced by the capital asset pricing model (CAPM) and the observed actual return. The difference is specifically called the abnormal returns, which are those that cannot be explained by market movements generated by CAPM.

Market Model

The market model defines the returns as shown in this formula.

Rit = αii + βmtRmit + έ it

where:

Rit is the cumulative dividend monthly stock return for the ith firm in month t;

Rmit is the return on a market portfolio month t relative to the announcement

of offer;

∞, β are the regression parameters; and

εit is a stochastic error term with a mean of zero.

Abnormal returns for firm i and month t are defined as follows:

ARit = Rit − αii + βmtRmit

CARs are guides to abnormal effects in a wide array of event studies in M&A research. To know the defined time period to arrive at CARs, the abnormal returns should be added.

In this model, the analysis suggests using a pre-event estimation window to derive the company’s standard stock relationship and a regression index to be discussed later.

Reference Index

Gathering data regarding the returns of the company being studied and the reference index are necessary for conducting an event study. One reference index is the S&P 500 which is typically used in measuring the performance of the whole market, although it is not exactly a measure for the overall market. This reference index is an index that reflects the performance of 500 stocks selected by Standard and Poors. But it is often connected with other often-cited market indices like the Dow Jones Industrial Average. This reference index, on the other hand, only includes 30 big capitalization companies.

In verifying the statistical significance of the estimated parameters such as α and β, standard econometric tests are used. T statistics, for instance, are used to test if the beta coefficient, β, is statistically significant. Usually, 2 or 1.96 is the value in excess of a certain significance threshold. Leading the researchers to conclude that there is a statistically significant relationship between the changes in the value of the returns on the market and the returns on the security in question.

In estimating the model, it is important for event studies researchers to always take note of the time periods they use in their historical data. Since different time periods may result in different values for the estimated parameters. And if the earlier time period featured unusual volatility, the returns could be abnormal. Although this could have been a function of the significant economic conditions and not a product of the event itself.

How to Conduct an Event Study

In conducting research with regards to m&a-related event studies, the initial step is usually to define the event window, which is the time when the event had its main effect. Researchers try to keep the event window short while making sure it is also long enough to capture the full effect. Considering that the longer the period, the more influence it has on the changes in the CARs.

Another strategy here is to define how frequently the data occurs. It depends on the type of study being done. The different types of studies could be used monthly or even minute-by-minute data. Although daily returns are more common in M&A research.

The Overall Market

The more variables, the greater the data needs. Other models can still be used, though, such as those with more explanatory variables that could consider other factors beyond the overall market. Historical data from a specific period are used to estimate the models used to measure the effects of an event. The basic market model is employed in M&A-related event studies to filter out the influence of the market. This is to measure the effects of events like the announcement of a merger. In estimating the parameters for showing the expected returns, regression analysis is used. Then, they are compared to the actual returns that occurred during the event window. So if an acquirer’s returns decline by more than can be explained by market movements following an announcement of a proposed acquisition. It can be said that this is because of the market disapproving of the deal.

Event studies can also be affected by outliers, just like in statistical analysis. These can be more of an issue with small samples. However, there is an array of methods that can be used here like the elimination of these observations.