The discussions about Skype and Ebay last week were among the best we have had this semester. There was a little confusion in one of the sections about stock market reactions to mergers and acquistions that I would like to clear up.

One student was under the impression that announcements of acquisitions generally led to increases in stock prices of both the acquirer and the target. My understanding, dervied from a study of much empirical research on the matter, is this: stock prices for the target routinely increase while stock prices of the acquirer drop.

There are several explanations for why this happens. A few of the most common are provided in the following exceprts are from an article by Alfred Rappaport, a Professor Emeritus at the Kellogg School of Management, Northwestern University:

Here are the sobering facts about mergers and acquisitions. First, a majority of them don't work. About two-thirds of all acquisition announcements trigger declines in the buying company's stock price, and the market's initial reaction usually corresponds to the buyer's relative stock performance over the next year. Second, corporate boards rarely vote against the acquisitions that their chief executives endorse. Finally, shareholder disapprovals are about as rare as sightings of Halley's Comet. In other words, there is not much of a safety net for value-destroying deals.

An acquirer creates value for shareholders only if the expected benefits or synergies are greater than the acquisition premium it offers. Most companies disclose the size of the synergies they expect. Compare the value of the expected synergies with the premium.

In many cases, even management's often-optimistic synergy estimate is insufficient to offset the premium. As a result, management's guidance unwittingly triggers an immediate, and warranted, drop in its stock price. Management's willingness to pay an acquisition premium that exceeds its own assessment of synergies should be an obvious red flag to shareholders and prospective purchasers of the acquiring company's shares.

Thus, one way we might interpret the sharp drop in Ebay's stock price after the announcement last September of its intention to acquire Skype is that investors thought that the premium being paid exceeded the returns that could be expected in one year. My inclination is to agree with that assessment. Do you?