Mergers and acquisitions and the valuation of firms

This paper studies the valuation relationship between market-to-book ratio and return on equity in the worldwide commodities sector. Our study of the firms in the worldwide commodities sector uses a market-to-book valuation model. The market-to-book ratio is a simple measure of the relative value that the market places on a share of stock. This per share book value provides a useful index of how much value the market places on the firm as a going concern (market price of stock) as opposed to the bundle of assets (book value per share) that the managers have to work with. A market-to-book below (above) one suggests that the firm’s value as a going concern is actually below (above) the value of its assets. Fama and French (1992) observed that stocks with a high book-to-market (the inverse of market-to-book) ratio, called value stocks as contrasted with growth stocks, capture substantial variation in average returns. Thus, stocks with a high market-to-book ratio, called growth stocks, indicate that the market views the company and its prospects more favorably. On the other hand, return on equity measures profitability as the return on shareholders' equity of the common stock owners. Wilcox (1984) has shown that a valuation model based upon market-to-book and return on equity is plausibly an alternative to a price-earnings ratio valuation model. Moreover, Ohlson (1990) describes market-to-book in terms of return on equity in an asset pricing equilibrium framework. We examine the association between market-to-book ratio and return on equity for firms in the worldwide commodities market. In general, Zhang (2005) finds that growth firms with high market-to-book ratios should be able to deal better with a downturn by deferring investment plans; and thus should be more profitable. Hence, we would expect that firms which have high returns on equity or high profitability sell for well above book value, and firms which have low returns on equity or low profitability sell below book value. On the other hand, it is unexpected when stocks that have low market-to-book ratios (value stocks) are highly profitable and vice versa, thus providing a mismatch that could prove a profitable investment opportunity. That is, low market-to-book ratio can render an arbitrage opportunity once the company shows returns. It is thus important to understand this relationship at a sectoral level.