Discussion of Hubris Hypothesis

K. Stephen Haggard, Ph.D.

 The Hubris Hypothesis

Roll, Richard (1986). “The Hubris Hypothesis of

Corporate Takeovers,” Journal of Business Vol.
59, No. 2, p. 197-216.
 What is the central prediction of the
Hubris Hypothesis?

That the total combined takeover gain to target

and bidding firm shareholders is nonpositive.
 What is hubris?

Excessive pride or self-confidence; arrogance.

Who, in Roll’s opinion, is afflicted with
hubris in corporate takeovers?

Bidding managers.
 Managers might over or
underestimate the value of a potential
target. Do we observe all of their
estimates? Why or why not?
No. We only observe the estimates that are
higher than the current target stock price.
We observe them through a bid. If managers’
estimates fall below the current target stock
price, no bid is forthcoming.
 What prediction does the hubris hypothesis
make regarding the share price of the target
upon announcement of an unanticipated bid? At
the failure of a takeover bid if no other bids are
received? Is the evidence consistent with these
predictions?
• Share price should go up
• Share price should go back down to original
level
• Yes
 If the target price returns to the original level
upon bid failure, what does that mean about the
amount of new information about the target
that is contained in the bid?

That the bidder’s offer did not contain any new

information. In other words, the bidder did not
have any “secret” non-public information that
was conveyed through their bid.
 Why might bidder share price drop
upon announcement of a bid?
If market participants think that the bid is a
negative NPV project for the bidder, then bidder
share price will go down. Offer would have a
negative NPV if bidder offers more for the target
than the target’s standalone value plus the
incremental value created by the merger. This
could happen if the bidder overestimates the
incremental value created by the merger.
 Why might bidder share price rise upon
announcement of a bid even if the acquisition
itself destroys value (i.e., the bidder is paying
too much for the target)?
The bid might also contain new information
about the bidder managers’ assessment of their
future earnings. If they think they are going to
have better earnings going forward, they might
be more willing to acquire another firm and
more willing to pay cash.
 What does it mean if the bidder’s share price
gets lower as the takeover starts to look more
likely?

The market thinks the deal destroys bidder

value. As the probability of deal closure
increases, the expected amount of the loss
(probability of deal going through * value lost if
deal does go through) gets greater. Similarly, we
will see the target firm’s stock value rise toward
the offer price as the deal looks more and more
likely to close.
 Why might a cash offer for a target generate a
higher bidder announcement return than a
stock offering?

When is a bidder willing to tender their shares

instead of cash? When they think their shares
are overvalued. If they thought their shares were
undervalued, they would certainly offer cash
instead. Therefore, whenever managers offer
their stock in exchange for a target, they are also
telling the market that their stock is overvalued.
Example: AOL bought Time Warner with stock.
 Why might bond prices of bidders in
cash deals drop upon announcement
of a cash offer?

Paying cash reduces the probability that the

bidder will be able to repay their debt
obligations, raising the risk of such obligations.
Greater risk requires greater reward (yield to
maturity), which pushes down bond prices.