Common stock valuation in industrial mergers

COMMON STOCK VALUATION
in
INDUSTRIAL MERGERS

COMMON STOCK VALUATION
in
INDUSTRIAL MERGERS

LYNN E. DELLENBARGER, JR.

University of Florida Press
Gainesville-1966

A University of Florida Press Book

COPYRIGHT 1966 BY THE BOARD OF COMMISSIONERS
OF STATE INSTITUTIONS OF FLORIDA
ALL RIGHTS RESERVED
LIBRARY OF CONGRESS CATALOG CARD NUMBER 66-30593
PRINTED BY THE DOUGLAS PRINTING CO., INC.
JACKSONVILLE, FLORIDA

Preface

I WISH TO THANK Dr. Ralph H. Blodgett,
Dr. Junius E. Dovell, Dr. Wylie Kilpat-
rick, Dr. James S. Lanham, and Dr. J.
Fred Weston for their constructive com-
ments at various stages in the preparation
of the manuscript. I am particularly in-
debted to Dr. Charles A. Matthews and
Dr. John B. McFerrin for their continued
encouragement and advice.
Appreciation is also due Dr. Ernest J.
Lytle and the Statistical Laboratory at
the University of Florida for their help
with the statistical computations.
Finally I wish to acknowledge the fel-
lowships received from the Ford Founda-
tion and the University of Florida during
periods when the manuscript was being
prepared. Although preparation of the
manuscript was not the basis for these
grants they were of great financial help.

Contents

I. Introduction -..... -..-.................................--..... 1
II. Common Equity Valuation _---......------ ....._____. ----- 24
III. Value Factors in Exchange Ratio Determinations --. 67
IV. Factors Modifying Basic Value Relationships ....... -- 95
V. Conclusion- .----......... -------------........... ....... ... ...... 138
Appendices .------.. ------. ------------------147
Bibliography ..---__--------. -------------.---.--. 161
Index --___----- -------------------------- 165

vii

Chapter I

Introduction

THE MERGING of independent business
enterprises is a complex undertaking requiring, by the com-
panies involved, at least tentative solutions to a wide range
of infrequently encountered problems in such areas as finance,
personnel, law, marketing, and production. Basic among these
problems is that of valuation: what value is to be attributed
to each of the enterprises participating in the merger? For
the companies involved the question is more specifically: what
are the relative value relationships among the constituent com-
panies? Absolute value will be important in its own right in
regard to the total capitalization of the final company,1 but for
each participating company the basic consideration is its own
value relative to the value of the other constituents. In this
latter case absolute value is important only as a means for
determining the relative value relationships. Unless this ques-
tion of relative value is answered to the satisfaction of a suffi-
ciently large number of influential people there is no merger.
This discussion investigates the problem of relative value as
it appears in the valuation of the common stock equity inter-
1. A term is needed to designate the company, and various elements
relating to it, which exists after a merger is completed. It could be called
the merged, joint, combined, or, with the definition of merger to be used
here, the parent company. In a true merger it is frequently referred to
as the surviving company and in a consolidation as the successor or new
company. The term "final" will be used here and throughout to designate
that company remaining after a merger whose common stock is held by
the stockholders of the constituents, and this term will include in its
meaning any of the above-mentioned situations.

2 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
ests in fifty corporate mergers. The purpose is to discover the
basic valuation factors which will offer satisfactory explana-
tions for the relative value relationships of the common equi-
ties implied in the actual merger terms agreed on by the
negotiators, and, in so far as possible, to consider the relative
importance of these factors.
Such an investigation immediately raises three questions:
1. Are the determinants of value sufficiently pervasive to
cause certain basic value factors to emerge from the merg-
ers considered here, or is each merger a situation so unique
that different factors will be dominant in each case?
2. If certain basic factors are present in a substantial number
of mergers, are they so evident that their presence is readily
apparent to the negotiators? A negative answer would sug-
gest that the significant factors, though present, are so
hidden or inaccessible that they are noted only vaguely by
the negotiators, if at all. The term "negotiators" is used to
indicate that group of people who actually formulate and
decide on the terms of merger. Although this authority may
rest officially in the board of directors, in actual practice
the group may differ in make-up from merger to merger
and may include, in addition to the directors, top manage-
ment, influential stockholders, possibly powerful creditors,
and investment bankers or others acting as financial advi-
sors. The importance of the negotiators' role is described at
the beginning of Chapter II.
3. If certain basic factors are present and evident, is their
nature such that they can be subjected to a form of meas-
urement which will yield significant, though perhaps
rough, results?
The positive position taken here on these questions is that
there are certain value factors which are measurable, evident,
and significantly present in a sufficient number of mergers to
influence the merger terms to such an extent that, although
the derivation of a precise formula may not be practicable,
some generalizations can be made with respect to the impor-
tance of these factors in the allocation of the final common
stock.

Significance of Merger Study
The question of value and valuation appears throughout the
literature of corporation finance so that any additional in-

Introduction 3

formation relevant to this larger question should prove use-
ful.2 More specifically, the problem of value is basic in dealing
with the financial aspects of mergers. The literature pertain-
ing to this specific area generally discusses the valuation
problem involved and possible bases for the determination of
relative value, but little concrete evidence is presented aside
from references to one or two illustrative cases.3 A more ex-
tensive treatment is given to the problem by Professor Bos-
land in a study of mergers4 and by J. Fred Weston,5 who
draws heavily on Bosland's study.
Another consideration is the legal aspect of the relative
value problem in mergers. In many cases where mergers are
proposed or completed a minority group of common stock-
holders feels that the terms of the merger are unfair. In such
cases, with no outside authority present to determine the fair-
ness of the terms, it becomes necessary for such a group to
institute legal proceedings to obtain compensation for their
shares or to enjoin the merger. However, as noted by at least
two authorities,6 the courts in handling these cases have
largely failed to make any clear-cut pronouncements on the
question of value but have taken the position that, in the
absence of fraud, management should be allowed wide discre-
tion in the determination of value. Such a position is under-
standable in view of the complex judgments involved, but it
leaves much to be desired. The need for additional guidance
in this area is noted in a study undertaken by the Securities
and Exchange Commission in 1938,7 and in the study by
2. Arthur Stone Dewing, The Financial Policy of Corporations, I, 275.
3. The following books offer examples of this type of treatment:
Harry G. Guthmann and Herbert E. Dougall, Corporate Financial Pol-
icy, pp. 561-76; William H. Husband and James C. Dockeray. Modern
Corporation Finance, pp. 634-49; Pearson Hunt, Charles M. Williams,
and Gordon Donaldson, Basic Business Finance: Text and Cases, pp.
595-606.
4. Chelcie C. Bosland, "Stock Valuation in Recent Mergers," Trusts
and Estates, XCIV, Nos. 6, 7, and 8 (1950), 516-24, 583-90, and 662-69.
5. J. Fred Weston, Managerial Finance, pp. 524-39.
6. James C. Bonbright, The Valuation of Property, II, 813; and U. S.
Securities and Exchange Commission, Report on the Study and Investi-
gation of the Work, Activities, Personnel and Functions of Protective
and Reorganization Committees: Part VII, Management Plans Without
Aid of Committees, p. 556. The latter reference is cited hereafter as
SEC, Management Plans Without Aid of Committees, 1938.
7. SEC, Management Plans Without Aid of Committees, 1938, pp.
412-15, 555-56, and 588-89.

4 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
Professor Bosland.8 To the extent that the present study dis-
tinguishes certain factors which were dominant in the estab-
lishment of the exchange terms examined here, it provides
a basis for comparison with the terms which might have been
reached if other factors had been dominant. In this sense it
may provide some guidance in the question of fairness. The
utility of the present study for the purposes mentioned above
will of course be limited by the common difficulty, always
present, of making generalizations in the area of value.
Methods and Problems Treated
The remainder of this chapter will be devoted to defining
two terms, "merger" and "exchange ratio"; to describing the
group of mergers covered; and to discussing briefly the meth-
ods used in analyzing the problem under consideration. Chap-
ter II contains a discussion of the problem of valuation and
the methods for its measurement. Chapters III and IV deal
with the statistical evidence, the former presenting generaliza-
tions based on correlation analysis and the latter considering
deviations from the general pattern. The conclusions are pre-
sented in Chapter V.
Definitions
Merger.-Independent corporations can associate them-
selves with varying degrees of closeness by several methods.
Leaving aside the looser and more informal means such as
trade associations, pools, and gentlemen's agreements, the
primary methods are the lease, merger, consolidation, and
purchase. The lease as a means of association has been used
primarily in the railroad industry and is not relevant to this
study.
Merger and consolidation are legal concepts which relate to
the fusion of two or more independent corporations into a
single business enterprise having one corporate charter. The
concepts are generally distinguished on the grounds that in a
merger one of the constituents survives under its old charter
and the others are absorbed into it, while in a consolidation a
new corporation with a new charter is created which absorbs
all the former constituents. The term merger as used here in-
cludes both of these concepts.
8. Bosland, Trusts and Estates, XCIV, No. 6, 518.

Introduction 5

The purchase of one corporation's assets or common stock
by another corporation is also included in the present meaning
of merger, provided that: (1) The common stockholders of
the purchased corporation become common stockholders of
the final corporation. This rules out purchases of either assets
or stock in which the final company's common stock is not one
of the means of payment, (2) The purchase includes substan-
tially all the assets or common stock of the purchased corpora-
tion.
These two qualifications do not require complete unification
or fusion, and the fact that a parent-subsidiary relationship
exists after the transaction is completed does not exclude it
from the present classification of mergers.
On the above basis the term "merger" is used here to de-
scribe the transaction which causes two or more previously
independent corporations to associate themselves in such a
way that the basic ownership interest becomes lodged in the
common stock of the final company which in turn is allocated
among the common stockholders of the previously independent
corporations. This type of transaction, involving the exchange
of common stocks, is reported to be currently the most widely
used method for effecting acquisitions.9
Exchange Ratio.-The implied value relationship between
the common equity interests of merging corporations is evi-
denced by the basis on which the common stock of the final
company is allocated among the common stockholders of the
constituent corporations. Thus, if two companies, A and B,
merge and 20 per cent of the final common stock goes to A's
stockholders and 80 per cent to B's stockholders, the implica-
tion is that the common equity interest in B was four times
more valuable than the similar interest in A. On a per share
basis this same value relationship is expressed by the exchange
ratio. Each shareholder of each constituent exchanges (or may
be assumed to exchange) the common stock of the independent
corporation for that of the final company, and the implied
value relationship between a single share of each constituent's
stock is evident in the relationship between the number of
final company common shares exchanged for each share of a

9. U. S. Federal Trade Commission, Report on Corporate Mergers
and Acquisitions, p. 9. Cited hereafter as FTC, Report on Corporate
Mergers, 1955.

6 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
constituent. This exchange ratio is defined here as the ratio
between the number of final shares attaching to a single share
of each constituent's stock. Two illustrations may clarify this
definition.
Example 1.-Company A is being merged into Company B
and no change will be made in the shares outstanding in the
hands of B's stockholders. This situation, which was common
in the present merger group, illustrates the need to assume an
exchange of shares in some mergers. Shareholders of A will
receive 2 shares of B stock for each share of A stock held. (A
2 to 1 ratio of exchange exists here; however, this is not the
same as the exchange ratio defined above.) Under these terms
1 share of A common stock is exchanged for 2 shares of B
common stock, and 1 share of B common stock outstanding
prior to the merger is exchanged (assumed) for 1 share of B
common stock, considered now as stock of the final company.
The relationship between the final shares attaching to a single
share of each constituent's stock is then 2 to 1, or 1 to 2, and
this is the exchange ratio.
In order to deal with the exchange ratios in a uniform man-
ner one constituent in each merger was chosen as the base
company and the exchange ratio was expressed in relation
to this company. Choosing Company B as the base company
in this example fixed the ratio, which may be expressed as
2/1, 200 per cent, or 2.00. This ratio indicates that a share of
Company A stock receives twice as much stock in the final
company as did a share of Company B stock which was out-
standing prior to the merger and implies that, relative to a
share of pre-merger B stock, a share of A stock was twice as
valuable. Throughout this study the company in each merger
which received the largest share of the final common stock
was selected as the base company. This method of selection
also resulted in choosing as the base company, in all but three
mergers, that constituent which was largest in terms of total
assets. The nonbase constituents are hereafter referred to as
the "other" companies whenever it is necessary to identify the
constituents on this basis.
Example 2.-Company A and Company B will merge (con-
solidate) into a new corporation, Company C, which is created
to absorb the two enterprises. Company C is the final com-
pany. Company A's stockholders will receive 60 per cent of

Introduction 7
the C common stock on the basis of 2 shares of C stock for
each share of A stock. Company B's stockholders will receive
the remaining 40 per cent of C stock on the basis of 5 shares
of C stock for each 3 shares of B stock. Company A is selected
as the base company since its shareholders, as a group, receive
the larger share in the equity of the final company. Under
these terms: (1) Each share of A stock receives 2 shares of C
stock, (2) Each share of B stock receives 5/3 share of C stock.
With A as the base company, and relative to a single share
of A common stock, the exchange ratio is 5/3 + 2 = 5/6, 83 per
cent, or .83. This ratio indicates that each share of B receives
only 83 per cent as much C stock as each share of A, which
implies that a share of B is considered to be only .83 as valua-
ble as a share of A.
Mergers Selected for Analysis
The group of corporate mergers forming the basis for this
study was selected in the following manner. Initially the group
included those mergers occurring in the eight years 1950-1957
in which all the constituents were industrial corporations
whose common stocks were listed on the New York Stock Ex-
change prior to the merger. There were sixty-seven such
mergers. (See Appendix A.) In accordance with the limita-
tions imposed by the definition of merger given above, this
group was reduced to sixty-one by dropping six mergers. Four
of these involved cash purchases and two involved the use of
preferred stock for payment.
Next, eight mergers were eliminated because both preferred
and common stocks of the final company were exchanged for
the common stock of one constituent. It was believed that these
eight mergers involved a distinct value problem in themselves
and they were dropped for this reason. In the remaining fifty-
three mergers each constituent's common stock received only
common stock of the final company in exchange.
The group was reduced to its final size of fifty mergers by
dropping three mergers representing special situations. Two
were cases in which, prior to the merger, one constituent
owned a large majority of the stock of the other. In the third
case one constituent owned 23 per cent of the stock of the
other corporation. In addition it had voting control over an
additional 27 per cent of the stock through a special arrange-

8 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
ment with a group of stockholders. This stockholder group
was offered two bases for the exchange of their shares, with
the option to choose the more desirable. Both of these bases
were different from the one offered to the stockholders of the
remaining 50 per cent of the stock. This merger was excluded
because of the three different bases for exchanging stock.
The remaining fifty mergers and the constituent corpora-
tions are listed below. The number at the left of each merger
in the list will be used throughout this study to identify that
particular merger. The date appearing at the end of each list-
ing is the date of the earliest official act relating to the merger
which was found and usually represents the authorization of
the merger agreement by the board of directors of one of the
constituents. In each merger the base company is indicated by
the subscript "b" and the final company is in italics. In cases
in which the final company assumes a new name simply as the
result of a name change by one of the constituents, this new
name is placed in parentheses.

1. Studebaker Corporationb + Packard Motor Car Company
Studebaker-Packard Corporation, June, 1954
2. Warner-Hudnut, Incorporatedb + Lambert Company =
Warner-Lambert Pharmaceutical Company, February,
1955
3. Standard Steel Spring Company, + Timken-Detroit Axle
Company = Rockwell Spring and Axle Company, May,
1953
4. American Radiator & Standard Sanitary Corporationb +
Mullins Manufacturing Corporation, December, 1955
5. Allis-Chalmers Manufacturing Companyb + Gleaner Har-
vester Corporation, December, 1954
6. Borg-Warner Corporationb + Byron Jackson Company,
June, 1955
7. Olin Mathieson Chemical Corporationb + Blockson Chemi-
cal Company, May, 1955
8. Merck and Company, Incorporatedb + Sharp and Dohme,
Incorporated, March, 1953
9. Sperry Corporationb + Remington Rand, Incorporated =
Sperry Rand Corporation, April, 1955
10. Union Carbide and Carbon Corporationb + Visking Cor-
poration, October, 1956
11. Sylvania Electric Products, Incorporatedb + Argus Cam-
eras, Incorporated, September, 1956

Introduction 9

12. Borg-Warner Corporationb + York Corporation, April,
1956
13. Crown Zellerbach Corporationb + Gaylord Container Cor-
poration, September, 1955
14. West Virginia Pulp and Paper Companyb + Hinde and
Dauch Paper Company, August, 1953
15. Saint Regis Paper Companyb + Rhinelander Paper Com-
pany, January, 1956
16. Mathieson Chemical Corporationb + E. R. Squibb and
Sons, August, 1952
17. Brown Shoe Company, Incorporatedb + G. R. Kinney
Company, Incorporated, October, 1955
18. American Can Companyb + Dixie Cup Company, April,
1957
19. Monsanto Chemical Companyb + Lion Oil Company, July,
1955
20. Dow Chemical Companyb + Dobeckmun Company, June,
1957
21. American Can Companyb + Marathon Corporation, Octo-
ber, 1957
22. Jones & Laughlin Steel Corporationb + Rotary Electric
Steel Company, December, 1956
23. General Dynamics Corporationb + Liquid Carbonic Cor-
poration, August, 1957
24. General Dynamics Corporationb + Stromberg-Carlson
Company, April, 1955
25. Copperweld Steel Companyb + Superior Steel Corpora-
tion, September, 1957
26. Federal-Mogul Corporationb (Federal-Mogul-Bower Bear-
ings, Incorporated) + Bower Roller Bearing Company,
May, 1955
27. Beech-Nut Packing Companyb (Beech-Nut Life Savers,
Incorporated) + Life Savers Corporation, June, 1956
28. Dresser Industries, Incorporatedb + Lane-Wells Company,
January, 1955
29. Continental Can Company, Incorporatedb + Hazel-Atlas
Glass Company, June, 1956
30. Continental Can Company, Incorporatedb + Robert Gair
Company, Incorporated, September, 1956
31. Baldwin Locomotive Worksb (Baldwin-Lima-Hamilton
Corporation) + Lima-Hamilton Corporation, July, 1950
32. Gulf Oil Corporationb + Warren Petroleum Corporation,
December, 1955
33. Electric Storage Battery Companyb + Ray-O-Vac Com-
pany, September, 1957

10 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
34. United States Pipe and Foundry Companyb + Sloss-Shef-
field Steel and Iron Company, September, 1952
35. Heyden Chemical Corporationb (Heyden Newport Chemi-
cal Corporation) + Newport Industries, Incorporated,
November, 1956
36. American Smelting and Refining Company, + Federal
Mining and Smelting Company, January, 1953
37. Carrier Corporationb + Elliott Company, April, 1957
38. Island Creek Coal Companyb + Pond Creek Pocahontas
Company, June, 1955
39. Avco Manufacturing Corporation, + Bendix Home Appli-
ances, Incorporated, May, 1950
40. National Lead Companyb + Doehler-Jarvis Corporation,
November, 1952
41. National Distillers Products Corporation,, + United States
Industrial Chemicals, Incorporated, April, 1951
42. American Metal Company Limited, (American Metal Cli-
max, Incorporated) + Climax Molybdenum Company,
November, 1957
43. Harris-Seybold Company, (Harris-Intertype Corporation)
+ Intertype Corporation, February, 1957
44. Consolidated Vultee Aircraft Corporation, + General
Dynamics Corporation, March, 1954
45. W. R. Grace and Company, + Davison Chemical Corpora-
tion, April, 1954
46. Nash-Kelvinator Corporationb (American Motors Cor-
poration) + Hudson Motor Car Company, January, 1954
47. New York Shipbuilding Corporation, + Nesco, Incorpo-
rated, March, 1954
48. Park Utah Consolidated Mines Company, + Silver King
Coalition Mines Company =United Park City Mines
Company, March, 1953
49. Mohawk Carpet Mills, Incorporated, + Alexander Smith,
Incorporated (Mohasco Industries, Incorporated), Novem-
ber, 1955
50. Textron, Incorporatedb (Textron American, Incorporated)
+ American Woolen Company + Robbins Mills, Incorpo-
rated, December, 195410
Distinguishing Characteristics of Merger Subgroups
The entire list of fifty mergers will be referred to as "Group
A." Two characteristics present in some of the mergers, how-
10. Whenever the distinction is necessary in the remainder of this
study, the relationships between Textron and each of the two other com-

Introduction 11

ever, prompted the decision to specify two other groups from
the whole. These characteristics were, first, a record of deficit
earnings just prior to the merger, and, second, evidence of
common control of the constituents.
On the basis of the first characteristic, the last five mergers
(46) through (50) were removed from Group A. These all in-
cluded cases in which one or more of the constituents experi-
enced deficit earnings to such an extent at some time during
the five years prior to merging that comparisons of earnings
in ratio form were not very meaningful. With the exception
of Electric Storage Battery Company in merger (33) which
experienced a deficit in one of the five prior years, all the
companies in the first forty-five mergers had positive earnings
in each of the five years prior to merging. These forty-five
mergers will be referred to as "Group B."
On the basis of the possibility of common control, mergers
(34) through (45) were dropped from Group B, leaving
mergers (1) through (33) in "Group C." This final group con-
sists, therefore, of those mergers in which the constituent
companies had records of positive earnings and in which there
was no indication of common control. It should be added that
mergers (47) and (50) were eliminated from Group C because
of both commonality of control and lack of positive earnings.
In determining the possibility that one constituent may have
controlled the other, reliance was placed primarily upon the
fact that one constituent owned stock in the other prior to
the merger. This was true for mergers (34) through (45),
(47), and (50), with the exception of (38). In the latter the
possibility that intercompany control existed prior to the
merger is based on the fact that both Island Creek Coal Com-
pany and Pond Creek Pocahontas Company had the same
directors, management, and selling organization. The extent
of the intercompany common stock ownership in each of the
other thirteen mergers is presented in Table 1.
For the purposes of this study two reasons made it desirable
to segregate the mergers in which the possibility of intercom-
pany control existed. First, in seeking to discover those bases
and measures of value which best serve to explain the ex-
change ratios, it seemed desirable to select mergers in which
panies involved in merger (50) will be identified as follows: Textron
and American Woolen (50.1); and Textron and Robbins Mills (50.2).

12 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS

the relative value considerations could be expected to be im-
portant. Unsuitable mergers in this regard would be those in
which the element of common control was so great that the
exchange ratios would be established on the basis of financial
convenience or form rather than value factors. Such situations
would be analogous to common stock recapitalizations in in-
dividual companies. In contrast, in mergers (1) through (33),

TABLE 1
PERCENTAGE OF ONE CONSTITUENT'S COMMON STOCK OWNED BY THE
OTHER CONSTITUENT PRIOR TO THE MERGER IN THE THIRTEEN
MERGERS IN WHICH SUCH INTERCOMPANY STOCK
OWNERSHIP EXISTED

Merger Company Owning Company Whose Stock Percentage
No. the Stock Was Owned Owned
45 Grace & Co. Davison Chemical 63
36 American Smelting Federal Mining 55
34 U.S. Pipe & Fdry. Sloss-Sheffield 55
50 Textron, Inc. American Woolen 47
Robbins Mill 42
47 N.Y. Shipbuilding Nesco, Inc. 30
41 Nat. Distillers U.S. Indust. Chem.* 25
37 Carrier Corp. Elliott Co. 22
44 General Dynamics Consol. Vultee 17
39 Avco Mfg. Corp. Bendix Home Appl. 16
35 Heyden Chem. Corp. Newport Industries 10
42 American Metal Co. Climax Molybdenum 9
40 National Lead Co. Doehler-Jarvis 7
43 Harris-Seybold Intertype Corp. 5
*U.S. Industrial Chemicals, Inc. also owned a little less than 2 per
cent of the outstanding common stock of National Distillers Products
Corporation.

Group C, the New York Stock Exchange listing applications
consulted showed no indications of any intercompany control,
and the exchange ratios in these thirty-three mergers may be
assumed to have been established on the basis of arm's length
bargaining by independent parties. This type of situation
seemed favorable for value considerations to be influential.
The presence of intercompany stock ownership in the thirteen
mergers noted in Table 1 and the circumstances which existed
in merger (38) are considered sufficiently important to distin-
guish these mergers on this basis, but the extent of these fac-
tors suggesting control was probably not large enough in any
of the fourteen mergers to allow valuation factors to be igno-

Introduction 13
red. Even in merger (45) in which W. R. Grace and Company
owned 63 per cent of Davison Chemical Corporation's common
stock, the amount of outside ownership would still appear to
have ruled out any exchange on the basis of convenience. Ethi-
cal reasons aside, the practical desire to obtain the amount of
stockholder approval necessary to effect the merger and to
avoid a substantial cash drain in the form of compensation to
dissenting stockholders would have argued for an exchange
ratio based on value considerations even in the absence of
arm's length bargaining.
The second aspect of the control question, which is of more
importance here, pertains to the nature of control as a definite
value factor itself. The control value involved attaches to what
is often termed "working control" rather than to any specific
amount of stock ownership required in various legal situa-
tions. Just when working control is obtained and to what de-
gree is difficult to assess and will vary from case to case. Cer-
tainly W. R. Grace and Company's ownership of 63 per cent
of Davison Chemical Corporation's common stock embraced
working control. On the other hand, Harris-Seybold Com-
pany's ownership of 5 per cent of Intertype Corporation's
common stock presumably did not represent control. One of
the major factors bearing on the amount of stock needed for
control is the extent to which the uncontrolled shares are dis-
persed. One study mentions 25 per cent ownership as ade-
quate in cases where the remaining stock is widely dispersed."1
In some cases smaller ownership interest may prove adequate,
with General Dynamics Corporation's 17 per cent interest in
Consolidated Vultee Aircraft Corporation's common stock be-
ing considered sufficient by one writer in a report for the Fed-
eral Trade Commission.12
No attempt was made in this study to distinguish finely be-
tween those mergers in which the prior intercompany stock
ownership carried working control and those in which it did
not. For this reason also, it was considered desirable to segre-
gate the above fourteen mergers in which control, as an inde-
pendent value factor to be bargained for, may have been
absent.
11. FTC, Report on Corporate Mergers, 1955, p. 41.
12. Robert Sheehan, "General Dynamics vs. the U.S.S.R.," Fortune,
LIX, No. 2 (1959), 164.

14 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
Characteristics Distinguishing the
Total Group of Fifty Mergers
A final aspect of the present merger group which deserves
attention is its relation to all other mergers of industrial cor-
porations occurring during the eight-year period covered. Of
the many possible bases for comparison those which seem
most significant are number and size, marketability of com-
mon shares, and dispersion of share ownership. These bases,
though not unrelated, will be discussed separately.
Number and size.-In terms of numbers alone the present
group of fifty mergers is only a very small part of the total
number of industrial mergers occurring between 1950 and
1957. This relationship is suggested by a comparison with
merger data for slightly earlier years. The Federal Trade
Commission reported 1,773 mergers and acquisitions in min-
ing and manufacturing for the years 1948-1954. For the eight
years 1940-1947 it reported 2,062 such mergers and acquisi-
tions. Both figures, being based on mergers reported in the
financial manuals, are probably understatements due to the
inadequate coverage of mergers involving small firms.13 An-
other study covering the years 1940-1947 reported 1,990
mergers based on information in the financial manuals but
estimated the number might be as high as 6,500 if all mergers
involving small firms had been included.'4 Using these figures
for comparison, then in the 1950-1957 period the present
group of 50 mergers might be assumed to represent anywhere
from about 3 per cent, to less than 1 per cent, using the esti-
mated maximum, of total industrial mergers. The rising trend
in mergers from 126 in 1949 to 387 in 195415 suggests that the
total number of mergers during the 1950-1957 period may well
have been in this general range.
Although the present group is small in terms of numbers, in
terms of economic significance, as measured by total assets
involved, it represents a substantial part of the industrial
merger activity occurring during 1950-1957. Again no strictly
comparable figures are presented but the above statement is

13. FTC, Report on Corporate Mergers, 1955, p. 17 and Table 1, p. 33.
14. J. Keith Butters, John Lintner, and William L. Cary, Effects of
Taxation: Corporate Mergers, p. 242.
15. FTC, Report on Corporate Mergers, 1955, Table 1, p. 33, and
Chart 1A, p. 19.

Introduction 15
suggested by a comparison with data in the two studies pre-
viously mentioned and by the nature of the group itself. The
Butters, Lintner, and Cary study covering 1940-1947 stated
that the 1,990 mergers involved the transfer of $3.4 billion of
assets and estimated this would have been about $5 billion if
the coverage had been more complete. The 50 mergers in the
present study involved the transfer of $2.8 billion of assets,
as shown in Table 2. While the relative significance of $2.8
billion of assets was no doubt less in the 1950-1957 period
than in the 1940-1947 period, the above figures clearly indicate
the relative importance of the present group.
This same relationship is suggested by considering the size
of the base or acquiring companies and the "other" or acquired
companies in each case. The following statement from the
Butters, Lintner, and Cary study offers one possible basis for
comparison. "During the eight years 1922-1929, there were
eight mergers between companies with assets of over $100
million and at least 14 instances in which companies of this
size acquired other companies with assets of more than $50
million; in comparison, as already noted, there were no merg-
ers during the recent period [1940-1947] between companies
with assets of more than $100 million and only one between
companies with assets of more than $50 million."'6
In contrast, the present group of fifty mergers included
eight in which each of the constituents had over $100 million
in assets and nine more in which each of the constituents had
assets of over $50 million. This latter total of nine results from
treating the two companies acquired by Textron in merger
(50) as a single acquisition. If they were treated as separate
acquisitions this total would be increased to ten.
The Federal Trade Commission report, while more recent,
does not provide as much information on asset size. The study
covering the 1,773 mergers during the 1948-1954 period shows
522 of the acquiring firms with assets of $50 million and
over.17 In the fifty mergers in the present group all but seven
of the acquiring firms had assets of over $50 million. This
serves to substantiate the view that the mergers included in
this study bulk large relative to total assets involved in all
industrial mergers during 1950-1957.
16. Butters, Lintner, and Cary, p. 244 and p. 294.
17. FTC, Report on Corporate Mergers, 1955, Table 2, p. 34.

16 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS

TOTAL ASSETS OF
ANALYZED,

Year and
Merger No.

1950
39
31
Total
1951
41
1952
16
34
40
Total
1953
36
8
48*
3*
14
Total
1954
46
44
47
45
1
5
50.1
50.2
Total
1955
28
2
9*
24
7
26
6
38
19
13
17
49
4
32
Total

TABLE 2
THE CORPORATIONS INVOLVED IN THE 50 MERGERS
GROUPED BY THE YEAR IN WHICH INITIAL
MERGER ACTION WAS TAKEN
(millions of dollars)

Base Other Year:
Company Company Tota

112.6
82.4
195.0

284.6

151.8
92.2
220.5
464.5

368.5
114.4
6.2
76.3
135.4
700.8

245.6
147.5
31.4
324.1
141.8
418.8
72.4
...0..
1,381.6

88.0
43.9
223.8
193.3
488.7
28.6
275.6
39.3
404.5
357.1
75.4
61.7
222.5
2,107.8
4,610.2

20.5
40.1
60.6

49.9

112.2
34.3
44.5
191.0

12.2
47.3
8.9
105.6
32.2
206.2

122.7
66.4
21.2
65.7
111.0
8.8
62.0
54.8
512.6

21.8
19.3
260.1
44.3
28.7
21.9
22.6
15.5
156.5
71.2
18.7
44.5
44.4
162.5
932.0

ly
al

255.6

334.5

655.5

907.0

1,894.2

5,542.2
....

,894o.2

0 0

0 0 0
0
0
0 0 .

Introduction 17

TABLE 2 (Continued)

Year and Base Other Yearly
Merger No. Company Company Total
1956
15 275.9 26.7...
12 330.6 70.1
27 51.5 16.1
29 381.9 40.9.....
11 207.5 9.5...
30 542.5 142.5.....
10 1,361.2 38.3...
35 38.0 22.4
22 732.1 33.2
Total 3,921.2 399.7 4,320.9
1957
43 37.9 18.5...
18 499.8 56.1 .....
37 184.2 45.4...
20 732.4 24.7....
25 54.3 15.9...
23 434.6 58.7 ..
33 69.5 19.7
21 685.1 168.9.....
42 186.5 75.9
Total 2,884.3 483.8 3,368.1
Grand Total 14,442.2 2,835.8 17,278.0

*The base company is smaller in terms of total assets.

Marketability of common stock.-Marketability of common
stock is the second basis on which a comparison is made be-
tween mergers in this study and industrial mergers as a
whole. The term marketability refers to the nature of the
market which exists for a corporation's common stock. Good
marketability for a stock requires a sufficient volume of trad-
ing so that at any instant of time a fairly precise price can
be determined for the stock and so that over time the price
moves in a continuous manner in the face of relatively large
individual buying and selling transactions. Poor marketability
implies no definite market at all or a market in which a wide
spread usually exists between bid and asked prices, little trad-
ing volume is present, and large purchases or sales result in
sharp fluctuations in prices.
The stock of the corporations included in these fifty mergers
possessed marketability to a degree sufficient to set them apart

18 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
from the stock of the typical corporation involved in an indus-
trial merger during 1950-1957. For this reason, a measure of
value, namely, a significant market price, existed in each of
the fifty mergers which was not present in the more usual
merger, or at least was not present to the same degree.
The selection of the fifty mergers was based on the fact that
all corporations in the group had their stocks listed on the
New York Stock Exchange, and conversely, each excluded
merger had at least one constituent whose stocks were not so
listed. While many stocks not listed on the New York Stock
Exchange no doubt have greater marketability than some
which are listed, stocks so listed, as a whole, may be presumed
to have a degree of marketability much greater than unlisted
stocks as a whole.
The fact that corporations covered in the present study
were large relative to the usual industrial corporation being
absorbed in a merger was developed in the preceding section.
Although asset size and stock marketability are not synony-
mous, it seems likely that many of the smaller firms involved
in mergers during 1950-1957 were closely held corporations
whose stocks had little or no marketability. For these two rea-
sons, the nature of the market for a company's shares and the
size of the merging corporations, the fifty mergers, as a group,
are distinctive in the marketability of the shares of the par-
ticipating corporations and this distinction is significant in
the problem of value.
Dispersion of share ownership.-Closely related to market-
ability is the dispersion of share ownership. Again, the se-
lected group of fifty mergers is distinctive in that the shares
of each of the corporations included in it were more widely
dispersed than were those of the typical corporation engaged
in merger activity during the period covered. No data are
available to support this position but it is suggested by con-
siderations similar to those mentioned in regard to market-
ability; namely, the contrast between corporations listed on
the New York Stock Exchange and those not so listed, and
corporate size.
In considering the contrast between listed and unlisted
stocks the following statements pertaining to standards of
eligibility for listing securities on the New York Stock Ex-
change emphasize this importance of the dispersion factor:

Introduction 19

The particular securities for which listing is sought must
have a sufficiently wide distribution to offer reasonable assur-
ance that an adequate auction market in the securities will
exist. . In the case of Common Stock issues, a broad dis-
tribution of at least 300,000 shares (exclusive of concentrated
or family holdings) among not less than 1,500 holders will be
looked for, with greater attention being given to holdings of
100 shares and above.s8
On the basis of these statements it may fairly be assumed
that the common stocks of the corporations included in the
fifty mergers were widely dispersed. In contrast there is the
large number of small unlisted corporations engaged in merg-
ers during 1950-1957 whose common stocks were held in very
few hands.19
The second contrast suggesting a difference in the degree of
common stock dispersion relates to corporate size, measured
in terms of total assets. The corporations included in the
merger group covered here were relatively large, which pro-
vides some basis for an assumption that the common stock
issues of these corporations were, on the whole, larger than
those of unlisted industrial corporations engaged in merger
activity. This assumption of larger common stock issues sug-
gests a greater degree of dispersion on the a priori grounds
that, in general, there is more likelihood of wide dispersion in
a large issue than there is in a small issue.
The present importance of this distinction based on stock
dispersion pertains to the types of value considerations which
may exist in mergers and the varying degrees of influence
which these considerations may have in different situations.
In a general way the factors influencing values in mergers
may be separated into personal (subjective) and corporate
(objective) factors. The objective factors would consist of
such things as past earnings and dividends, asset values, stock
market prices, capital structures, product and industry char-
acteristics, and similar historical developments. While these
factors are open to personal subjective interpretation, they

18. New York Stock Exchange, Company Manual, Sec. B1, p. B-3.
19. This contrast in dispersion is also suggested in a study of the
over-the-counter market which permits a comparison between New York
Stock Exchange listed and over-the-counter industrial common stocks
with respect to transaction size and number of stockholders. Irwin
Friend et al., The Over-the-Counter Securities Markets, pp. 25-28.

20 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
are more or less definite and objective in nature. In contrast,
the personal factors would include such considerations as
estate tax problems, personality conflicts within a corporation,
personal gain or loss from the sale of large stockholdings
including the tax aspects of such gains or losses for the in-
dividuals concerned, the desire for greater personal power or
recognition, the desire for increased (decreased) responsibil-
ity, and other similar types of considerations.
In mergers in which one or all of the constituents are small
closely-held corporations, the personal factors may have a
strong influence on the terms of the merger, overshadowing or
offsetting the weight of the objective factors. In mergers in-
volving larger corporations whose stocks are fairly widely
dispersed in the hands of the public, the influence of the objec-
tive factors should be more dominant. Although some of the
personal factors may still be important for top executives in
the large corporations, their influence on the terms of merger
may be checked by the fact that these terms must be subjected
to the vote of stockholders who will give these personal fac-
tors little weight. Since the importance of the objective value
factors may well be increased by a wider dispersion of the
stock of the constituent corporations, there appears to be a
sound basis for distinguishing these fifty mergers from the
typical industrial merger.
From the above discussion of the characteristics of the
mergers examined, it will be apparent that the group is neither
random nor average in character. Therefore, any conclusions
drawn from the subsequent analysis may very well need to be
subjected to substantial modifications if any generalizations
are to be made concerning mergers falling outside the group.
On the other hand, the group comprises those situations most
favorable to objective analysis and so appears to be well suited
for a starting point in the investigation.

Possible Approaches to the Problem
The problem, restated, is to discover and identify those fac-
tors which will offer an explanation of wide applicability, for
the exchange ratios established in fifty industrial mergers
occurring during the period 1950-1957. Three possible meth-
ods of approach were: (1) communications with the parties
who were responsible for establishing the terms of merger,

Introduction 21

(2) statistical analysis of the relevant financial data, and (3)
reference to the relevant literature of finance.
Communications.-Communications with the persons who
played a central role in the merger transactions have not been
used. While the information which might have been gained
would have been valuable, the problems involved in determin-
ing just who the influential people were and in obtaining the
information once these people were selected ruled out the use
of this method. Some information slightly similar to that
which might have been obtained by personal communications
is presented in Table 3. This lists the various factors con-

TABLE 3
VALUATION FACTORS WHICH RECEIVED ATTENTION IN THE MERGER
TERM FORMULATIONS IN 33* OF THE 50 MERGERS ANALYZED
ACCORDING TO STATEMENTS CONTAINED IN THE NEW
YORK STOCK EXCHANGE LISTING APPLICATIONS

General Classes of Number of Mergers
Factors Mentioned in Which Mentioned
Market price of shares (aggregate market value
of stock, history of market prices of shares) 30
Earnings and earning power (historical,
present, prospective) 30
Book value 21
Future growth (product strength and nature,
nature of companies' business, industry prospects) 16
Asset and balance sheet position (value of physical
properties, financial condition, nature of assets) 15
Dividends (historical, present, prospective) 14
Sales volume (backlogs) 6
Management 2
Investment value of stocks 2
Return on invested capital 1
Unrealized appreciation 1
Future capital requirements 1
Asset coverage 1
Liquid position 1
Price-earning ratio 1
*In the listing applications relating to the other 17 mergers no men-
tion was made of the specific factors considered.

sidered in the formulations of merger terms as indicated by
managements' statements contained in the New York Stock
Exchange listing applications examined. In this same category
are any other published statements made by management.
While material obtained from such sources may have limited

22 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
value due to the fact that it is contained in statements made
for public distribution, it still provides useful information for
some aspects of the problem and is used in various parts of
this study, particularly Chapter IV.
Statistical Analysis.-Chapter III discusses the results ob-
tained from subjecting various measures of value derived
from financial data to correlation analysis. These results are
used to evaluate the over-all importance of the major value
factors in the total merger group, A, and in the two sub-
groups, B and C. The measures used in the analysis are the
exchange ratios and ratios expressing the relationships be-
tween the constituents, per share earnings, stock market
prices, book values, and cash dividends.
The financial data were obtained largely from the financial
statements contained in the New York Stock Exchange listing
applications relevant to the mergers examined here. These list-
ing applications were filed by the corporations as a necessary
step in the procedure to obtain authorization to list the addi-
tional amounts of a previously listed stock or a new stock issue
that would be used in effecting the merger transaction. In
addition to various types of financial statements these applica-
tions also contain a considerable amount of other information,
such as a copy of the merger agreement, a description of the
constituents' businesses, and a description of the various se-
curities which were authorized for the constituents prior to
the merger and for the final company after the merger.
In Chapter IV some of the mergers are analyzed on a more
individual basis to seek explanations for the deviations from
the general pattern. Consideration is given to the extent to
which the relative value relationships were affected by such
factors as earning trend and stability, liquid asset positions,
and general financial strength.
Reference to Literature.-Reference to the relevant litera-
ture was the initial approach to the problem. Most of the
material on mergers dealt with such aspects as tax considera-
tions, the economic theory of mergers, and industrial concen-
tration and antitrust implications which were not immediately
pertinent to the present problem. The material on value in
turn contained little relating specifically to the problem at
hand.
In the financial textbooks, where the problem of valuation

Introduction 23
in mergers is usually dealt with specifically, the subject is gen-
erally treated briefly by discussing the possible bases for rela-
tive value and by citing a few actual mergers as illustrative
examples. The value factors most generally mentioned are his-
torical and future earnings, assets values, dividends, stock
market prices, and management. (See Note 3.) Although it is
customarily suggested that these are the factors which receive
consideration, no definite conclusions concerning their relative
importance in actual merger term determinations are usually
drawn other than to state that little can be done in the way of
formulating generalizations.20
The study by Professor Bosland mentioned earlier is com-
parable in many respects to the discussions of merger valua-
tion appearing in the financial textbooks except that more
mergers are specifically considered. The study presents a sub-
jective evaluation of these mergers in terms of the value
factors usually considered in the financial textbooks and con-
cludes that present and prospective earnings are the domi-
nant value factors.21
Further references to specific literature bearing on the
problem of valuation are contained in Chapter II where the
question of value factors and their measurement is discussed
in some detail.
20. For two examples of this position see: Husband and Dockeray, p.
635; Guthmann and Dougall, p. 576.
21. Bosland, Trusts and Estates, XCIV, Nos. 6, 7, and 8, pp. 516-24,
583-90, and 662-69.

Chapter II

Common Equity Valuation

THIS CHAPTER DISCUSSES the nature of
common stock equity value and methods for its measurement.
It also describes the measures actually used in this study and
considers some limitations to their usefulness arising from the
nature of the data to which these measures are applied.
First, there is the question of who was responsible for the
value relationships actually established in the mergers consid-
ered, since in these cases, as in most questions of value, many
viewpoints may be involved. There are the myriad considera-
tions of the individual stockholders with their personal views
on value. Closely related is the value problem as it might ap-
pear to a committee representing the collective interests of a
large group of stockholders. Again, there is the viewpoint of
the courts in dissenting stockholder cases involving stock valu-
ations or injunctions. Finally, there is the viewpoint of the
negotiators who formulate the terms of the merger. It is be-
lieved that the value relationships established in the actual
mergers analyzed in this study represent the value judgments
of the negotiators. "The terms of agreement, the participation
of the stockholders in the shares of the corporation into which
their corporation would be merged or consolidated, would be
traded out by the representatives acting in their behalf. In
other words, the merger or consolidation would be the result
of two or more independent boards of directors negotiating
with each other at arm's length on behalf of their respective
stockholders."'
1. SEC, Management Plans Without Aid of Committees, 1938, p. 315.
24

Common Equity Valuation 25
The stockholders, in most cases, must pass judgment on
these terms by voting for or against the merger, and the courts
will hand down decisions on value in dissenting stockholder
cases, but in both of these situations it is a question of con-
sidering what the negotiators have presented rather than the
formulation of new valuation plans.
It is assumed that in making these value judgments the
negotiators acted in the best interests of the security holders,
reaching as fair and equitable a plan as possible under the cir-
cumstances.2 This would mean that the judgments and the
merger terms would be based largely on the objective value
factors consistent with the view that monetary gain is the
central goal in business enterprise, while personal and non-
monetary considerations such as prestige, power, and all
psychological motivations which might enter as legitimate de-
terminants of value for various people would be eliminated.
This assumption would not seem unrealistic for the mergers
considered here; and, as noted in Chapter I, the fact that the
merger terms must be approved by stockholder vote would
place some check on personal considerations entering to any
great extent into the merger terms. The soundness of this as-
sumption is important because the measures used in analyzing
the constituents' relative value positions relate to these objec-
tive factors. If the actual terms had been established on other
bases, the analysis would have disclosed little aside from the
fact that objective factors were not the dominant considera-
tions. The results obtained in the analysis support this assump-
tion, and it may be concluded that the relative value positions
assigned to the constituents' equities by the negotiators were
based, in large part, on objective value considerations.

Common Equity Allocation
As noted earlier, the basic value problem in mergers is one
of relative value. The merger transaction involves the alloca-
tion of the final common stock among the constituents and
poses the question: What values are involved in the compari-
son on which this allocation is based ? There are three principal
theories or views concerning the bases for allocating the final
common equity and for establishing the relative value of the
2. Ibid. See pp. 12-13, for the view that this assumption may not
always hold.

26 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
common equities of the merging corporation." The first holds
that the allocation should be based on the relative contribution
to the final common equity value attributable to the common
equity of each constituent; the second holds that the allocation
should be based on the relative values of the common equities
viewed as interests in independent enterprises; and the third
holds that the allocation is strictly a matter of bargaining
strength with no definite basis being applicable.
The view based on bargaining strength, while pointing out
the complexity of the whole allocation procedure, is not in
harmony with the present analysis. It is a fundamental as-
sumption in this study that merger terms were based primar-
ily on the values present and that the exchange ratios largely
reflect the negotiators' conclusions as to the relative values of
the constituents' common equities. While bargaining strength
and skill were no doubt factors in the determination of the
final merger terms, it is assumed that the basic objective value
factors were so influential that their significance can be rec-
ognized in spite of deviations resulting from the bargaining
process. "It must be remembered, also, that in mergers and in
most other valuation situations, the final determination of
value is a part of a bargaining process and that a compromise
value is therefore likely to result. In such cases it would be
largely a matter of coincidence if the agreed-on value corre-
sponded exactly to that indicated by any of the objective ap-
proaches. This does not mean that they are therefore of no
value in practical situations, for they will normally play a sig-
nificant role in setting rational limits within which the negoti-
ated value will fall."4
I-The first view-that allocation should be based on relative
contributions to the value of the final common equity-prob-
ably receives the greatest attention in American mergers5 and
no doubt represents the ideal basis. This basis may well have
been adopted for the value judgments in the mergers covered
here, but the difficulties involved in first estimating the final
equity value and then determining each constituent's contribu-
tion to this value suggest that this basis is more in the nature
of a standard to be approximated and that it must be reached
by some other approach.

3. Bonbright, II, 817.
5. Bonbright, II, 819.

4. Hunt, Williams, and Donaldson, p. 605.

Common Equity Valuation 27
The second view-that allocation should be based on the rel-
ative values of the common equities viewed as interests in
independent enterprise-is the one adopted for this study
This view is not considered to be the best theoretically, but
only the most suitable for the purposes of the present analysis.
Since it underlies the measures of value used in this study,
the extent to which the first view was adopted in the actual
merger negotiations may have caused the analysis to be less
effective than it might otherwise have been. However, this
would not seem to be too serious a consideration because (1) in
some cases either view might produce the same or very similar
results, (2) in some mergers the negotiators may have adopted
the second view, and (3) in any merger a difference in views
on allocation will probably be responsible for only a very
small part of the total difference between estimated values.
With the adoption of the second view on allocation, the na-
ture of common equity value in independent enterprises be-
comes important since relative value relationships are now
considered to be based on a comparison of such values. How-
ever, since common equity value is based fundamentally on the
value of the business enterprise, the latter will be examined
first in order to provide the background for the discussion of
common equity value.

BUSINESS ENTERPRISE VALUE
A business enterprise is an aggregate of assets-tangible
and intangible-and organized people meshed together to
serve as a unified instrument of production. For the purpose
of this discussion, the value of this instrument is considered to
rest on its ability to generate a monetary profit through the
sales of the goods and services produced. Profit maximization
(or loss minimization) is assumed to be its guiding policy, so
that profit maximization and value maximization are synony-
mous. As the term is used here, business enterprise profit is
considered to be the income available for the suppliers of the
more or less permanent capital of the enterprise and consists
of net income after taxes plus any interest on long-term debt.
Stating the nature and policy of the business enterprise in
this way means that at any given instant the present value of
a business springs from the future earnings it can generate,
or more realistically, from the anticipated future earnings it

28 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
is expected to generate. A maximum present value is usually
associated with the anticipated future earnings that result
from the continued operation of the enterprise by the present
owners. However, in some instances it might be associated
with the sale of the complete business as a unified operating
entity or with the piecemeal disposal of the business assets.
The fourth possible course is merging with another enterprise.
At this point, however, merging will not be considered since the
purpose here is to determine value for an independent business
enterprise, this value then being used in merger valuations.
Components of Estimated Business Enterprise Value
Since future earnings are always unknowns, anticipations
concerning future earnings and present value determinations
must be based on other information which is known and, con-
sequently, historical in nature. This information which consti-
tutes the factual material available for consideration when
making estimates of enterprise value may be conveniently
grouped into four categories designated as asset factors, per-
sonnel factors, earnings factors, and factors in the economic
environment. These factors are related in the following man-
ner: the personnel of a company, working with the assets
available during a particular period and in the economic en-
vironment which existed during this period, produce a certain
amount of earnings. This relationship and its four compo-
nents, as they appeared in the past, comprise the material
which may be examined in forming estimates of future earn-
ings and enterprise value. While this material is historical in
nature, it is not examined for the purpose of evaluating the
past as such, but to seek such possible light as the past can
throw on the future. However, in estimates of earnings and
value which use the past as a guideline to the future, allow-
ance must be made for the important element of uncertainty.
"It is true, too, under our competitive system, that the price
which men will pay for this instrument [a business viewed as
an instrument for creating earnings] will depend on the rela-
tive certainty with which these earnings can be counted upon
to continue."6
Uncertainty concerning the future is inherent in the nature
of the business enterprise and, since the present enterprise
6. Dewing, I, 288.

Common Equity Valuation 29
value rests on the future operations of the business, even an
estimate based on the most elaborate analysis must take ac-
count of this factor. The degree of uncertainty concerning the
future may vary among different types of businesses and in-
dustries but it is always present. The risk which arises in
making estimates of enterprise value due to the uncertainty
associated with the future operations of the business may be
referred to as the business risk and it constitutes an essential
element in every estimate of business value.

COMMON EQUITY VALUE
The nature and source of common equity value is basically
the same as the nature and source of business enterprise
value; in a sense, these two values are opposite sides of the
same coin. On one side is the value of a profit-producing in-
strument, the business enterprise, and on the other side is the
value of an interest in this instrument, the common equity. If
the common equity were the only interest in the enterprise,
the identity in value would be complete and no modification
would be needed in the above statements. However, other in-
terests, such as those of general creditors, long-term bond-
holders, and preferred stockholders, may be present; and, when
this is the case, the common equity would be only a partial and
residual interest in the total enterprise. This means that be-
fore moving from business enterprise to equity value some
allowance must be made for any prior interests which may be
present.
The fundamental source of business enterprise value is an-
ticipated future earnings and the appropriate earnings figure
is net income after taxes plus any interest on long-term debt.
If modified to allow for prior interests, this statement be-
comes: the fundamental source of common equity value is the
anticipated earnings available to the common equity. The ap-
propriate earnings amount is net income after taxes less pre-
ferred stock dividends, if any, and this is intended in any
subsequent reference to common equity earnings. Just as the
present value of the enterprise is the discounted value of an-
ticipated enterprise earnings, the present value of the common
equity is the discounted value of the anticipated future com-
mon equity earnings.
Since the source of equity value is anticipated earnings,

30 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
maximum common equity value is associated with maximum
common equity earnings; and, maximum equity value, when
the equity is valued as an interest in an independent corpora-
tion, is the relevant value in this study of merger terms. Dif-
ferent anticipated earnings and values for the enterprise will
be associated with different possible courses of action. Since
the common equity earnings are one part of total enterprise
earnings, different common equity values are also associated
with the different possible courses of action which a business
may take; and, in general, maximum value is associated with
the continued operation of the business by its present owners.
In an actual situation common equity value, like enterprise
value, can only be estimated because the future factors on
which its value rests are unknown. The close relationship be-
tween equity and enterprise value, developed above, indicates
that the discussion entitled "Components of Estimated Busi-
ness Enterprise Value" is also relevant to estimated common
equity value. However, two new considerations peculiar to the
common equity interest require recognition when an estimate
of equity value is made.

Two Additional Considerations in Common Equity Value
First, the proposition that anticipated earnings are the
source of equity value may not represent the full story in all
cases since this would appear to require that the equity be
viewed as an undivided interest possessing complete control
over and access to these earnings. This view may be the most
appropriate for some purposes and may represent the actual
situation for closely-held corporations but it should be rec-
ognized that a second view, referred to here as the "stock-
holder view," may also exist in cases where the common equity
share ownership is widely diffused, as it is in the corporations
included in this study. In these latter cases the individual
stockholders are actually one step from the earnings. The
average stockholder in a widely-held corporation usually has
no more control over or access to the earnings than he does to
the assets lying behind his book value. Before he may realize
these earnings they must first be transformed into dividends
or market price appreciation. Because of this the stockholder
view would consider the immediate source of common equity
value to be anticipated future dividends and market apprecia-

Common Equity Valuation 31
tion. While anticipated earnings are certainly a fundamental
factor behind both dividends and price appreciation, the equity
values arrived at from these two views would not necessarily
be identical for two reasons. First, judging from historical
data, the relationships between anticipated earnings and an-
ticipated dividends and market prices would not be expected
to be constant or predictable so that a present value based on
future earnings might not correspond with one based on fu-
ture dividends and market prices. Second, the valuation based
on earnings could logically be expected to result in a higher
value since control over these earnings is implied, an implica-
tion which is absent in a valuation made under the stockholder
view.
The possible presence of these two views on value is impor-
tant because control over and access to future earnings is an
element which is involved in mergers. While the individual
stockholders may not actually possess this type of control or
power, legally the right is vested in the common equity and
this collective right is transferred to the final company and
the final common equity in a merger. It seems likely that the
negotiators, who are assumed to have acted in the best inter-
ests of the stockholders, looked on the common equity from the
undivided interest point of view rather than from the "stock-
holder view" and so leaned most heavily on a valuation in con-
formity with the first view with its implied control over earn-
ings. This does not mean that the factors of importance in the
stockholder view-dividends and market prices-have had no
influence on the negotiators. Dividends and market prices are
immediately available and of prime importance to stockholders
as a basis for judging their relative treatment in a merger
and, since stockholder approval is usually required to effect a
merger, the reaction of stockholders to the terms presented to
them will be a definite consideration for the negotiators.
The second new consideration concerns an additional ele-
ment of uncertainty which is present in common equity valua-
tions when prior interests are present in the capital structure.
The use of funds provided by these prior interests on a fixed
return basis may have a favorable effect on equity value by
allowing greater earnings for the common equity than would
otherwise result, but the presence of these fixed returns means
that a new element of risk, which may be referred to as finan-

32 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
cial risk, must be allowed for in estimates of equity value. This
risk arises from the fact that when these fixed returns repre-
sent creditors' claims, the future operations of the business
contain an added element of uncertainty for these operations
may be interrupted or stopped if these claims cannot be met
in the future. To a much lesser extent this same sort of uncer-
tainty and risk exists when the claims are in the form of
preferred stock dividends. For this reason both business and
financial risks must be recognized in an estimate of common
equity value.

METHODS OF COMMON EQUITY VALUATION

Three Points of Importance in Evaluating the Methods
This section describes and evaluates the basic methods of
measuring common equity value. Throughout the discussion of
the individual methods there are three points which are im-
portant for evaluating the appropriateness of the methods for
the present study. First, it is important to note that the meth-
ods certainly do not cover the whole range of measures which
might possibly enter into an estimate of value but only the
more conventional and basic type of measures. Even some of
these latter measures require more information than is gener-
ally available to the public. In contrast, the negotiators in
many of the mergers included in this study no doubt had ac-
cess to a wide range of relevant information and relied on
thorough analysis of such detailed aspects of personnel, assets,
earnings, and the economic setting as were mentioned above.
For this reason the following discussion undoubtedly does not
cover many of the value measurements considered by the nego-
tiators in the actual mergers and, in this sense, is an over-
simplification of the actual valuation process. However, the
discussion is believed to cover the more basic considerations
and aspects of the measurement problem.
Second, the methods discussed here are treated primarily as
measures of absolute common equity value in independent cor-
porations. This conforms to the view on final common equity
allocation adopted for this study. However, it is important to
re-emphasize that in this analysis absolute values are not im-
portant, as such, but are developed solely for the purpose of
measuring relative value. This is important because some

Common Equity Valuation 33
measures having weaknesses in measuring absolute values
may be more reliable when used on a relative or comparative
basis. This point may be illustrated by assuming an extreme
situation in which each of two companies has only one asset
and are identical in every other respect. These two assets are
identical machines which each company purchased ten years
prior to the date of valuation. In such a case, depreciated cost,
or any other asset value measure, might prove a poor measure
of the companies' current absolute values but a suitable meas-
ure for establishing the relative value relationship existing
between the companies.
Finally, it may be well to note again, that in addition to the
view that pictures the common equity as an undivided interest
there is also the stockholder view. While the former view is
the more basic and important, the stockholder view should also
be recognized in evaluating the appropriateness of the follow-
ing methods.
The following classification of the methods to be considered
is somewhat arbitrary but provides a convenient and logical
approach to the analysis:
A. Asset valuation methods
1. Cost and cost depreciated
2. Reproduction cost and reproduction cost depreciated
3. Selling price
B. Capitalized income method
C. Hybrid method
D. Common-stock-market-price method
E. Cash dividend method
Asset Valuation Methods
The asset value method arrives at the value of the common
equity by first valuing the total assets of the enterprise and
then deducting from this value the claims of all interests prior
to the common equity. The value of the total assets remaining
after this deduction is the value placed on the common equity.
In a highly simplified way the following line of reasoning
would seem to underlie the use of this method. In the purchase
of goods or services (assets) for commercial use as opposed to
purchase for consumer use, the prices paid will be based on
the anticipated earnings to be realized from the use of the
assets. In a demand-supply equilibrium situation for any

34 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
given asset no one, in an economic sense, could pay more or
sell for less than the established price and still cover all costs.
In such a situation the asset prices could be considered to rep-
resent their commercial value and for an individual enterprise
the sum of the prices, or costs, of its assets, less the prior
claims against these assets, could be considered to represent
the value of the common equity. Leaving aside the possibility
that some of the factors responsible for future earnings may
not be recognized in the sum of total assets, this procedure
might be acceptable for valuing the common equity in a new
enterprise if it is assumed that the purchaser in question will
actually be able to employ the assets as usefully and efficiently
as all other purchasers. Actual business history suggests the
weakness of this assumption.
The above reasoning needs to be expanded to allow for the
element of time, for even if it were assumed that asset costs
were initially measures of asset value, a problem still remains
in a valuation made one or ten years later when some of the
original assets are still in use. Depreciation, reproduction cost,
or some form of market price are methods for adjusting for
the passage of time and changing conditions, but the reason-
ing still rests on a link between some form of purchase cost
and value. Such reasoning would appear to underlie the more
common variations included in the asset value approach.
The two problems arising in this method are the valuation
of the assets and the valuation of the claims to be deducted.
The problem of valuing the prior claims, which represent the
interests of creditors and preferred stockholders, is relatively
unimportant and the amount deducted will be the same in all
of the variations. The usual procedure is to deduct liabilities
at their full face amount and preferred stock at par, and this
procedure will be used in this discussion. While the deduction
for preferred stock might be based on the amount of this
claim in involuntary reorganization,7 when this is different
from par, and the deduction for long-term creditor obligations
might be based on par, plus-or-minus unamortized premium
or discount,8 the difference in common equity value which
would result from using these latter amounts would be re-

7. Harry G. Guthmann, Analysis of Financial Statements, p. 133.
8. W. A. Paton and A. C. Littleton, An Introduction to Corporate Ac-
counting Standards, pp. 39-40.

Common Equity Valuation 35
latively insignificant. The major problem in this method is
the valuation of the assets, and differences in asset valuations
constitute the basis for distinguishing the variations to be
discussed.
Cost and cost depreciated.-In the cost method the assets
are valued at their original cost as this is entered on the books
of account, and the sum of these costs less the deduction for
claims of prior interests represents the common equity value.
The cost depreciated method is similar except that it takes the
time element into account through a technical allowance for
depreciation and obsolescence based on a systematic handling
of expired cost. A familiar example of common equity value

EXAMPLE 1
ILLUSTRATION OF COST AND COST DEPRECIATED METHODS USING DATA
FROM AMERICAN CAN COMPANY'S BALANCE SHEET OF
DECEMBER 31, 1956
(amounts in thousands of dollars)

Cost
Cost Depreciated
Total assets, undepreciated 682,214 682,214
Less: depreciation ....... 182,373
Asset valuation used 682,214 499,841
Liabilities 143,833
Preferred stock 41,233
Total deduction 185,066 185,066
Common equity valuation 497,148 314,775

measured by this latter method is the common equity section
appearing in a formal balance sheet. Example 1 shows the
values of American Can Company's common equity which
would result from the use of these methods, based on the De-
cember 31, 1956, balance sheet.
These two variations are frequently presented in discussions
of value and then criticized on the grounds that original cost,
even when depreciated, has little use as an indicator of current
value because of its historical nature.9 An extreme example
illustrating this point is found in the listing application rele-
vant to merger (42) involving Climax Molybdenum Company
and American Metal Company, Limited.

9. For an example of this treatment see Wilford J. Eiteman, "Valua-
tion of Business Enterprises," Essays on Business Finance, pp. 294-96.

36 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
The difference between the book value and the computed
value of these holdings [value of common stock interests in
other companies based on market quotations, when available,
for these stocks] on November 15, 1957, was $114,245,000 or
$16.12 per American Metal common share, . adding this
difference to the book value of $16.10 per share on June 30,
1957, results in an adjusted value of $32.22 per American
Metal common share.10
Although the above-mentioned criticism of the method is
sound it might be noted that few, if any, accountants, financial
writers, or other experts would seriously contend that either
of these methods is well suited or intended to be used in estab-
lishing the current absolute value of the common equity. How-
ever, these methods may be more acceptable when they are
used to determine relative values, especially when the com-
parison involves firms in the same industry with somewhat
similar assets. This may be illustrated by referring again to
merger (42). While the balance sheet amounts understated the
current values of some of American Metal's assets, the same
thing was also true for some of Climax' assets so that the cost
figures would be more acceptable for comparative purposes
than as measures of current independent value. "For example,
Climax' mines are carried on Climax' books at only $484,000.
This is a fraction of the earning power of Climax' proven
molybdenum ore reserves."
It might also be noted that if some indication of value based
on assets is desired the information available to anyone not
closely associated with the company involved largely limits the
choice of methods to these two.
Reproduction cost, new and depreciated.-The two varia-
tions of the asset valuation method based on reproduction cost
recognize that changes in asset costs may occur with the pas-
sage of time and for this reason have the most significance in
cases involving valuations heavily weighted with fixed or
durable assets. Reproduction cost new involves the determina-
tion of what the cost would be to reproduce an asset in a new
condition. Reproduction cost depreciated involves finding the
10. American Metal Climax, Inc., listing Application No. A-17385,
(Department of Stock List, New York Stock Exchange, June 19, 1957),
p. 9. Other listing applications will be cited hereafter by giving the com-
pany name, the listing application (abbreviated L. A.) number, and the
date of the application.

Common Equity Valuation 37

percentage of this new cost corresponding to the percentage
that the old unexpired cost bears to the total old cost.
For the purpose of illustrating these two techniques it is
assumed that on December 31, 1956, it would have cost $700,-
000,000 to reproduce the fixed assets (property, plant, and
equipment) carried at $448,274,848 on American Can's bal-
ance sheet of this date." On the above date the "allowance for

EXAMPLE 2
ILLUSTRATION OF REPRODUCTION COST METHODS USING DATA FROM
AMERICAN CAN COMPANY'S BALANCE SHEET OF DECEMBER
31, 1956, AND ASSUMED REPRODUCTION COST
(amounts in thousands of dollars)

Reproduction Reproduction
Cost Cost
New Depreciated
Reproduction cost of fixed
assets (assumed) 700,000 700,000
Less: depreciation
(40% X $700,000,000) ....... 280,000
Fixed asset value used 700,000 420,000
Other assets 233,940 233,940
Total asset value used 933,940 653,940
Liabilities 143,833
Preferred stock 41,233
Total deduction 185,066 185,066
Common equity value 748,874 468,874

depreciation" was equal to approximately 40 per cent of the
undepreciated fixed assets. Example 2 shows the common
equity values which would result from the use of these two
methods, based on the above figures.
The use of either of the above techniques implies that there
is a desire to reproduce the assets in their old style and form.
Aside from the unlikelihood that there is any intention of
replacing many old assets with identical new ones, this as-
11. Although the figure for reproduction cost was simply assumed in
this case, it may not represent an unusual difference over original cost.
The following statement provides one example of an actual estimate of
this type of difference. "In the case of General Electric Company's plant
and equipment . it is estimated that . it would take about $2.4 bil-
lion to replace existing plant and equipment as it wears out, compared
with the $1.5 billion in original cost." General Electric Company, 1957
Annual Report, p. 27.

38 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
sumption would not be sound in cases where the earnings
attributable to an asset would not justify its acquisition at its
current cost. "The essential worth of existing property from
a business standpoint is not directly a factor of costs of physi-
cal reproduction minus a reasonable allowance for deprecia-
tion but rather income-generating ability.""12
Although these two techniques are subject to a general
weakness of all asset approaches in that they fail to take ac-
count of all the possible factors contributing to future earn-
ings and value, there are special circumstances in which these
methods would provide useful information for an estimate of
maximum equity value. "In those rare situations where a busi-
ness can be reproduced, it is obvious that replacement cost
will act as a limit to the value of an existing company."13
One very strong criticism of this method, and any other in-
volving appraisal, was made by a company president discuss-
ing valuations in mergers. "Quite often, in preparation for a
sale, the owners will have their plant and property revalued
by so-called 'independent' appraisers, and this appraised value
will be listed on the balance sheet. In our experience, the valu-
ation of independent appraisals is worthless, and we would
neither pay this value nor give it any weight at all in our
evaluation."14
A different and more realistic application of reproduction
cost in the measurement of common equity value is found in
the following statement. "The concept [asset value] is based
on replacement cost but is related to the cost of replacing pro-
ductive capacity rather than identical physical units. . The
current value on a going concern basis of corporate assets,
with fixed assets adjusted to replacement cost, less all liabili-
ties, is the total asset value of the common stock equity."
This measure, in the sense that it represents the current
cost of earnings-producing capacity, would provide a useful
basis for comparison in relative valuations. It is not used in
this study because the necessary information was not availa-

12. Bion B. Howard and Miller Upton, Introduction to Business Fi-
nance, p. 509.
13. Eiteman, pp. 296-97.
14. William C. MacMillen, Jr., "How to Find the 'Right' Company,"
Corporate Mergers and Acquisitions, American Management Association
Management Report No. 4, p. 59. This report is cited hereafter as AMA
Report No. 4.

Common Equity Valuation 39
ble. However, this type of asset value measure no doubt re-
ceived the attention of the negotiators in the actual mergers
for it has been mentioned that this concept is a very real indi-
cation of value in the minds of executives.15
Selling price.-A final variation of the asset value method,
which may be termed the "selling price method," is mentioned
here even though its applicability is somewhat limited. Under
this method the deduction for claims of prior interests is the
same as in the previous methods. However, the assets are
valued at the prices for which they can be sold. These prices
in turn are based on comparisons with prices established in
actual sales of similar assets.
The use of this method is limited to situations in which fair-
ly active markets exist for those types of assets involved in
the valuation. In the absence of such markets the estimated
selling prices would have to be based on some other method of
valuation, and selling price would become a concept of value
rather than a method of measurement. Because of its depend-
ence on market trading, this method, when applicable, would
usually involve the valuation of the assets on an individual
basis and would be most suitable in a situation in which maxi-
mum equity value is associated with liquidation and the piece-
meal disposal of assets. In some cases it might relate to the
selling price of the total assets, as a whole, by comparisons
with the prices received in the actual sales of similar busi-
nesses. However, because the use of the method requires simi-
larity of assets and frequent sales, a basis for estimating total
asset selling price could probably only be obtained for small
businesses of a fairly standardized character. For this reason,
together with the fact that liquidation was probably not the
contemplated alternative to merger for the corporations cov-
ered, this method of valuation is not well suited for the present
study.

Capitalized Income Method
General procedure.-The capitalized income method is the
second major approach to common equity value measurement.
With this method the common equity value is found by divid-
ing an amount, thought to be representative of future earn-
15. Dan Throop Smith, Effects of Taxation: Corporate Financial Pol-
icy, pp. 57-58.

40 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
ings, by a capitalization rate which converts these earnings
into a present value. The results obtained may be subject to
minor adjustments for such things as excess nonoperating
assets or a deficiency of needed assets, but these adjustments
do not change the basic method. "The only means by which
the going-concern value concept can actually be applied is to
estimate what future net income will be on an average annual
basis and to divide this sum by a given percentage rate."16
This method is obviously in accord with the proposition that
the source of common equity value is future earnings. It is
also closely related to the following economic theory of capital
asset valuation. "The theory is that the present value of any
object of wealth is simply a discounted or capitalized valuation
of the anticipated services derivable by the owner of this
wealth.""17
The reasoning behind this theory and the capitalized income
method may be clarified somewhat by noting that the capitali-
zation rate is, in effect, the rate of return on the capitalized
value which is considered necessary or appropriate for the
situation in which the capital is employed.
Under this method the value of the common equity may be
derived through the use of two alternative procedures which,
theoretically, should both produce the same result."8 The first
procedure is to capitalize the total earnings accruing to the
business enterprise as a whole at a rate reflecting only the
business risk involved and then to deduct the claims of the
prior interests from this capitalized value to arrive at the
common equity value. The second procedure is to capitalize
only the smaller earnings available to the common equity at a
higher rate to allow for both the business and financial risk
present in common equity valuations. In theory the change in
the capitalization rate used should exactly offset the absence
of any deductions in the second alternative. These two pro-
cedures are illustrated in Example 3, using assumed capitali-
zation rates and figures from American Can's balance sheet
and income statement applicable to the year ending December
31, 1956. Past earnings, rather than estimated future earn-
ings, are used for the sake of simplicity. In this example the

16. Howard and Upton, p. 511.
17. Bonbright, I, 218.
18. Eiteman, pp. 303-4.

Common Equity Valuation 41

capitalization rate applied to the common equity earnings was
carried out to several decimal places. While this degree of re-
finement was necessary to produce equal common equity values
in the illustration, it no doubt represents an unrealistic over-
refinement of the type of capitalization rate which would be
derived in an actual situation.
In addition to illustrating the difference in these procedures

EXAMPLE 3
ILLUSTRATION OF TWO ALTERNATIVE CAPITALIZED INCOME PROCEDURES
USING DATA FROM AMERICAN CAN COMPANY'S FINANCIAL
STATEMENTS OF DECEMBER 31, 1956, AND ASSUMED
CAPITALIZATION RATES
(amounts in thousands of dollars)

Using Using
Enterprise Common Equity
Earnings Earnings
Net income after taxes
plus interest $ 37,922 $ 37,922
Less: interest and
preferred dividends ........ 5,984
Earnings to be
capitalized $ 37,922 $ 31,938
Capitalization rate (assumed) 6% 7.14549%
Capitalized value $632,033 $446,967
Liabilities $ 143,833
Preferred stock 41,233
Total deduction 185,066 .......
Common equity value $446,967 $446,967

this example may also serve to point out the importance of the
capitalization rate in valuations made by this method. If the
rate applied to the enterprise earnings of $37,922 thousand
had been 7 per cent instead of 6 per cent, the capitalized value
would have been $541,743 thousand. In this case a change of
only 1 percentage point in the rate produced a difference of
approximately $90 million in the capitalized value.
The remaining discussion of this method deals only with the
procedure based on the capitalization of common equity earn-
ings since it is probably the more common and especially be-
cause it focuses attention more directly on the two basic prob-
lems involved-the derivation of the capitalization rate and

42 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
the selection of the earnings figure to be capitalized. In this
discussion it will be helpful to express some of the relation-
ships symbolically. Where this is done V will represent the
common equity value of an independent enterprise; RV, the
relationship between equity values of independent enterprises;
E, the common equity earnings to be capitalized; and C, the
capitalization rate to be used. In terms of these symbols the
common equity value of an enterprise derived by the capi-
talized income approach may be expressed as:
E
V = .
C"
Earnings figure to be capitalized.-The common equity earn-
ings figure, E, to be capitalized should represent an estimate
of the future earnings expected to accrue to the common eq-
uity. This estimate may be arrived at through the elaborate
type of analysis mentioned earlier in which various categories
of past information are used for projecting the major value
components into the future. Such analyses were no doubt em-
ployed in some of the mergers considered in this study.
A somewhat simpler technique, which may also have been
used, bases the estimate primarily on past earnings adjusted
in the light of anticipated future conditions.19 This technique
assumes some continuity in the earnings pattern, and the past
earnings record is used as the foundation for the projection
of this pattern into the future. When a recognizable trend is
found in the past it may be extended into the future; or, if
the past earnings record has been relatively stable, a simple
average of the past may serve as the basis for the estimate.
While these two examples may oversimplify the situation and
while more elaborate and detailed procedures may have been
used in many of the mergers, the technique emphasizing the
past earnings record is the one relied on in this study in so far
as a measurement based on earnings is concerned.
Capitalization rate.-Once the earnings estimate has been
made, a capitalization rate, C, is required. The function of this
rate in deriving the absolute value of the common equity is

19. C. Oliver Wellington, "What Is a Sound Purchase Price?" in Cor-
porate Mergers and Acquisitions (American Management Association
Report No. 4), p. 66; and Benjamin Graham and David L. Dodd, Secur-
ity Analysis: Principles and Technique, p. 413.

Common Equity Valuation 43
(1) to convert the earnings figure, representing a flow over
time, into a present value by dividing the figure by the rate of
return required on riskless investments and (2) to adjust the
present value so computed for the amount of risk and uncer-
tainty in the situation relative to the risk and uncertainty
existing in alternative investment opportunities. Where com-
mon equity is concerned, the total risk includes both the busi-
ness risk inherent in the nature of the business enterprise and
the financial risk arising from the manner in which the busi-
ness was financed, if other than common equity interests are
present.
Problem in application.-While the capitalized income ap-
proach is mechanically simple and the reasoning behind it
sound and free from criticism, when it is applied in an actual
valuation several difficulties appear because of the many per-
sonal judgments involved. There is always a question as to
the reliability and accuracy of the earnings estimate, even
when extensive analysis is involved. The possibility for errors
of this sort may be seen by considering that the estimate, in a
sense, must take account of all future earnings up to the point
at which their discounted present value becomes negligible,
but once an estimate passes beyond the relatively near future
the opportunity for influential unknown conditions to appear
may make it little better than a guess. The major question,
however, appears in the determination of the capitalization
rate. The determination of this rate rests largely on individual
judgments and the rate settled on by any individual would
reflect his personal recognition of, and sensitivity to, the risks
actually present. To some extent this personal factor may be
avoided by basing the rate on comparisons with other rates
existing for equities considered to involve about the same type
and degree of risk. The recent sale of a similar business would
provide this type of information or, if no recent sale had oc-
curred, the earnings-price ratios for stocks of similar com-
panies might be used. However, the significance of these com-
parisons is limited by the fact that the appropriateness of a
rate hinges on the earnings estimate to which it is applied,
and there is usually no way of knowing what earnings esti-
mates lay behind the comparative rates or ratios used. There
is also the possibility that some of the risk factors covered by
a rate were partially allowed for in the earnings estimate,

44 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
even when they are both computed by the same individual.
The significance of the above problems is increased by the
mechanics of the method itself. Since the capitalization process
involves division, error in either the earnings figure or the rate
tends to be magnified in the final valuation unless such errors
should happen to compensate each other. Some indication of
this property of the capitalization process was noted in con-
nection with Example 3.
It is apparent that the capitalized income method is not an
exact technique in actual application, and the value arrived at
through its use may be subject to substantial error. In spite of
these opportunities for error, this method is generally re-
garded as the most suitable valuation method when continued
operation of the business is anticipated.
In spite of the practical difficulty of determining a definite
and precise value for the specific business, the capitalization
of earnings is the only means at our disposal for determining
the value of a going business.20
In every case in which the issued has arisen, the Commis-
sion [Securities and Exchange Commission] has insisted that
the enterprise must be valued as a going concern, and that its
going concern value is determined by the prospective earnings
capitalized at a rate commensurate with the risks inherent in
the enterprise. [Relevant exceptions noted were (1) nonoper-
ating properties having independent value, (2) assets which
could be disposed of without impairing earning power, and
(3) enterprises that can be more profitably liquidated than
operated.]21
Notwithstanding this inexactness, it is still true that when
businessmen evaluate assets on the basis of their earnings
their thought processes approximate closely the mathematical
procedure [of the capitalization process].22
Application in relative valuations.-This application of the
capitalized income method to a situation where relative value
is the important concern, as it is for this study, requires some
modifications of the previous discussion. The relationships in-
volved may be illustrated by considering two companies, 1 and
2, for which:
20. Dewing, I, 287.
21. "Valuation by the SEC in Reorganizations," Harvard Law Re-
view, LV, No. 1 (1941), 127.
22. Eiteman, p. 304.

Common Equity Valuation 45
El Eo V1
V,- 1 ;V- R, ;andRV- .
C1 C2 V.
This may be illustrated more concretely by using American
Can as Company 1 and Dixie Cup as Company 2. The valua-
tion date is assumed to be December 31, 1956, and the earn-
ings for the year ending on this date may be assumed to fairly
represent the future annual earnings, E. The earnings-price
ratio based on 1956 earnings and the average of the high and
low common stock prices during 1956 will be used for C. Based
oA these figures and with dollar amounts stated in millions, the
above relationship would be:

32 4 533
V, = 533 ;V. = 44 ;andRV 12.
.06 .09 44
Based on the above figures, American Can's common equity
is twelve times more valuable than Dixie Cup's common equity
measured by the capitalized income method. The actual alloca-
tion of the final company's common stock in merger (18) im-
plied that American Can's common equity was approximately
6.7 times more valuable than Dixie Cup's common equity.
The relative common equity value relationship, RV, was de-
termined above by first establishing the independent absolute
values and using these as the basis for comparison, but the
first step may be bypassed by direct comparisons of the two
factors lying behind the V's.

V1 E. E, E, C2
RV = -= -+ -= X
V2 C1 C., E2 C1
Using American Can and Dixie Cup in these relationships
would result in:

32 .09
RV = x = 12.
4 .06
Arranging the relationships in this latter form permits the
earnings figures and the capitalization rates to be compared
separately and aids in considering the use of the capitalized
income method in relative valuations. In this form the relative
value relationship is based on the ratio between future earn-
ings estimates adjusted for differences in capitalization rates.
The ratio between the estimated future earnings E1 and E2

46 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
will be considered first. When these estimates are used for
comparative purposes, as they are here, reliance on past earn-
ings data for their derivation may command more support
than it does when the estimates are used for absolute valua-
tions. In the former use it is the relation between E, and E2
which is important, rather than the amounts of the figures
themselves, and often this relationship is suggested by the re-
lationships between the annual earnings figures in the past. In
many of the mergers covered in this study the past earnings
of the constituents in a given merger exhibited a somewhat
constant relationship during the five years prior to the merger.
These cases represented situations in which the past earnings
of both constituents either exhibited considerable stability,
exhibited the same type of "trend," or fluctuated together. Al-
though the relationships in these cases were not without vari-
ation, they were constant enough to suggest that the past
operations were subject to some extent to common influences.
In general their operations were subject in common to the
broad business conditions in the economy during these years.
More particularly, if the constituents of a given merger were
in the same industry or segment of an industry, as many of
those covered in this study were, the particular conditions
existing for the industry were common to their operations. In
such cases these common influences would be expected to con-
tinue into the future so that the relationship between E, and
E, would not be expected to differ markedly from the past re-
lationship unless there was substantial evidence to support
such a deviation. If the past relationship is believed to fairly
represent the relationship which could be expected in the fu-
ture, the estimate of future earnings could be based exclusively
on the past earnings. While past earnings are used in this
study to represent the relationship between E, and E2, it is
recognized they are not perfect indicators of this ratio and
their adequacy will vary from merger to merger.
Once the problem of the earnings relationship E,/E2 has
been decided, the question of the capitalization rates, C1 and
C2, still remains to be answered. Where relative value is the
primary concern, that part of C arising from the rate of re-
turn on riskless investments is not needed, so that C becomes
simply a means for weighing the estimated earning, E, for the
comparative risks involved. This observation does not lessen

Common Equity Valuation 47
the problem but only poses it more definitely. If C, = C2, the
relative value relationship could be determined through the
use of the future earnings ratio alone. However, the use of
only this ratio in a situation where C, does not equal C, would
result in an error due to the unaccounted for differences in
risk and uncertainty attaching to the earnings figures. In this
study, rather than to attempt the determination of the C's, or
the ratio between C, and C2, ratios based on uncapitalized
earnings are used. Then, in Chapter IV, an explanation is
sought for the deviations that result from this procedure by
examining some of the factors that would have been consid-
ered in the derivation of a capitalization rate. This does not
meet the problem head-on, but the errors resulting from the
use of the earnings ratio alone may be no greater than those
which might have resulted if capitalization rates had been
computed with the available information. This is particularly
true in view of the magnifying nature of the capitalization
process noted previously.
It is also possible that in many instances the ratio of capi-
talization rates, Cs/C1, would not be far from 1, especially in
mergers involving constituents engaged in the same general
type of business. In addition, all the constituents covered in
this study are relatively large listed corporations and in some
cases the constituents were of approximately the same size.
For this reason those elements of risk associated with small
or new companies would not be present here. It is also held
by some that differences in capital structures do not have a
significant effect on value except in extreme cases.23 If this
position is accepted, it would mean that differences in the
financial risk element would not give rise to differences in the
capitalization rates to any great extent. Nevertheless, in spite
of the considerations to the contrary, deviations are to be ex-
pected in the absence of any adjustment for capitalization rate
differences.

Hybrid Method
The term "hybrid method" is used here, not to define a
clear-cut valuation method, but only to refer to techniques
which are distinguished because they combine the two classes
23. Bosland, Trusts and Estates, XCIV, No. 8, 668; and Franco
Modigliani and Merton H. Miller, "The Cost of Capital, Corporation

48 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
of valuation procedures previously discussed. The method con-
sists of valuing the assets (usually by a method mentioned in
the section describing asset valuation methods); combining
this value with an element of goodwill, positive or negative,
derived by the capitalized income method; and then deducting
the claims of the prior interests from this combined value.
The present description of this method is based on a pres-
entation by A. E. Cutforth,24 who states his general position
on value as follows: "The value of a business at any date is,
of course, represented by the excess of the total value of its
assets over the total amount of its liabilities at such date ....
The assets will of course require to be valued on the footing
that they form part of a 'going concern,' and not at the amount
they would be expected to realize on being sold piecemeal."
The method used by Cutforth to determine value on this
basis is as follows:
Step 1-Divide the assets into three groups: fixed assets,
floating assets, and goodwill, which is characterized as "capi-
talized super-earnings." (The term "floating assets" is essen-
tially equivalent to current assets.)
Step 2-The fixed and floating assets are then valued on an
appraisal basis, "such basis being that of a fair price as be-
tween a willing buyer and a willing seller" [with the previ-
ously mentioned criterion that they be considered as forming
part of a going concern].
Step 3-The value of goodwill is then computed by estimat-
ing the average future earnings, deducting from this an
amount representing a fair commercial return on the average
capital to be employed in the business, and multiplying the re-
mainder by the number of years purchase thought to be ap-
propriate. "The value of goodwill of a business may then, I
think, be defined as the capitalized value of what may be called
the anticipated "super-profits" of that business-that is to say,
the capitalized value of the profits in excess of a figure repre-
senting a fair commercial return upon the capital employed
in the business."
Finance and the Theory of Investment," The American Economic Re-
view, XLVIII, No. 3 (1958), 276-77.
24. A. E. Cutforth, Methods of Amalgamation: The Valuation of
Business for Amalgamation and Other Purposes. A similar presentation,
termed the "Detailed Approach," may be found in Wellington, AMA Re-
port No. 4, pp. 67-70.

Common Equity Valuation 49
Step 4-The claims of prior interests are then deducted
from the combined value reached in Step 2 and Step 3, to ar-
rive at the value of the common equity.25
Variations in the method could arise from differences in the
detail used in classifying the assets into groups, in the meth-
ods used to measure the asset values, and in the techniques
employed in computing goodwill. Any criticism of this type of
method would depend somewhat on the use to which it is put.
As the sole means for valuing the common equity it would be
subject to previously mentioned shortcomings attaching to
whatever measurement methods are combined and may seem
to be an overrefined technique in view of the nature of the
problem. The assignment of earnings to specific assets, or
groups of assets, is an example of such overrefinement and is
subject to the criticism that "in most cases it is impossible to
determine the contribution that an individual asset makes to-
ward earnings."26 However, to the extent that earnings can
be assigned, the method would be useful as a check, when used
in conjunction with some other method, to point out any obvi-
ous discrepancies in the value previously assigned to a partic-
ular asset or group of assets.27 Methods of this type may have
been used in the mergers covered in this study either as a
check or as a basic valuation measure, but this method is given
no further consideration here because the information re-
quired was not available and because the important value ele-
ments involved are covered to some extent by the measures
associated with the asset valuation method and the capitalized
income method.

Common-Stock-Market-Price Method
In absolute valuations.-In the common-stock-market-price
method the value of the common equity is based on the price
of the common stock established in the trading of the shares
in a securities market. The absolute value of the equity is ar-
rived at by multiplying a representative price by the number
of common shares outstanding. The application of this method
may be illustrated by assuming that American Can Company's

25. Cutforth, pp. 26, 29, 101.
26. H. A. Finney and Herbert E. Miller, Principles of Accounting:
Advanced, p. 568.
27. Wellington, AMA Report No. 4, pp. 66-67.

50 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
common equity was to be valued on December 31, 1956. On
this date there were 11,108,965 common shares outstanding.
It will also be assumed that $41.19 was considered to be a
representative price for a share of common stock. This price
represents the average of the high and low prices for Ameri-
can Can's common stock established on the New York Stock
Exchange during the quarter ending on the above date. Using
these figures, American Can's common equity would be valued
at $457,578,268.35 (11,108,965 X $41.19).
This method differs from those previously discussed in at
least two respects. First, the measure used in this method is
an accomplished valuation itself. That is, the valuation of the
common equity has already been made apart from any effort
or action on the part of the appraiser who may use it, and the
method simply involves the acceptance, rejection, or modi-
fication of the existing valuation. This characteristic may be
significant in that the reasoning and valuation factors lying
behind the valuation cannot be known with any degree of cer-
tainty, if at all, by the user of this method. This may lessen
the weight which can be placed upon such a market valuation.
Second, the valuation is made neither by those people asso-
ciated with the operation of the business nor by anyone hired
to appraise the business, but represents an independent valua-
tion made in the market place. This independent valuation may
be considered to represent either the consensus of a large
number of people or the judgment of a personified market
place, but in either case the valuation may be considered to re-
flect a certain degree of comprehensiveness, impartiality, and
futurity.
As a measure of absolute value this method is subject to
numerous arguments, pro and con. On the favorable side is
the simplicity of the calculation once a representative price
has been accepted. More importantly, some of the basic rea-
soning involved in the capitalized income method lies behind
the valuation established through the market price approach;
that is, stock market prices may be assumed to reflect, perhaps
imperfectly, future prospects and relative risks. Prices are the
result of trading, and individuals, to some degree, may be as-
sumed to base their purchases and sales on judgments pertain-
ing to the future prospects of a company's earnings and the
comparative risks involved at any given price. To the extent

Common Equity Valuation 51
that such judgments are involved, the market price may be
favorably considered as a measure of value, especially since the
price represents a composite judgment of many individuals.
This same process may be considered to make the market
price a somewhat comprehensive measure since numerous pos-
sible future conditions are no doubt reflected in the buying
and selling decisions. Finally, this type of valuation is virtu-
ally always free of any possible bias which might exist in a
valuation made by those closely associated with a company.
On the other hand, one of the method's shortcomings lies in
the fact that its use is restricted to those companies whose
common stocks enjoy some degree of trading activity. This is
not a serious obstacle in this study. Of more concern is the
problem of selecting the representative price to be used. Stock
prices may fluctuate substantially during even a short period
of time. This raises the question of what price, or average of
prices, best represents the market's basic evaluation. A funda-
mental weakness lies in the fact that in most cases the market
price results from the trading of only a relatively small part
of the total shares outstanding and no consideration of control
or its value is usually present in this trading or in the result-
ing market price. For this reason such prices are not repre-
sentative of the price which would be established in a trans-
action where all shares changed hands and the common equity
was viewed as an undivided interest possessing control over
earnings. Finally, there are the possibilities that the market
price may continually reflect speculative and technical factors
having no connection with the basic value of the equity, and
that the judgments of those individuals whose decisions are
reflected in the market price are not based on a very high de-
gree of investment experience, objectivity, and comprehensive-
ness. The possibility that the market price reflects speculative
trading is particularly pertinent for the present study since
any rumors of a pending merger may be one source for such
speculation. The possible effect of this type of speculation in
the mergers covered here will be considered in the discussion
of the market price ratio used in this study.
It would be difficult to evaluate the relative significance of
these arguments and the balance between favorable and un-
favorable factors probably shifts from case to case and over
periods of time. For a stock in which most of the trading ac-

52 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
tivity originated with institutional investors, the market price
might be a fairly good measure of value, while for a stock
receiving a lot of speculative attention the market price might
prove a very poor measure.
In relative valuation.-Common stock market prices are
more helpful and less subject to criticism in measuring rela-
tive value than in measuring absolute value. One of the defects
in measuring absolute value by market price is the failure to
take into account the element of control and the value asso-
ciated with control. To the extent that this element of value is
not reflected in the market prices of any of the constituents'
stocks, its absence will not be of serious importance in deter-
mining relative value. Further, it should be pointed out that
while general changes in market price levels will affect ab-
solute values, relative values will be affected only to the degree
that prices of stocks of the constituent companies are influ-
enced differently by the general changes.
From the stockholders' point of view, market prices are ex-
tremely important indicators of relative value. Since they can
be easily determined by stockholders, at least by stockholders
of the constituent corporations of the mergers covered in this
study, and since stockholder approval is usually required to
effect a merger, the market price will be a factor of substan-
tial significance for the negotiators. Even if the negotiators
did not believe that market prices accurately reflected the
relative values involved, it does not seem likely that the merger
terms could deviate too markedly from the pre-merger price
ratios.
Therefore, market prices are significant factors in relative
valuations both because of their somewhat greater ability to
measure relative relationships, for either an original valuation
or as a check on the relationships established by some other
method, and because of their significance for the individual
stockholders.

Cash Dividend Method
The cash dividend method in absolute valuations is mechani-
cally similar to the capitalized income approach. However, in
this case, anticipated cash dividends are capitalized instead
of anticipated earnings and the capitalization rate must now
allow for possible changes in the future dividend payout rate

Common Equity Valuation 53
as well as for the types of risks previously mentioned. The
valuation of American Can Company's common equity on De-
cember 31, 1956, may be used to illustrate this method. It will
be assumed that the $21,934,699 of cash dividends paid to the
common stockholders during 1956 is representative of such
payments in the future. The capitalization rate will be as-
sumed to be 4 per cent, which is approximately the dividend
yield based on the average of the high and low stock prices
during 1956 and the cash dividends of $2.00 per share paid
during this year. Using these figures the value of American
Can's common equity would be approximately $548,367,475
($21,934,699 .04).
The application of this method in relative valuations is also
similar to the capitalized income method; that is, the pro-
cedure may involve either a comparison of the absolute capi-
talized values or it may involve the separate consideration of
the anticipated dividends and the capitalization rates. In this
latter procedure the ratio of the anticipated future cash divi-
dends may be based largely on past dividends and the past in-
tercompany dividend relationships. However, a comparison of
past dividends may be less exact and meaningful because of
the discretion management has in setting dividends and be-
cause of the problem involved in handling extra dividends and
in determining which dividends are extras and which are not.
The dividend approach differs somewhat from any of the
others mentioned. Earnings and assets are both potential
sources of value for the common equity viewed as an undivided
interest. Market price, while not a source in itself, may be
looked at as an independent valuation of this interest when
relative relationships are involved. Dividends, however, would
appear to be a source of value and a means for measuring
value only from the individual stockholder's view. For this rea-
son, as well as several others to be noted, dividends would not
be expected to play too significant a role in relative equity
valuations, and what influence they do have might be expected
to stem primarily from considerations concerning stockhold-
ers' reactions to the merger terms and, less directly, from any
influence dividends may have on market prices.
Even from the individual stockholder's view, the influence
of relative dividend payments may not be as great as might
be expected. Their influence could reasonably be expected to be

54 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
greatest in cases where the constituents had established fixed
dividend payments so that a rather definite past relationship
between the constituents' dividend payments could be recog-
nized. To the extent that the past payments were irregular no
definite basis would exist for comparison with the new rela-
tionship resulting from the merger terms. A further factor
tending to modify the over-all importance of dividends is that
with today's tax structure some stockholders may prefer a
low dividend and high earnings retention. Nevertheless, the
cash dividend relationship still remains an easily recognized
measure of relative value of very immediate concern for a
large number of stockholders so that its possible influence on
negotiators, although indirect in nature, would seem to require
recognition.

Comparison of Valuation Methods
Before concluding this section on methods of valuation some
consideration will be given to the differences in equity value
which result from the use of the various methods. To illustrate
this point the different values computed for American Can's
common equity throughout this section are presented below:

Illustrative Values Computed
for American Can's
Methods of Common Equity
Valuation (millions of dollars)

Cost 497
Cost depreciated 314
Reproduction cost new 749
Reproduction cost depreciated 469
Capitalized income 447
Common stock market price 458
Cash dividends 548
First, it should be noted that the above values are only illus-
trative since many of the figures involved in their computation
were simply assumed. After giving due allowance to the above
point, the various common equity values still serve to illustrate
the type of difference which may result through the use of
different methods of valuation. However, for the purposes of
this study in which the primary concern is relative value, these
differences in absolute amounts are not important in them-

Common Equity Valuation 55
selves. The fact that the value based on reproduction cost new
is more than twice that based on cost depreciated is not neces-
sarily important, for this same value relationship may exist in
the other company involved in the comparison, and any com-
parison will be made with respect to values derived by the
same method. The important point is that when the compari-
son is made with values derived by one method, one constitu-
ent may possess the greater value; while when the comparison
is made with values derived by another method, the other con-
stituent may possess the greater value. In such a situation a
constituent's negotiators might tend to emphasize that method
most favorable to their company and be able to produce some
support for their position since each of the methods has both
strong and weak points.
The capitalized income method is theoretically the soundest
but its application in an actual valuation involves a consider-
able amount of personal judgment so that the resulting value
may be open to dispute. On the other hand, the values derived
by the asset value methods are based on more definite data
but the appropriateness of such values may be questioned.
While the values so derived may be more acceptable in relative
valuations than in absolute valuations and may be considered
to suggest relative earnings-producing capacity they are still
subject to the criticism that:
1. They are not comprehensive enough in their coverage and
fail to account for the value of such factors as organiza-
tions, superior management, or simply being an established
going concern.
2. Cost in itself is not necessarily any indicator of earning
power and in actual practice the same asset may have dif-
ferent earning power for different owners.
The common-stock-market-price method is a clear-cut pro-
cedure and involves little judgment aside from the selection of
a representative price. However, it may reflect influences hav-
ing no relevance for the purposes of the valuation; and, since
it is based on only a portion of the total common stock, it does
not actually take account of the fundamental nature of the
common equity as an undivided interest.
The cash dividend method takes account of an important
value element from the stockholder view not covered by the
other methods; but, on the other hand, it too does not reflect

56 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
the fundamental value of the common equity viewed as an un-
divided interest. It is also less basic in that it reflects to some
extent the discretionary policies of management as well as the
operating results of the business.
Since each of the methods emphasizes various possible value
elements and there is no conclusive proof that any one method
is exclusively a better indicator of value in actual applications,
it is very likely that consideration is given to each of these
methods although some may receive greater attention than
others.

MEASURES USED AND DATA LIMITATIONS
This section describes the basic measures of relative equity
value used in this study and considers some of their significant
limitations arising from the nature of the data to which they
are applied. The concrete application of these measures of
value is developed and the groundwork is provided for the
statistical analysis in the next chapter.

Measures of Relative Value
The measures used here are in ratio form and are based on
per share relationships. This allows comparison with the ex-
change ratio, Y, which expresses the per share value relation-
ship implied by the actual terms of the merger. The measures
used are:

X,, the ratio of the last full year's earnings per share.
X,, the ratio of the 5-year averages of earnings per share.
X3, the ratio of common stock market prices.
X4, the ratio of per share book values.
X5, the ratio of cash dividends per share paid during the last
full year.
Each of these ratios will be explained in turn.
Earnings ratios: X, and X..-Two earnings ratios are used
to indicate the relative value of the equities. These earnings
ratios are based on past earnings relationships, unadjusted for
future conditions and comparative risks, so they represent im-
perfect approximations of a ratio based on adjusted estimated
future earnings. Nevertheless, these past relationships should
still provide a meaningful indication of the earnings relation-
ship.

Common Equity Valuation 57
The earnings used in these ratios are those available for the
common stock:
A. After taxes.
B. After preferred dividends, if any.
C. Before special income deductions or credits when this ad-
justment is possible.
D. On a per share basis after adjustments for changes in capi-
talization, such as:
1. Adjustments for stock dividends and stock split-ups.
2. Adjustments to put the capitalization on a pro forma
basis, when possible, for such changes as the conversion
of preferred stock into common. When the preferred
stock was redeemed for cash instead of being converted,
no adjustment was made.
The first earning ratio is X1, the ratio of the last full year's
earnings per share. This ratio was selected because of the last
year's earnings proximity to the future. While one year's earn-
ings may not be representative of the equity's true earning
power in some cases, the latest earnings would seem best
suited to reflect the influence of conditions which may be pres-
ent in the near future. They also represent the most recent
actual results and so may be foremost in the minds of the
negotiators and the stockholders. The following example illus-
trates the computation of the ratio.
Last Full Year's Earnings
Constituents in Merger (18) Per Share
American Canb28 $2.92
Dixie Cup 4.55
Ratio of last full year's earnings = 4.55 2.92 = 1.56.
ThiA ratio indicates that a share of Dixie Cup common stock
was 1.56 times more valuable than a pre-merger share of
American Can common stock on the basis of the last full year's
earnings and may be compared with the exchange ratio of
1.65, actually established by the negotiators.
The second earnings ratio is X,, the ratio of the 5-year aver-
ages of earnings per share. A 5-year average may represent
28. The subscript "b" is used to indicate the company in each merger
which serves as the point of reference, or base company, for the purpose
of expressing relative value relationships. The base company in each
merger is that constituent whose common stockholders, as a group, re-
ceived the largest percentages of the final company's common stock.

58 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
the "true" or "normal" earning power of the common equity
better than any single year's earnings, since the earnings of
any one year may reflect the influences of some extraordinary
condition. While a period longer than five years may be con-
sidered necessary to derive a truly representative earnings
figure, a 5-year period was used here because it was believed
to be sufficiently long to balance out short-term irregularities
and because the more distant the earnings, the more likely is
the possibility that they were affected by conditions no longer
relevant. For these reasons the inclusion of more distant years
in the average would make it less representative of the future.
The fact that the earnings data were usually available for a 5-
year period on a consistent basis in the listing applications
was also a factor in this choice. The ratio is computed in the
following manner.
Total Per Share 5-Year Average
Constituents in Earnings for of Earnings
Merger (18) 5 Years Per Share
American Canb $13.30 5 = $2.66
Dixie Cup 18.35 5 = 3.67
Ratio of 5-year average earnings = 3.67 2.66 = 1.38.
This ratio is interpreted to indicate that a share of Dixie
Cup common stock is 1.38 times more valuable than a pre-
merger share of American Can common stock on the basis of
the average earnings over the past five years.
Ratio of common stock market prices, X3.-The ratio of the
common stock market prices is used to indicate the market's
appraisal of the common equities' relative values when these
equities are considered as interests in independent corpora-
tions. For this purpose the prices used should be those exist-
ing just prior to the time at which news of the merger, or its
terms, first reaches the market. The date chosen to represent
this time was that on which the earliest official act was taken,
based on the information in the listing applications. Usually
this was the date on which the agreement of merger was first
approved by one or more boards of directors. While informa-
tion no doubt leaks into the market in many cases before any
official action is noted, anything prior to this date would have
to be largely speculative in nature for the merger itself re-
mains tentative until stockholder approval is obtained, in fact

Common Equity Valuation 59
until the final closing of the agreement on the effective date.
However, as noted earlier, any speculative activity in the stock
would tend to lessen the significance of the market price as a
measure of relative value. The prices used in the ratio X3 were
selected from the period prior to the date of the first official
announcement of the merger in order to free this ratio, as
much as possible, from the effect of such speculation. To check
on the possible presence of such distortion in X,, ratios be-
tween the sums of the quarterly high and low prices of the
stocks of the constituents in each merger were computed for
each of the four calendar quarters prior to the quarter used
for determining X3. For each merger the average of these four
prior ratios was then computed and these averages were then
correlated with Xs. A coefficient of correlation of .93 was ob-
tained, which would suggest that the ratio, X3, was probably
not subject to any large amount of distortion due to specula-
tive activity arising from rumors of the merger.
The price figure used in the ratio for each constituent is the
sum of the high and the low stock prices during the calendar
quarter just prior to the official date noted above. (This is the
date given in the list of mergers in Chapter I.) The following
example based on merger (18) illustrates the manner in which
this ratio was computed. The agreement date, April 30, 1957,
was the earliest date mentioned in the listing application.

Sum of High and Low Market
Constituents in Prices During the Quarter
Merger (18) Ended March 31, 1957
American Canb 83.25
Dixie Cup 109.00
The ratio of the common stock market prices = 109.00 83.25
= 1.31.
This is interpreted to mean that the market for this quarter,
based on the prices used, appraised a share of Dixie Cup com-
mon stock as being 1.31 times more valuable than a share of
American Can common stock.
Ratio of per share book values, X,.-The ratio of per share
book values shows the relative amount of assets, as indicated
by the accounting records, behind the common equities. This
ratio is of significance to this study in so far as the quantity
of assets per share affects the quantity of earnings per share.

60 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
It is therefore intended to give some rough indication of the
relative earnings-producing capacity of the assets. The appro-
priate book values for this measure are those existing just
prior to the merger, and consequently, the most recent book
value figures, on a per share basis, are used.
To the extent that goodwill and other intangibles do not
represent what might be termed "real asset values," it would
have been ideally desirable to exclude them from the book
value measure. Their exclusion would also have been desirable
because of the somewhat arbitrary manner in which this type
of asset can be handled. However, since in only four cases'2
were intangibles greater than 1 per cent of the total assets of
any of the constituent corporations, it was believed that their
inclusion would have no significant effect on the book value
relationships.
The ratio is computed in the following manner.

Constituents in Book Value
Merger (18) Per Share
American Canb $28.34
Dixie Cup 33.86
The ratio of per share book value = 33.86 28.34 = 1.19.
This ratio is interpreted to indicate that on the basis of the
earnings-producing capacity of the assets behind the common
equities and to the extent that this is indicated by book values,
a share of Dixie Cup common stock was 1.19 times more valu-
able than a share of American Can common stock.
Ratio of cash dividends per share paid in last full year, X,.
-The ratio of the cash dividends paid is used to indicate the
relationship between the annual per share cash dividends
which the stockholders are accustomed to receive and which
they might also reasonably expect to receive in the immediate
future if the corporations continued to operate as independent
enterprises. If the dividend payments do not fluctuate greatly,
the latest year's cash dividends would seem best suited for this
measurement because of their proximity to the future. The
29. These four companies and the percentage of total assets repre-
sented by intangibles in each case are:
Merger (47), Nesco, Inc., 1.2%.
Merger (6), Byron Jackson, 2.2%.
Merger (28), Lane-Wells, 2.9%.
Merger (40), National Lead, 9.4%.

Common Equity Valuation 61
dividend figures used in this ratio included extra as well as
regular cash dividends. The ratio is computed in the follow-
ing manner.

Constituents in Cash Dividends Paid
Merger (18) Per Share
American Canb $2.00
Dixie Cup 1.90
The ratio of cash dividends paid per share = 1.90 + 2.00 = .95.

This ratio is interpreted to indicate that on the basis of the
relationship existing between cash dividend payments stock-
holders would consider a share of Dixie Cup common stock to
be only .95 times as valuable as a share of American Can com-
mon stock.

Suitability of the Basic Financial Data
The above measures, and some which will be introduced in
Chapter IV, are all limited by the quality of the data to which
they are applied. The remainder of this chapter is devoted to
an examination of the source, limitations, and adjustments of
the original data.
Source.-The underlying data which form the basis for the
various numerical measures in this study were drawn largely
from the financial statements contained in the New York
Stock Exchange listing applications of the constituent cor-
porations. These statements consist primarily of the consoli-
dated balance sheet, income, and surplus statements from one
or more periods just prior to the merger, and the summary of
earnings which generally covers summarized operating re-
sults for a number of years prior to the date of merger. In
addition some supplemental information such as market prices
and book value is usually given.
In most cases the financial information from these sources
was accepted for use in this study with little change, not
necessarily because it was ideally suited to the purpose at
hand, but because the necessary information for making a
meaningful adjustment was lacking. Under these conditions
the data, as utilized for the purposes of this study, are subject
to several shortcomings which will be considered along with
those adjustments which have been made.

62 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
Limitations.-A major shortcoming in the data as originally
presented is the lack of comparability of the accounts of the
constituents of any given merger. It should be noted here that
the incomparability being considered is due to the application
of equally acceptable accounting alternatives rather than to
clerical mistakes or incorrect accounting. Because the major
emphasis in this study is on intercompany comparisons, the
significance of the results will be lessened to the extent that
the data are not on a comparable basis. The possible extent of
this incomparability is indicated by one author who mentions
the following list as "areas where differences are most likely
to be discovered":

1. Depreciation and maintenance policies.
2. Provision for uncollectible accounts.
3. Inventory-pricing policy.
4. Accounting for intangibles.
5. Valuation of investments.
6. Provisions for contingencies or losses.
7. Officers' salaries.
8. Capitalization policy-division between expense and asset
classifications.
9. Fixed asset valuations in the accounts-cost or appraisal
basis.
10. Accrual and prepayment policies.
11. Surplus entries.30
Another area where differences may arise is in the policy
regarding the consolidation of the accounts of subsidiaries and
associates. No adjustments other than those already present
in the original data have been made in any of the above-men-
tioned areas and the result of this study must be interpreted
with this limitation in mind.
A second limitation in the data is due to the lack of compara-
ability in the accounts of a given company over a series of fis-
cal periods. This limitation affects the measures involving
averages, especially the earnings averages. The nature of this
limitation may be illustrated by examining two types of
changes which may give rise to incomparability in the ac-
counts.
First, there may be changes in management policy which
result in acceptable accounting alternatives such as policy
30. Finney, pp. 567-68.

Common Equity Valuation 63
changes regarding depreciation charges, bad debt charges, or
the inclusiveness of the consolidated statements. In most cases
involving such changes the results are stated as they would
have been under the former alternative, and the differences
caused by the change are noted in the statements for the year
of the change. However, where only one figure can be used a
choice must be made, and the figure used here is the one re-
sulting from the most recently adopted alternative. Ideally in
such a case the adjustment should be applied to all the past
years included in the study, but this has not been done unless
it was originally presented in this way.
Second, there may be changes in the size of the operating
unit to be included in the consolidated statements, such as
those arising from the sale of a major operating division or
the acquisition of a subsidiary. Assuming that past earnings
can serve as a significant guide to future earnings, the past
earnings used should be on a basis consistent with the earning
power existing at the time of the merger. Thus, if a new com-
pany had been purchased in the past year, the earnings results
of this company should be combined with those of the pur-
chasing company for all the prior years covered in cases where
an average earnings figure is to be computed. Similarly, if a
division or operating subdivision which contributed signifi-
cantly to the past earnings had been sold or closed, the past
earnings attributable to this unit should not appear in any
average of past earnings. The figures used have not been so
adjusted unless they were originally presented in this form.
A third limitation relates to asset valuations. The assets, as
presented in the financial statements available, are largely
carried at depreciated cost which is not necessarily indicative
of current market or appraisal value. This detracts from the
significance of any value relationship based on asset value as
this is presented in the financial statements. A similar situa-
tion exists for companies with large mineral reserves where
not only the valuation but also the extent of the asset is in
doubt.
Adjustments and treatment of specific data.-Because the
intercompany comparisons are made here largely on a per
share basis, certain adjustments are needed. In market price,
earnings, dividends, and book value data, adjustments in the
per share figures have been made for stock splits and stock

64 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
dividends if this was not already done. Other special per share
adjustments were made in those cases where they were neces-
sary and the information was available. As an illustration of
this type of adjustment, in the Dixie Cup-American Can
merger (18), where Dixie Cup preferred stock was to be con-
verted prior to the merger, the number of Dixie Cup common
shares was increased to give effect to this conversion; earn-
ings available for the common stock were increased by the
amount of the preferred dividend; and the per share figures
were adjusted accordingly.
However, some adjustments which would have affected per
share results were not made because they hinged on uncertain
future events. Two such adjustments related to stock options
and convertible securities. Generally the terms and data on
stock options were presented in great detail and in most cases
the continuing corporation assumed the absorbed company's
plan, with certain adjustments based on the exchange ratio.
These plans constituted a means by which the amount of stock
going to one or the other of the constituents could be changed
from what it would otherwise have been and thus were a
means for affecting each company's percentage participation
and the per share figures. However, there was no way of
knowing when or to what extent these options would be exer-
cised. Adjustments to give effect to the possible future exercise
of these options were omitted. While no check was made, it
is believed that omitting these adjustments did not affect the
results significantly.
Considerations similar to those mentioned with regard to
stock options also applied in the case of outstanding converti-
ble securities which could affect the common shares outstand-
ing as of the exchange date or the percentage participation of
the constituents after the merger. Such cases include converti-
ble securities outstanding prior to the merger which would re-
main outstanding and unchanged, or convertible securities
offered in exchange for similar securities previously outstand-
ing. As in the case of stock options, the future uncertainty in
the situation made any adjustment difficult and arbitrary and
none was made.
Another area in which adjustments were not made related
to consolidated statements. Aside from the questions which
arise from consolidated statements in regard to comparability

Common Equity Valuation 65
between companies and over time, there are other questions
relating to the financial statements of any one company in any
one period. The decision of the accountant and management
was largely accepted in this matter so that the figures used
are those which appear in the consolidated statements and no
adjustments are made for the results of unconsolidated sub-
sidiaries and associates. For many companies it was stated
that the omission of these results did not affect the consoli-
dated figures significantly. However, in other cases, the uncon-
solidated results were considered to be of such significance
that the financial statements of the unconsolidated subsidiaries
were presented or the parent's equity in the assets and income
of the unconsolidated subsidiaries was presented in footnotes.
The possible influence of these unconsolidated results in some
mergers will be noted in Chapter IV, but no adjustments were
made for them in the figures used in the basic ratios.
The following treatment was accorded certain items in the
balance sheet.

1. United States Government securities have been moved to
the asset side of the balance sheet whenever they were pre-
sented as a deduction from the liability for Federal income
taxes.
2. Treasury stock presented as an asset has been treated as a
reduction of common equity.
3. No adjustment has been made for commitments noted in
the financial statements such as rental payments under
long-term leases or for possible liabilities arising from im-
pending legal action.
4. The categories of assets included in intangibles were: (a)
goodwill, (b) patents and trade-marks, and (c) intangibles.
5. Certain special assets and liabilities and their related debits
and credits in the income statement were left unchanged.
Two examples are: (a) tax liability reserves arising from
the decision to equalize the effects of accelerated amortiza-
tion, and (b) assets arising from the income tax reduction
value of a tax loss carry-over possessed by an acquired
company.
The following treatment was accorded certain income state-
ment items.

1. "Interest expense" included all items classed originally as
interest but excluded any charges or credits for amortiza-

66 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
tion of debt premium or discount where a distinction be-
tween these items was made in the income statement.
2. Net sales as originally presented sometimes included other
types of income and sometimes did not. The figure given
was the one used.
3. In so far as possible special nonrecurring charge and credit
items were excluded from the "after tax net income for
common stock" because it is the regular and recurring earn-
ing power which is of interest here.
4. Excess profits taxes, when present, were treated as regular
tax items and no adjustment was made to exclude them
from the income tax charge.

Chapter III

Value Factors in Exchange Ratio Determinations

HERETOFORE, the distinguishing char-
acteristics of the fifty mergers which form the empirical basis
for this analysis have been identified and described. The con-
cept of the exchange ratio was developed to represent the
relative values actually assigned to the constituents in these
mergers. The major bases on which the value of the common
equity may rest were examined, and five ratios were presented
for use in measuring the relative positions of the merging con-
stituents with regard to each of these value bases.
In order to investigate the role played by each of these value
bases in the formulations of the actual exchange ratios, the
following questions must be considered: Were these value
bases important factors for the merger group as a whole and,
if so, what was the relative importance of each ? The emphasis
is placed on the over-all, or general, importance of these value
bases for all the exchange ratios, rather than on their impor-
tance in any individual merger. Although this latter aspect is
touched on briefly in this chapter and is treated in some detail
in Chapter IV, it is not the primary point in the present dis-
cussion. In seeking answers to these questions about the gen-
eral significance of the value factors it has been necessary to
examine the over-all relationships between the various relative
value ratios and the exchange ratios. Simple and multiple cor-
relations were the major methods used in making this exami-
nation.
This chapter, then, consists primarily of a discussion and
evaluation of the general importance of the five valuation fac-
67

68 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
tors based on the results obtained in the correlation analysis.
The correlation procedure will be described first, and then the
results obtained from the simple and multiple correlations will
be discussed in turn. Some consideration will also be given to
the characteristics displayed by several merger subgroupings.
However, before proceeding with this discussion, it may be
well to review briefly the nature of the merger group involved
and to consider some of the general circumstances condition-
ing the correlation results.

Summary Review of Merger Group
The fifty mergers analyzed occurred during the eight years,
1950-1957, and represented situations in which the common
stockholders of the constituent companies received only com-
mon stock in the final company. These constituents were all
industrial corporations whose common stocks had been listed
on the New York Stock Exchange prior to the merger. While
this group of mergers represented a small part of the merger
activity occurring during this period in terms of the number
of companies involved, it represented a substantial part of the
activity in terms of the total assets involved.
The specification that the merger group would include only
those mergers whose constituents had common stocks listed on
the New York Stock Exchange prior to the merger gave rise
to two distinguishing characteristics for the group. The first
is that the common shares of these constituents enjoyed
greater marketability than the shares of the usual industrial
corporation taking part in a merger. This in turn meant that
in these mergers a fairly definite measure of value existed in
the form of the market prices of the shares. The second and
closely related characteristic is that the shares of the constitu-
ents were probably fairly widely dispersed in the hands of
the public which, in turn, meant that objective value factors
may have been more dominant in the negotiators' decisions
than personal (subjective) factors.

Relationship of Exchange Ratio to Relative Value Ratio
The conditions underlying the proposed analysis may best
be summarized by noting the circumstances which would be
required to achieve perfect correlation between the actual ex-
change ratios and the measures of relative value used in this

Value Factors in Exchange Ratio Determinations 69
study. The basic data being compared consist, on the one hand,
of the exchange ratios which represent the relative values
actually assigned to the constituents' equities by the nego-
tiators and, on the other hand, of the relative value ratios
computed in this study on the basis of the different types of
historical financial data. For perfect correlation between the
two sets of data, the following conditions would have had to
exist.
First, the negotiators would have had to base their decisions
solely on what have been termed "objective" valuation meas-
ures. Since the five ratios used in this study rest on historical
financial data, a discrepancy would result if the exchange
ratios reflect the influence of personal considerations or bar-
gaining strengths and skills.
Second, the negotiators would have had to adhere to the
theory that the final equity should be allocated on the basis of
the relative equity values of the constituents viewed as inde-
pendent enterprises. Since the five ratios are based on this
view, a discrepancy would result if the negotiators gave weight
to any other view on allocation, the most probable of which
would be the anticipated contribution of each constituent to
the final equity earnings and value.
Third, the negotiators would have had to consider the same
value factors covered by the five ratios, and only these, or a
discrepancy would result.
Fourth, even if the negotiators considered only the same
factors, they would still have had to measure the importance
of these factors in terms of historical relationships or else it
must be assumed that the historical relationships indicated in
the five ratios used here accurately represent the relationships
which would have been arrived at through the use of amounts
based on projections of the historical data into the future.
Fifth, even if all the conditions above were fulfilled, a dis-
crepancy would still result unless the ratios relied on by the
negotiators had been based on the same historical data pre-
sented in the listing applications and the negotiators had not
had access to more recent or extensive historical financial
data.
Because it is unlikely that any of these conditions are com-
pletely met, no near-perfect correlations were anticipated.
However, if the negotiators' actual views approached those

70 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
assumed in this study and if the reasoning contained in the
discussion of the value factors and measurements is sound,
the analysis should indicate the importance of the value fac-
tors being examined.

Correlation Procedure
The fifty mergers under consideration were treated as three
groups in the correlation analysis. Group A included all fifty
mergers; Group B included the first forty-five mergers and
excluded those in which a constituent's deficit earnings or lack
of cash dividends did not permit the construction of a mean-
ingful relative value ratio; and Group C included the first
thirty-three mergers and excluded those mergers in Group B
in which some element of intercompany control was present.
The exchange ratios, Y, for the mergers in each of these
groups were correlated with the five relative value ratios (See
Appendix B, Table B-l) :

X1, the ratio of the earnings per share in the last full year
prior to the merger.
X,, the ratio of the average of earnings per share for the five
years prior to the merger.
X3, the ratio of the common stock market prices for the quar-
ter just prior to the time of the initial official action.
X4, the ratio of per share book values just prior to the merger.
X5, the ratio of cash dividends per share paid during the last
full year prior to the merger.
The analysis included the simple correlation of each series
of relative value ratios with the exchange ratios; the simple
correlation of the relative value ratios with each other; and
the multiple correlation of Y and all five relative value ratios.
Before turning to the discussion of each of these correla-
tions three points applicable to the entire analysis should be
noted. First, in interpreting the results of the correlations,
any question concerning the direction of cause and effect may
be answered in a clear-cut manner since the data included in
the five ratios came before those included in the exchange
ratios in time sequence. While the presence of this time se-
quence does not mean that a cause and effect relationship can
be automatically assumed, it does rule out any implication that
the relative value ratios were caused by the exchange ratios

Value Factors in Exchange Ratio Determinations 71
and lends support to the basic assumption in this study that
the exchange ratios reflect the influence of the value bases
represented in the five relative value ratios. Second, since the
items in the series to be correlated, namely, the exchange
ratios and the relative value ratios, represent a cross section
drawn from a specified period of time, the analysis is not sub-
ject to the qualifications involved in the correlation of vari-
ables in time series.1 Third, the variables are assumed to be
associated in a linear relationship. Such an assumption seems
logical in view of the fact that relative values in ratio form
are the items being correlated and there would be little reason
to expect that for a given value base ratios of different magni-
tudes would receive proportionally greater or lesser weight in
exchange ratio formulations simply because of this difference.
This point may be clarified by an illustration. Assume that
in merger A the ratio of earnings per share for the last full
year is 2.00. This means that the exchange ratio, if based on
this value base alone, will also be 2.00, with 2 shares in the
final company being exchanged for 1 share in the "other" com-
pany and 1 share in the final company being exchanged for 1
share in the base company. Assume further that in merger B
the ratio of earnings per share for the last full year is 3.00.
The exchange ratio would, in so far as determined by this
value base, be 3.00, with 3 shares of the final company being
exchanged for 1 share of the "other" company and 1 share of
the final company being exchanged for 1 share of the base
company. If the variables were associated in a nonlinear re-
lationship, the anticipated exchange ratio for merger B would
be either greater or less than 3.00, depending upon whether
the "other" company's relatively greater earnings per share
were assigned a premium or were discounted.

FINDINGS FROM SIMPLE CORRELATIONS
Nature of Relationships Examined
In this section, the extent to which the actual exchange
ratios were related, in the aggregate, to the constituent com-
panies' relative positions as measured by each of the five value
ratios is examined, and attention is centered on the influence
on the exchange ratio of each factor as if it were the only fac-
1. Mordecai Ezekiel, Methods of Correlation Analysis, p. 350.

72 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
tor determining this ratio. This contrasts with the next sec-
tion, in which a given combination of these factors is taken
and examined with respect to the influence of each factor as
an element in this combination and with respect to the influ-
ence of the total combination. This means that no allowance
is initially made for the relationships which may exist among
the value factors themselves, such as the relative market
values being influenced by relative earnings per share. How-
ever, such relationships are considered in the latter part of
this section.
The present analysis rests on the simple correlations of each
series of relative value ratios with the exchange ratios. Two
closely related sets of statistical measures developed in these
correlations are used in evaluating the influence of the value
factors. The first set consists of the coefficient of correlation,
r, and the coefficient of determination, r2. The coefficient of
correlation, r, measures the degree of correlation or associa-
tion which exists between the exchange ratio, Y, and a given
relative value ratio, X. In these correlations it is assumed that
Y is the dependent variable and that the various X's are the
independent variables. The coefficient represents the variation
(standard deviation) in the estimated exchange ratio, Y', ex-
pressed as a proportion of the variation2 in the actual ex-
change ratio, Y.
The coefficient of correlation may vary between 1 and -1
but in this analysis the relevant range is from 0 to 1. A coeffi-
cient of 0 would indicate the absence of any correlation and
would suggest that the value base under consideration played
no part in the exchange ratio determinations. A coefficient of
1 would denote perfect correlation and would suggest that the
value factor under consideration played a substantial, if not
the sole role, in the exchange ratio determinations. The coeffi-
cient of determination, r2, is a measure of association similar
to r. However, in situations where a cause and effect relation-
ship is considered to exist, r2 may be used to express the per-
centage of variance (standard deviation squared) in the
2. Throughout this study it is necessary to distinguish between the
actual exchange ratios, Y, derived from the merger terms and the ex-
change ratios derived from the linear regression equations used in this
study. For this purpose the latter ratio is referred to here as the esti-
mated exchange ratio, Y'. For examples of similar treatments see Ezekiel,
pp. 128-29, and Kermit O. Hanson, Managerial Statistics, p. 164.

Value Factors in Exchange Ratio Determinations 73
dependent variable, Y, which is explained by the variance in
the independent variable, X. In this way it suggests the extent
of the influence of a given factor.3
The second set of statistical measures relates to the regres-
sion of Y on X as expressed in the linear regression equation
Y'= a + bX. This equation presents the relationship on which
the estimated exchange ratio, Y', rests. The estimated ex-
change ratios, themselves, represent the exchange ratios which
would have resulted if the terms for each merger had been
exactly equal to the average relationship between Y and a
given relative value ratio, X. (See Appendix B, Table B-2.)
The regression coefficient, b, in the above equation represents
the average change in the estimated exchange ratio, Y', asso-
ciated with a unit change in the particular relative value ratio
under examination. The general conformity of Y to Y' is indi-
cated by the standard error of the estimate, s, which is the
standard deviation of the residuals found by comparing Y'
with the actual Y, and therefore measures the degree of "scat-
ter" about the regression line.
The above statistical measures as developed for the three
merger groupings are presented in Table 4. The relevant rela-
tionships may also be seen in Figures 1 through 5. In Figure 1,
the relationship between the actual merger terms, Y, and the
ratio of earnings per common share for the most recent year
prior to the merger is depicted. Each merger is represented by
a dot, numbered to correspond with the number assigned the
merger in Chapter I, and positioned in accordance with the
variation in this particular merger of the actual exchange
ratio from the relative value ratio being considered. Further-
more, the regression line as determined by the linear regres-
sion equation for each group of mergers is plotted. Figures 2
through 5 present in similar fashion the relationships between
the actual exchange ratios and each of the other four relative
value ratios.
Correlation of Exchange Ratio, Y, and Market Price Ratio, X,
The most evident feature in Figures 1 through 5 and in
Table 4 is the extremely high degree of association between
the actual exchange ratio, Y, and the common stock market
price ratio, Xs. Since this association is so striking it will be
3. Ezekiel, pp. 137-39.

74 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS

discussed first. It should be kept in mind that if the actual ex-
change ratios were exactly equal to the common stock market
price ratios, the dots representing the mergers would fall on
the 45 degree, or Y = X, line. The strong tendency for this
relationship to exist is shown by all of the statistical measures

TABLE 4
SIMPLE CORRELATION OF THE EXCHANGE RATIO, Y, WITH THE FIVE
RELATIVE VALUE RATIOS, X, IN THREE MERGER GROUPS

Linear Regression
Relative Value Equation
Ratios r r2 s b Y' a + bX
Groun A *

pk- I v uJ .XJl
(50 mergers)
X,
X2
X3
X4
X5
Group B
(45 mergers)
Xi
X,
X3
X4
X5
Group C
(33 mergers)
Xi
X2
X3
X4
X5

t
t
.95
.63
t

.65
.66
.95
.64
.77

.83
.87
.92
.77
.85

t
t
.90
.40
t

.42
.43
.91
.41
.59

.69
.76
.85
.59
.71

t
t
.18
.44
t

.43
.42
.17
.43
.36

.22
.19
.15
.25
.21

t
t
1.00
.55
t

.56
.39
1.02
.58
.72

.56
.62
1.18
.56
.66

t
t
Y' .08 + 1.00X
Y .47 + .55X
t

Y'
Y'
Y'
Y'
Y'

.49 + .56X
.59 .39X
.09 + 1.02X
.45 t .58X
.32 .72X

.38 + .56X
.27 + .62X
-.04 + 1.18X
.36+ .56X
.28 + .56X

*Group A consists of fifty mergers but fifty-one exchange ratios be-
cause merger (50) involved three companies.
tThe relative value ratios X1, X,, and X5 were not correlated with Y
in Group A because deficit earnings or lack of dividends for companies
involved in some of these mergers did not allow the construction of
meaningful ratios.

derived. It is perhaps most extreme when all of the mergers-
Group A-are considered. The equation for the regression line
for Group A is Y' = .08 + 1.00X. The line, therefore, is par-
allel to the 45 degree line and lies only slightly above it. It
therefore crosses the axis almost at the origin. The coefficient
of correlation is an exceptionally high .95 while the small de-

Value Factors in Exchange Ratio Determinations 75

gree of scatter is indicated by the relatively low value for s,
namely .18. In terms of the coefficient of determination, r2, the
ratio Xs may be considered to offer an explanation for 90 per
cent of the variance in Y for Group A. The overriding impor-
tance of this measure of relative value is further developed in
the discussion of the findings from the multiple correlations.
When the results of the analysis of Groups B and C are ex-
amined, the effect of the X3 ratio on the exchange ratio is
almost, but not quite, as striking. The statistical measures for
these two groups, as presented in Table 4, show regression
lines almost parallel to the Y = X line and again only very
slightly removed from it. High coefficients of correlation and

300 /

MERGERS Y 49
i / .

1.00 .

REGRESSION LINE FOR GROUP C,
g45 MERGERS: Y' = .49 + .56X
162~ -------REGRESSION LINE FOR GROUP C,
33 MERGERS: Y' = .38 + 56X

.00 1.00 2.00 o00 4.00 5.00
LAST FULL YEAR'S PER SHARE EARNINGS RATIO (XI)

Figure 1.-Relation between the actual exchange ratio (Y) and the last
full year's per share earnings ratio (X1) for mergers in groups B and C.

determination and somewhat lower values for s than for
Group A are found. Thus, regardless of which group is being
considered, an exceptionally high relationship between the
actual exchange ratio and the market price ratio has been
revealed.
At least two interpretations may be given to this importance
of the market price ratio. The market price of the common
stock may be considered to be an independent valuation mea-
sure with major influence as such. On the other hand, X3 may
represent an approximation of the ratio which would have

76 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS

existed if comprehensive future earnings estimates, adjusted
for risk, had been used. The negotiators in any merger may
have actually derived a risk-adjusted ratio of future estimated
earnings from extensive and detailed data, independent of
market price valuations, but because of the similarity of the
relevant data, such a ratio might closely approximate one
reached on the basis of market prices. If this latter situation
had been the case, the correlation between Y and X, would
require a different interpretation than that indicated on the
surface. The proposition that Xs is an independent valuation
measure would seem to be the more likely of these two alterna-

3.0045 MERGERS 9

. .REGRESSION LINE FOR GROUP C,
3G MERGERS Y .2 7 + -62X2

00 I. 2.00 3.00 400 500
5-YEAR AVERAGE PER SHARE EARNINGS RATIO (X2)
Figure 2.-Relation between the actual exchange ratio (Y) and the
5-year average per share earnings ratio (X,) for mergers in groups B
and C.
tives in view of the closeness of the association indicated
above, and of the importance attributed to market prices in
the statements of management summarized in Table 3.
In addition to the general importance of X,, one other inter-
esting feature related to the market price is revealed by the
material in Figure 3 and Table 4. In Figure 3 there is a tend-
ency for the dots to fall above the 45 degree line and the re-
gression lines also lie slightly above this line. These dots are
plotted for pairs of ratios representing relationships between

the base and "other" companies, but in all but three mergers
(3), (9), and (48), the base company was also the larger com-
pany in terms of total assets. If the ratios in these three

Value Factors in Exchange Ratio Determinations 77

mergers are put on a comparable basis with the others in
terms of asset relationships, only twelve, or approximately 24
per cent, of the fifty-one dots in Figure 3 would fall below the
45 degree line. As noted above, a relationship of one to one
between the exchange ratio, Y, and the market price ratio, X3,
in any given merger would be represented in Figure 3 by a
dot falling on the 45 degree line. Dots above this line represent
situations in which Y was greater than X:, indicating a merger
in which the terms were more favorable to the "other" com-
pany than they would have been if they had been exactly
equivalent to the market price ratio. Dots below the 45 degree

3.00 /

S .oo ERERS: .08 OOX

REGRESSION LINE FOR GROUP A,
b1.00- 45 MERGERS: .08 + 1.02X
_. REGRESSION LINE FOR GROUP B,
S45 MERGERS : V .09 + 1.02X3
1 ----- -REGRESSION UNE FOR GROUP C,
0( 33 MERGERS: 0Y -.04 + II8X3

00 o i.00 .o00 3.00 4.00 6.o
COMMON STOCK MARKET PRICE RATIO (X3)

Figure 3.-Relation between the actual exchange ratio (Y) and the
common stock market price ratio (X,) for mergers in groups A, B, and
C.

line represent mergers in which the terms, when judged by
market price ratios alone, were more favorable to the base
companies. The concentration of the dots above the 45 degree
line in Figure 3 suggests that in the mergers analyzed here
the smaller constituent, in terms of total assets, received the
more favorable treatment in the merger terms, in so far as
relative market prices are concerned, and this concentration
also provides evidence in support of such statements as the
following: "If the holders of outstanding stock of a smaller
company are to be induced to accept an exchange into stock of
a larger company, obviously some consideration must be of-

78 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS

fered. This usually takes the form of a premium in market
price of the new offering as compared to that of the old hold-
ing."4
One additional feature tentatively suggested by the correla-
tions is that market price may have been a more important
factor, in general, for the additional mergers included in
Groups B and A than it was for the thirty-three mergers in

3,00

0 2- .

P
13 REGRESSION LINE FOR GROUP A,
100 50 MERGERS: Y' 47 + .55X4
REGRESSION LINE FOR GROUP B,
d.ca 06 45 MERGERS: Y' A .5+8X4
S___----- REGRESSION LINE FOR GROUP C,
33 MERGERS: Y' .36 + 56X4

.00 . . I
.00 .o 2.00 3o00 4.00 500
BOOK VALUE PER SHARE RATIO (X4)
Figure 4.-Relation between the actual exchange ratio (Y) and the
book value per share ratio (X4) for mergers in groups A, B, and C.

Group C. The coefficient of correlation, r, for Xs, increased
from .92 for Group C to .95 for Groups B and A, while the
coefficients of correlation for the other four relative value
ratios decreased from Group C to Group B with r, for X4 also
being lower in Group A than Group C. This type of relation-
ship would be in accord with the assumption that in the twelve
additional mergers in Group B, in which there was a possibil-
ity of intercompany control prior to the merger, an exchange
ratio closely associated with the market price ratio might be
of particular advantage. The air of impartiality which such an
association would give to the exchange ratio might prove help-
ful in forestalling or answering any objection based on the
question of prior control.

4. James B. Walker, Jr., "Financing the Acquisition," Legal, Finan-
cial, and Tax Aspects of Mergers and Acquisitions, Financial Manage-
ment series: No. 114, p. 29.

Value Factors in Exchange Ratio Determinations 79

For example, in merger (45) any criticism of this sort
which might have arisen because of Grace and Company's
ownership of 63 per cent of Davison Chemical Corporation's
common stock prior to the merger might have been answered
by pointing out that the exchange ratio of 1.40 was very close
to the market price ratio of 1.37. The market price ratio may
also have carried extra weight in the five additional mergers
included in Group A because of the difficulty in appraising
past earnings relationships when deficits have been present to
any great extent. Merger (48) provides an example of this
type of situation. Both Park Utah Consolidated Mines and
Silver King Coalition Mines had experienced either deficits or
negligible earnings in the five years prior to the merger and
neither company was carrying on active mining operations at
the time of the merger. The exchange ratio and the market
price ratio were 1.14 and 1.22, respectively. The closeness of
these two ratios provides evidence of the strong influence of
comparative market prices in determining the relative value.

3.00 -

.oo .. .- .
Cr--

1.00 3
7 -- REGRESSION LINE FOR GROUP B,
17 3 7 ,2 145 MERGERS : Y' .2 + .72X5
------ REGRESSION LINE FOR GROUP C,
33 MERGERS : Y' .28 + .66XR

.o00 100 2.00 3.00 4.00 5.00
LAST FULL YEAR'S PER SHARE CASH DIVIDEND RATIO (Xg)
Figure 5.-Relation between the actual exchange ratio (Y) and the
last full year's per share cash dividend ratio (X5) for mergers in groups
B and C.

Correlation of Exchange Ratio with Relative Value Ratios
Reference to Figures 1, 2, 4, and 5, and Table 4 indicates
that the relative value ratios X,, X,, X4, and X5 each exhibited
considerable positive correlation with Y although none of them

80 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
attained the same level of importance that was indicated for
X3. The only ratio, other than X3, analyzed for all of the
mergers, Group A, was the ratio measuring relative book
values, X4. Not surprisingly, the degree of correlation between
this ratio and the exchange ratio is much lower than between
the market price ratio and the exchange ratio. This is true for
all groups of mergers, and in Groups B and C, the coefficient
of correlation is lower between Y and X, than between Y and
any of the other value bases. The lack of significance of this
ratio is also seen by the substantial divergence of the slope of
the regression line from the Y = X line and by the wide dis-
persion of the dots about the regression line.
Of the other three ratios analyzed for Groups B and C, the
ratio of cash dividends for the year just prior to the merger,
Xs, exhibits the greatest degree of correlation with the ex-
change ratio. The coefficients of correlation are .77 for Group
B and a surprisingly high .85 for Group C. The standard error
of the estimate, s, is also relatively low for X,. With the excep-
tion of s for X3, only s for X. when measured for Group C is
lower than s for X,. This indicates a relatively low degree of
dispersion about the regression line for the X, ratios. It would
appear, therefore, that the merger terms fit more closely with
the ratio of cash dividends than with any of the value bases
used in this study, with the obvious exception of the relative
common stock market price ratio.
The earnings ratios, X, for the most recent year and X. for
the average of the past five years, have coefficients of correla-
tion with Y for Group C of .83 and .87, respectively, and .65
and .66 for Group B. When the regression lines are inspected,
however, it is found that they diverge in all cases very sub-
stantially from the Y = X line and that the dots, when plot-
ted, show a high degree of scatter. This is surprising in that
it indicates a much lower influence on merger terms of the re-
lative earnings of the constituent corporations than would be
anticipated in the light of generally accepted value theory.
In contrast to Figure 3, the other four figures reveal no pro-
nounced tendency for the dots to fall either above or below the
45 degree line. This suggests the absence of a general tendency
for either the base or the "other" company to receive more
favorable treatment in terms of these four particular meas-
ures.

Value Factors in Exchange Ratio Determinations 81
Correlations Between Relative Value Ratios
One circumstance conditioning the association between Y
and a given relative value ratio, X, is the association which
may exist between the relative value ratios themselves. As a
measure of the degree of association between the relative
value ratios, coefficients of correlation were derived for vari-
ous pairs of X's for Groups B and C. These coefficients are pre-
sented in Table 5. Coefficients for the relationships between
Y and X in these two groups are also presented in this table
for the purpose of comparison. Relationships for Group A
were not considered because no ratios for X1, X_, and X, were
computed for the five additional mergers included in this
group.
The fact that all of the paired ratios in Table 5 exhibit sub-
stantial positive correlation becomes significant in correlation
analysis which ascribes ". . to any particular independent
variable not only the variation in the dependent variable which
is directly due to that independent variable but also the varia-
tion which is due to such other independent variables corre-
lated with it as have not been separately considered in the
study."'
This characteristic of correlation results is of particular in-
terest in several instances. First, the coefficient of correlation
between X3 and each of the other relative value ratios may be
considered.
Group C Group B
X3, X, .75 .62
X3, X, .71 .54
X3, X, .62 .52
X3, X, .75 .72
In each case, r is lower in Group B than in Group C. This
situation, coupled with the fact that X3 is more closely corre-
lated with Y in Group B than in Group C, may offer one pos-
sible explanation for the lower correlation coefficients for Y
and the other four relative value ratios in Group B than in
Group C. To the extent that this explanation is appropriate, it
adds support to the position that market price is an important
independent value factor. On the other hand, this explanation
for the differences in coefficients of correlation between Groups
5. Ezekiel, p. 202.

82 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS

B and C weakens the basis for assuming that market price
was more influential in Group B than Group C. The greater
correlation shown between Y and the other four relative value
ratios in Group C may have been due simply to their closer
correlation with X, in this group.
The coefficients in Table 5 may offer some insight as to why
the correlations between Y and the two earnings ratios were
not greater. First, the coefficient for the correlation between
X, and X, is not particularly high, especially in Group B. This

TABLE 5
COEFFICIENTS OF CORRELATION FOR PAIRS OF RELATIVE VALUE RATIOS
AND BETWEEN Y AND X FOR MERGER GROUPS B AND C
RANKED IN THE ORDER OF r FOR GROUP C

Ratios r
Correlated Group C Group B
Y, X3 .92 .95
X2, X5 .91 .56
Y, X2 .87 .66
Y, X5 .85 .77
Y, X1 .83 .65
X1, X2 .83 .61
X4, X5 .80 .69
X1, X5 .80 .79
Y, X4 .77 .64
X2, X4 .76 .64
X1, X3 .75 .62
X3, X5 .75 .72
X1, X4 .73 .60
X2, X3 .71 .54
X3, X4 .62 .52

points out the difficulty of selecting a representative earnings
ratio even when the problem of risk adjustment is excluded.
Second, to the extent that X3 is the dominant factor reflected
in Y, the relatively low correlation between X3 and the earn-
ings ratios X, and X, would explain their lower correlations
with Y. As between the two earnings ratios, the fact that Xs
showed a higher correlation with X, than X, might be ex-
pected because of the contemporary nature of X, and X1. How-
ever, when this situation is coupled with the fact that Y
showed a higher correlation with X, than with X,, its suggests
that X, may have received more individual attention in the
exchange ratio determinations than did X,.

Value Factors in Exchange Ratio Determinations 83
In the following section, in which the results of the multiple
correlations are discussed, the indefiniteness occasioned by the
correlation between value ratios is lessened, and the relative
importance of these ratios is shown more clearly.

FINDINGS FROM MULTIPLE CORRELATIONS

Measures for Examined Relationships
The purpose of the multiple correlation was to obtain an in-
dication of the combined influence of the valuation factors and
to obtain a more definite idea as to the relative importance of
each of these factors. The statistical measures developed in
this analysis are similar to those derived in the simple correla-
tions. The degree of association between Y and all five relative
value ratios is indicated by R, the coefficient of multiple cor-
relation, and by R2, the coefficient of multiple determination.
These two measures suggest the combined influence of all five
relative value ratios.
The linear relationship existing between Y and the five re-
lative value ratios may be expressed in a multiple linear re-
gression equation. Since ratios for X,, X,, and X, were not
computed for the five additional mergers included in Group A,
equations were derived only for Groups B and C. These equa-
tions are:
* Y' = .01 .07X1 + .08X, + .85X3 + .11X, + .08X.
c Y' = -.05 .01X, + .34X, + .79X3 + .12X, .13X5

Just as in the simple correlations, the standard error of the
estimate, S, provides a measure of the conformity between the
actual exchange ratios, Y, and their associated estimated ex-
change ratios, Y', computed from the above equations. (See
Appendix B, Table B-3.)
The relative importance of each factor, as an element in the
total combination of factors, is indicated by P, the coefficient
of partial correlation, and by B, the net regression coefficient.
These two coefficients show relationships between a given X
factor and Y after allowance has been made for any variation
in Y which is attributable to the other four X factors. "The
coefficient of partial correlation may be defined as a measure
of the extent to which that part of the variation in the de-

84 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS

pendent variable which was not explained by the other inde-
pendent factors can be explained by the addition of the new
factor.""
Similarly, the net regression coefficient, B, indicates the
average change in Y associated with a unit change in the given
X factor after all the variation in Y associated with the other
relative value ratios has been eliminated. To put these B's on a
more comparable basis for the purpose of judging the relative

TABLE 6
MULTIPLE CORRELATION OF THE EXCHANGE RATIO, Y, WITH THE FIVE
RELATIVE VALUE RATIOS, X, IN TWO MERGER GROUPS

Statistical
Measures for Ratios to Which Related
Two Groups X1 X2 X3 X4 Xn All Five X's
Group C:
(33 mergers)
R ... ... ... .. ... .976
R2- .. . .. .. .. ... .95
S .. .. . .... .... .09
P -.04 .63 .87 .42 -.27....
B -.01 .34 .79 .12 -.13....
B' -.02 .47 .62 .17 -.16....
Group B:
(45 mergers)
R .... .... .... .... .... .975
R2 ... .. ... . .. .... .95
S . .. .. .. .. .... .13
P -.20 .41 .92 .34 .19....
B -.07 .08 .85 .11 .08....
B' -.08 .14 .80 .12 .09...

importance of the factors, each regression coefficient may be
multiplied by the quotient produced by dividing that factor's
standard deviation by the standard deviation of Y. The result-
ant amounts are termed the "Beta" coefficients which are des-
ignated here as B'.7 These various statistical measures de-
rived for Groups B and C are presented in Table 6.

Interpretation of Results
The relatively high values for R and R2 in Table 6 suggest
that the relationships contained in the five relative value ratios

6. Ezekiel, p. 214.
7. Ezekiel, p. 217.

Value Factors in Exchange Ratio Determinations 85
offer a substantial explanation for the exchange ratios, Y. In
terms of R2, 95 per cent of the variance in Y is explained by
these five ratios for Groups B and C. In Table 7, the coeffi-
cients of correlation r between Y and Xs are compared with
the coefficients of multiple correlation between Y and all five
measures of relative value for both Groups B and C. The ap-
propriate standard errors of the estimate are also given.
The data in Tables 6 and 7 suggest that while X:, is clearly
the dominant factor, the inclusion of X,, X_, X4, and X, does

TABLE 7
COMPARISONS OF THE COEFFICIENTS OF CORRELATION AND OF THE
STANDARD ERRORS OF THE ESTIMATE OBTAINED IN THE
SIMPLE AND MULTIPLE CORRELATIONS

Coefficient of Standard Error
Ratios Correlated Correlation of the Estimate
with Y Group B Group C Group B Group C
X3 (simple correlation) .95 .92 .17 .15
All five X's (multiple
correlation) .98 .98 .13 .09

increase the degree of correlation. Therefore, these additional
factors presumably account for part of the variation in Y not
produced by X3 alone. This increased correlation is also appar-
ent in the lower values for S derived from the multiple corre-
lation. These relatively low values for S indicate that on the
average there was little deviation between the actual exchange
ratios, Y, and the estimated exchange ratios, Y'. This in turn
suggests that the relationship between Y' and X expressed
in the multiple linear regression equations is fairly represen-
tative of the actual relationship between Y and X.
The additional light which the multiple correlations throw
on the relative importance of each relative value ratio will
now be considered. Reference to the measures of P and B' in
Table 6 again discloses the dominant role played by X:. Since
these statistical measures indicate the importance of X3 after
variation in Y associated with the other ratios has been al-
lowed for, the importance of market price as an independent
measure of value is strongly indicated. In particular, X3 takes
account of a considerable amount of variation in Y which is
not accounted for by the earnings ratios X, and X,. This in

86 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
turn suggests that unless the earnings positions of the con-
stituents are reflected in market prices, the earnings are not
as influential as theory would imply, a point also brought out
by the results of the simple correlations. This point may be
illustrated by reference to mergers (19), (20), and (40)." The
exchange ratios and relative value ratios for these three merg-
ers are presented in Table 8.
It may be noted in Table 8 that the exchange ratios in each
of these mergers were less than X,, X,, X4, and X,, but greater
than X3 and were usually closer to X3 than to any of the other

TABLE 8
EXCHANGE RATIOS,Y, AND RELATIVE VALUE RATIOS, X, FOR
MERGERS (19), (20), AND (40)

Merger
No. Y Xi X2 X3 X4 X5
19 1.50 2.45 2.64 1.13 2.35 2.41
20 .75 1.25 1.19 .43 1.23 1.06
40 1.15 2.38 3.79 1.02 2.86 1.76

ratios. In order to consider the relationships in these mergers
more closely, pertinent financial data are presented in Table 9.
The data contained in Tables 8 and 9 suggest that the
"other" companies in each case were undervalued in the terms
of merger except on the basis of market price. From the stand-
point of profitability as measured by the after-tax earnings
on assets and common equity, the "other" companies' results
in the most recent year prior to the merger were slightly
better than those of the base companies, with two exceptions.
In merger (20) the "other" company exhibited the lower rate
of earnings on total assets, and in merger (40) the "other"
company exhibited the lower rate of earnings on common
equity. The leverage present in the companies in these three
mergers would not seem sufficient to detract from the profit-
ability relationships to any extent. In mergers (19) and (40)
a slight downward trend in the earnings of the "other" com-
panies may have been present in contrast to a possible upward
trend in the earnings of the base companies, but these trends
8. The constituents in these mergers were:
(19) Monsanto Chemical Co., and Lion Oil Co.
(20) Dow Chemical Co., and Dobeckmun Co.
(40) National Lead Co.b and Doehler-Jarvis Corp.

Value Factors in Exchange Ratio Determinations 87

would require considerable projection before an earnings ratio
comparable to the exchange ratio would result. A comparison
of capitalized anticipated future earnings might have yielded
earnings ratios more in line with the exchange ratios, espe-
cially in mergers (19) and (20) where the base companies, Mon-
santo Chemical and Dow Chemical, were no doubt considered
attractive growth situations. However, it would still appear
that market price was influential as an independent value in-

TABLE 9
SELECTED FINANCIAL DATA FOR THE CONSTITUENTS IN
MERGERS (19), (20), AND (40)

Merger (19) Merger (20) Merger (40)
Type of Data Base Other Base Other Base Other
(dollars)
Per share earnings for
5 years prior to merger:
Earliest 1.79 5.98 1.48 1.07 1.09 7.42
1.55 4.37 1.36 1.98 1.21 7.96
1.43 3.30 1.59 2.27 1.29 3.96
1.63 3.46 2.47 2.78 2.41 6.29
Most recent 1.46 3.58 2.15 2.69 2.05 4.88
(In percentage)
Rate earned on total
assets after taxes:
most recent year
prior to merger 6.7 7.9 8.0 7.3 10.4 11.7
Rate earned on common
equity after taxes:
most recent year
prior to merger 9.9 11.0 12.4 13.0 17.3 14.6
Common equity as per-
centage of total assets
at time of merger 57 68 58 44 55 80

dictator rather than as an approximation of the relative value
ratio which might have been reached by the negotiators on the
basis of capitalized anticipated earnings or any of the factors
covered in the other X ratios above.
The higher values of P and B' for X3 in Group B as com-
pared to Group C, together with the lower values of P and B1
for X, and X. in Group B as compared to Group C, tend to
support the previously mentioned proposition that market
price was a more influential measure of value for the twelve

88 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
additional mergers included in Group B than for those in
Group C. To the extent that the supposition concerning X3 is
sound, it may be concluded that the possible reaction of stock-
holders to the merger terms received greater attention in the
twelve additional mergers included in Group B than it did in
the thirty-three mergers included in Group C.
The values of P and B' in Table 6 for the two earnings
ratios X, and X, suggest that while X, was of considerable im-
portance, particularly in Group C, X, had little independent
influence in the exchange ratio formulations. The negative
coefficients for Xi, as well as those for X, in Group C, would
not seem logical and might best be interpreted as indicating
the unimportance of the independent contribution of these fac-
tors. In other words, the most recent year's earnings may be
considered influential since they are one of the determinants
of market price but aside from this they have little independ-
ent influence. In contrast, X, appears to have had an inde-
pendent influence on the exchange ratio, especially in Group
C, apart from any association it may have with X:. It was
originally anticipated that X1 would be an important value
factor because of its proximity to the future. However, the
statistical analysis developed here suggests that average earn-
ings were considered as the better measure of the fundamental
earning power of the constituent companies.
The values of P and B' in Table 6 for X4, the book value
ratio, while lower than those for either X, or X,, still indicate
an importance greater than might have been expected from
the discussion in Chapter II and suggest that book values had
an independent influence in the exchange ratio determinations.
This importance of book value may have been due to its "sub-
jective or psychological importance,"9 or to its use as a meas-
ure of earning producing capacity. The importance of book
value suggested here may also indicate that in these negotia-
tions pertaining to large corporations with widely dispersed
share ownership there was considerable reliance on a philoso-
phy or basis of value commonly present in the valuation of
closely-held smaller corporations.1' In the type of corporation
analyzed in this study the individual stockholders have neither
control over nor access to the assets represented by the book
9. Howard and Upton, p. 509.
10. Smith, pp. 189-90, and Graham and Dodd, pp. 477-78.

Value Factors in Exchange Ratio Determinations 89
value of their stock, and the worth of their investment may
best be measured by reference to market prices, dividends, or
earnings. In contrast, the stockholders, in closely-held corpora-
tions may view the corporate assets as their own personal
property and may believe that, in the absence of an active
market for their stock, book value best measures the worth of
their investment.
Among the fifty mergers analyzed in this study were seven
in which the characteristic viewpoint for closely-held corpora-
tions was most likely to be present. These mergers are distin-
guished because in each case a considerable block of common
stock of one or both constituents was controlled by one per-
son, a small group of persons, or a company not involved
in the merger. Although it is possible that similar holdings
may have existed in some of the other mergers included in this
study, these are the only ones in which concentrated holdings
of this size were noted in the listing applications. The block
holdings in these mergers were as follows:

1. In merger (7), 67 per cent of the common stock of Block-
son Chemical Company (the "other" company) was held by
three persons.
2. In merger (32), 46.2 per cent of the common stock of War-
ren Petroleum Corporation (the "other" company) was
held by three persons.
3. In merger (10), 40 per cent of the common stock of Visk-
ing Corporation (the "other" company) was held by a trust
and one person.
4. In merger (14), 17.5 per cent of the common stock of Hinde
and Dauch Paper Company (the "other" company) was
held by one person and 33 per cent of the common stock of
West Virginia Pulp and Paper Company (the base com-
pany) was held by 100 members of one family.
5. In merger (15), 30 per cent of the common stock of Saint
Regis Paper Company (the base company) was held by its
officers and directors.
6. In merger (48), 22.8 per cent of the common stock of Park
Utah Consolidated Mines Company (the base company) was
held by Anaconda Copper Mining Company and 25 per cent
of the common stock of Silver King Coalition Mines Com-
pany (the "other" company) was held by American Smelt-
ing and Refining Company.
7. In merger (31), 21.7 per cent of the common stock of Bald-

90 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
win Locomotive Works (the base company) was held by
Westinghouse Electric Corporation.
In these seven mergers the companies which were distin-
guished by the presence of block holdings of their common
stocks may have emphasized the book value relationship in the
merger negotiations if this was to their advantage. This in
turn would mean that a close relationship between Y and X,
could be expected in these mergers. The relationship between
the exchange ratio, Y, and the book value ratio, X,, in these
seven mergers is presented in Table 10.

TABLE 10
COMPARISON OF EXCHANGE RATIO, Y, AND BOOK VALUE RATIO, X4, IN
SEVEN MERGERS IN WHICH A SUBSTANTIAL BLOCK OF COMMON
STOCK WAS HELD IN ONE OR A FEW HANDS

Merger (X4 Y)/Y 100
No. Y X4 (per cent)
7 .75 .75 0
10 .40 .44 10
14 1.33 1.15 -14
15 1.00 1.32 32
31 1.00 .63 -37
32 .80 .78 2
48 1.14 2.52 121

The fact that the percentage differences between X, and Y
were relatively small in mergers (7), (32), (10), and (14),
which were the mergers in which the larger block holding per-
centages were present, suggests that in these cases special
emphasis may have been placed on relative book values. It
should be noted that in mergers (7), (10), and (32) the block
holdings related to the stock of the smaller constituent alone,
and in all of these mergers the differences between Y and X,,
are small.
The relative importance of the remaining ratio, X,, the ratio
of the last full year's share cash dividends, will now be con-
sidered. As in the case of X,, X, may be considered to influence
the exchange ratio determinations in the sense that it is a de-
terminant of the market price ratio, but it appears to have
had little independent influence apart from its effect on market
prices. This conclusion appears to be in conflict with the sig-
nificance of dividends developed in the simple correlations be-

Value Factors in Exchange Ratio Determinations 91
tween Y and X,. However, in so far as there is a relatively
high correlation between X3 and Xs, the simple correlation
would produce a high coefficient between Y and X5, despite the
low significance of dividends as revealed by the multiple cor-
relation. The fact that no great importance was placed on the
dividend ratio by the negotiators, which is the conclusion sug-
gested by the present analysis, may be the result of the diffi-
culty in many cases of selecting a representative dividend
ratio, the somewhat arbitrary nature of dividend payments,
or the varying importance placed on dividend payments by
different types of stockholders.

GENERAL CONCLUSIONS
The relatively high correlation coefficients obtained in both
the simple and multiple correlations suggest rather clearly
that the five value factors considered here determined to a
very substantial degree the actual exchange ratios in the
mergers covered in this study. In terms of the coefficient of
determination, R2, 95 per cent of the variance in Y was ac-
counted for by the combination of these five relative value
ratios. The high values obtained for the coefficients of correla-
tion are somewhat surprising in view of the earlier discussion
of the conditions which would have been required for perfect
correlation and the limitations in the financial data analyzed.
The high correlations obtained, together with the relatively
low values for the standard errors of the estimate, suggest
that the five value factors, both individually and as a group,
tend to possess a certain level of importance throughout the
mergers analyzed here. While there is considerable deviation
in individual mergers as evidenced by the scatteration of the
dots about the regression lines in Figures 1 through 5, the
general pattern of the over-all scatteration for any given fac-
tor would still appear to be close enough to the regression
lines to suggest this general tendency toward a common level
of importance, particularly in view of the many diverse ele-
ments which might possibly enter into any individual valua-
tion. This type of general pattern is particularly distinct in
the case of the market price ratio, X3. Here, the pattern is
unique in that the dots show a general tendency to fall above
the 45 degree line. This characteristic suggests that in the
mergers analyzed here the smaller constituent in each merger

92 COMMON STOCK VALUATIONS IN INDUSTRIAL MERGERS
tended to receive more favorable treatment in terms of the
market price relationships.
The high coefficients of correlation obtained in the multiple
correlations appear to be due in large part to the presence of
the market price ratio, X3, which is the dominant value rela-
tionship throughout this analysis. Even the simple correlation
values of .95 and .92 obtained for r in the correlation of X:, and
Y in Groups B and C, respectively, were not far different from
the value of .98 obtained for R in the multiple correlations for
Groups B and C. The relatively high correlations between X,:
and each of the other four value ratios might provide grounds
for believing that the importance of X, is due to the fact that
the influence of the other four value factors is summarized in
the market prices. However, the relatively large values ob-
tained for P and B' for X, in the multiple correlations sug-
gest that the importance of market price is due in large part
to its influence as an independent value factor.
The importance that market price appears to possess in the
mergers analyzed here suggests that it is either a better mea-
sure of fundamental relative values than is generally con-
ceded or that market price, in spite of its imperfections, is
relied on more heavily than might be expected. The latter
possibility would seem to offer the sounder explanation. While
the market price of common shares may be an important mea-
sure of value from a theoretical point of view, in actual ap-
praisals its use would be supported by important favorable
considerations. In the first place, it offers a definite and easily
determinable relationship which can be used at least as a
starting point in negotiations; that is, while other factors may
sway the negotiators one way or another, the use of the market
price relationship fixes a fairly definite point of departure for
the negotiations. On the other hand, because of the possible
disagreement which might exist with regard to the proper con-
tent of the other measures, their use might make it difficult to
arrive at any definite acceptable relationship around which to
negotiate. Another favorable feature of the market price ratio
is that it is a relationship which is of direct importance to the
constituents' stockholders and one which can be considered to
be free from any personal bias or special interests of the nego-
tiators. This feature is particularly relevant for the proposi-
tion that market prices may have been more important in the

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	Front Cover
	Title Page
	Preface
	Table of Contents
	Introduction
	Common equity valuation
	Value factors in exchange ratio...
	Factors modifying basic value...
	Conclusion
	Appendices
	Bibliography
	Index