Profitability Measures as Indicators of Post-Merger Efficiency

IN recent years a number of academic studies in industrial economics and company finance have measured the profitability of companies before and after merger. Sometimes their aim has been to assess the gain from merger to particular groups of wealth-holders, such as the acquirer's equity owners; and at other times the exercise has been directed at assessing the impact of merger on efficiency, often as part of a discussion of whether government should foster or inhibit merger. This paper is concerned with the second type of exercise and aims to describe some of the pitfalls which can be encountered by a researcher who is trying to draw inferences for efficiency change from the observed post-merger change in common measures of profitability. With each of the measures discussed below the problem arises of disentangling the effect on profit of efficiency changes from that of changes in bargaining power. For instance, if the participants' bargaining power is on average enhanced by merger-and it is argued elsewherel that this is a reasonable generalization-then profitability could rise even though efficiency remained unchanged or actually fell. Consequently, no inferences for efficiency could be drawn solely from evidence of improved profitability after merger. If, however, merging firms record a fall in profitability, or even simply no change, the problem may not be insuperable: other things equal one could conclude that, with bargaining power on average enhanced, efficiency had declined.2 Even in this case, of course, an estimate based on profitability of the size of the decline will be biased upwards. The next three sources of bias and distortion involve some discussion of the accounting basis of various profitability measures; and in explaining them the following symbols will be used: