The effect of foreign diversification on analysts' prediction errors

Abstract

This study examines the effect of foreign acquisitions by U.S. firms on analysts' prediction errors. For a sample of 102 focus-preserving (FP) foreign acquisitions and 83 focus-decreasing (FD) acquisitions during 1985–1997, we find that post-merger analysts' prediction errors are significantly higher for U.S. firms that choose to expand internationally outside their core business segment, relative to those that undertake global expansion within their core business. Given the potential costs associated with declines in the accuracy of analysts' earnings forecasts, we examine the incentives that may lead firms to engage in focus-decreasing foreign investments. To that end, we examine the financial characteristics and valuation effects of the acquiring firms and the industry conditions of both the acquiring and target firms' rivals. The findings indicate that the industry conditions of the FD acquiring (target) firms are less (more) attractive relative to those of FP acquiring and target firms. Moreover, we find that announcements of FD foreign acquisitions result in significantly positive abnormal returns for the acquiring firm and in significantly negative contemporaneous abnormal returns for the industry rivals of both the FD acquiring and target firms.