The HUBRIS Hypothesis

[hubris (hyoo-bris) noun. Overbearing pride or presumption, excessive pride or self-confidence]

The Hubris Hypothesis of Corporate Takeovers

The Hubris Hypothesis is advanced as an explanation of corporate takeovers. It suggests that there is a tendency for acquisitor companies to pay too much. Company managers are over optimistic about their ability to add value to a new company.
Hubris on the part of individual decision makers in bidding firms can explain why bids are made even when a valuation above the current market price is essentially a valuation error. Bidding firms are said to be infected by hubris simply tend to pay too much for their targets.
It is often argued by varoius experts that there really are no gains associated with corporate takeovers and even if there are, they are highly overestimated and the source of these small gains are basically 'elusive'.
The basic steps undertaken in a corporate takeover are -
a) The bidding firm identifies a potential target firm
b) A "valuation" of the equity of the target firm is undertaken. It may typically include any nonpublic information. Also, the valuation would incorporate any estimated economies due the synergy effect or the negatives like a weak management (that will cause a discount in the target's market price).
c) This 'value' is compared to the current market price of the target firm. If the value is below the price, the bid is abandoned. However, if the value is above the market price, a bid is made. (The bid typically would not be the previously determined 'value', since it should include provisions for rival bids, for future bargaining with the target and valuation errors)
So, the key element here is the "Valuation" of the target firm. The valuation of an asset that has an observable market price (a preexisting active market) must be distinguished from other bids for assets that trade infrequently. In takeover attempts, the current market price forms a lower bound, as the bidder knows for certain that the shareholder will not sell below that.

Now let us consider a case of no potential synergies or any other source of takeover gains but the bidding firms believe that such gains exist. This means that valuation can be considered a random variable whose mean is the target firm's current market price. Only when the random variable exceeds the mean, a bid offer is made. But when there aren't any sources of gains for the bidding firm, the takeover premium is a mistake made by the bidder.
But if there were no value at all in takeovers, why would firms make a bid in the first place? But such behaviour rests on the assumption that individual are rational beings. A typical individual bidder believes that the valuation is right and is convinced that the market does not reflect the full economic value of the combined firm. This is the underlying premise of the Hubris Hypothesis - When there are no actual aggregate gains in a takeover, the takeover can be explained by the overbearing presumption of bidders that their valuations are correct.

The hubris hypothesis is consistent with strong form market efficiency. Financial markets are assumed to be efficient in the sense that a) no industrial reorganization can bring gains in an aggregate output at the same cost or reductions in aggregate costs with the same output and b) management talent is employed in its best alternative use.
Although perfect form market efficiency is unlikely, it does serve as an ideal benchmark against which other forms of efficiency are measured.