This paper examines the ability of cash flow and earnings based measures of return to assess the differences between target firms and their industries and to explain target firms' abnormal returns during the takeover period. In a sample of 63 completed takeovers over the period 1977 to 1989, takeover targets have mean cash flow to total assets and earnings to total assets below their industry average in each of the three years preceding the year of the takeover. If these ratios are interpreted as measures of managerial performance, the implication is that target firms were underperformers which may have been taken over for a better use of their asset potential. Target firm abnormal returns observed during the takeover period are significantly related to both the difference between target firm and average industry earnings to total assets and to the difference in cash flow to total assets. Abnormal returns are negatively related to the difference in earnings to total assets, suggesting that target firm assets are indeed underutilized. The difference between target firm and target industry cash flow to total assets is positively related to target firm abnormal returns, suggesting that acquiring firms value the near term cash flow of targets.
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