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High short interest is associated with overvaluation, and the purpose of this paper is to find contradictions to the commonly held “overvaluation hypothesis” when merger and acquisition (M&A) targets are examined. This paper extends the work of Ben-David et al. (2015), who confirm high short interest indicates overvaluation when focused on acquiring firms.

Short interest is examined as a predictor of acquisition likelihood using longitudinal data for US firms from 2003 to 2013. How short interest impacts the premiums paid by acquiring firms is examined with target, acquirer and deal characteristics.

M&A targets have high short interest and short interest increases acquisition likelihood, suggesting undervaluation. Highly shorted firms also experience outsized reductions in share price prior to merger announcements, and the premiums paid are also significantly predicted by short interest levels.

Short selling activity can be motivated for reasons other than overvaluation, and many short positions can be held for long periods before they are closed, leading to high short interest levels for extended periods. Therefore, investors and researchers are cautioned that high short interest levels may exist in stocks that have already declined in price and could be poised for a reversal.

This study adds to the growing body of work indicating that short interest might not be the signal of overvaluation most researchers accept it to be.