Beruflich Dokumente
Kultur Dokumente
Michael G. Hertzel
Department of Finance
W. P. Carey School of Business
Arizona State University
Phone: (480) 965-6869
Email: michael.hertzel@asu.edu
Zhi Li
Department of Finance
W. P. Carey School of Business
Arizona State University
Phone: (480) 965-3131
Email: zhi.li.2@asu.edu
*
We thank Stephan Dieckmann, David Robinson, Sunil Wahal and brown bag seminar participants
at Arizona State University for helpful comments.
Behavioral and rational explanations of stock price performance around SEOs:
Evidence from a decomposition of market-to-book ratios
Abstract
This paper examines the extent to which investment opportunities and/or mispricing
motivates equity issues and contributes to low post-issue stock returns. Using the
book ratios into misvaluation and growth option components, we find that issuing firms
have both greater mispricing and greater long-run growth opportunities relative to the
overall market. Issuing firms with greater mispricing tend to decrease long-term debt and
earn lower post-issue abnormal returns. In contrast, firms with greater growth
opportunities invest more aggressively in R&D and capital expenditures and do not
experience more negative post-issue stock price performance. Our results are more
consistent with behavioral explanations for SEO underperformance, and show that
managers have more information about true firm value than outside investors and act to
maximize current shareholder’s wealth. The results do not support theories that link post-
2
1. Introduction
experience significant stock price run-ups in the year prior to the offering and low stock
returns over the subsequent five years. Two alternative explanations of this pattern in
returns have appeared in the literature. The behavioral view is that the pre-issuance run-
issue equity when firms are overvalued, and that investors are slow to recognize and
investment based rational explanations have emerged. Carlson, Fisher and Giammarino
(2006), using a real options approach, posits that the pre-issue run-up reflects growth
options coming into the money, that managers issue equity in order to invest in these
growth options, and that lower post-issue returns reflect a decrease in firm risk as risky
growth options are converted into less risky assets in place. Zhang (2005), using a Q-
theoretic framework, argues that the pre-issue run-up reflects a decrease in the required
return on capital that causes more investment opportunities to become positive NPV
projects, that firms issue equity to finance these investment projects, and that low post-
issue stock returns reflect the decreased required return on capital. Both of the rational
theories predict that firms increase investment after SEOs and that there is a negative
3
RKRV) that decomposes pre-issue market-to-book (M/B) ratios into misvaluation and
growth option components. Previous research has documented that SEO firms have
higher than average market-to-book ratios. High M/B ratios can be viewed both as a sign
of overvaluation, consistent with the behavioral view, or as a sign of high growth options,
M/B ratios, we are able to provide sharper tests of competing predictions as well as
evidence on the possibility that both explanations contribute to the observed pattern in
performance.
The RKRV methodology uses an accounting multiples approach to break M/B into
three components: firm-specific error, time-series sector error, and long-run value-to-
misvaluation component of the M/B ratio. Time-series sector error measures valuation
deviations when contemporaneous sector multiples differ from long-run sector multiples.
This component indicates whether the sector, or possibly the entire market, is overvalued.
Our empirical testing methodology proceeds in three steps. First, for a sample of
4325 seasoned equity offerings over the 1970 to 2004 time period, we show that all three
components of M/B, on average, are significantly larger for issuing firms than for a
control sample of non-issuing firms. This finding suggests that SEO decisions may be
both.
4
Second, we examine the relation between the use of issue proceeds and the pre-
issue components of the market-to-book ratio. The goal of this analysis is to provide
evidence on the extent to which the error components of M/B reflect misvaluation and
can thereby serve as useful metrics in our analysis of post-issue stock price performance.
Assuming that managers act in the interest of existing shareholders, post-issue investment
in real assets should be positively related to the pre-issue level of growth options and
uncorrelated with the level of misvaluation. If the firm-specific error and time-series
Weisbach (2005) and examine post-SEO changes (over horizons of 1 to 4 years) in seven
accounting variables that likely capture the use of issue proceeds: capital expenditures,
R&D, total assets, debt-reduction, cash, acquisitions and inventory. We regress the
changes in these accounting variables on the three components of the M/B ratio while
controlling for primary capital raised in the SEO, other sources of funds generated within
the firm, firm size, and fixed effects for year and industry. This analysis yields the
following results:
5
Post-issue changes in cash positions are positively related to firm-specific
These findings suggest that firms with high levels of growth options invest more in real
assets, whereas firms with high valuation errors are more likely to pay down debt and/or
stockpile cash. This evidence is consistent with the interpretation of firm-specific error
Our last set of tests focus on the relation between post-issue stock price
performance and pre-issue components of M/B. The real investment theories predict a
negative relation between investment level and future stock returns. In contrast,
behavioral theory predicts that post-issue stock returns should be negatively correlated
with the degree of overpricing at the time of issuance. In these tests we separate issuing
firms into quartiles based on firm-specific error and long-run value-to-book and then
calculate long-run (3- and 5-year) post-issue abnormal returns for each quartile portfolio
abnormal returns, i.e., issuing firms with high levels of growth options do
not have lower post-issue abnormal returns than issuing firms with lower
finding that issuing firms with more growth options have higher levels of
6
In contrast, we do find a relation between firm-specific error and post-
issue returns; issuing firms with high firm-specific error have more
sector error. Evidence that more overvalued firms have lower post-issue
issue returns.
sample selection procedure and the data. Section 3 describes our empirical methodology
2. Data
Our sample includes all firms, as identified from the SDC database, which
conduct SEOs over the period 1970 to 2004. Accounting information and stock price
data are from Compustat and CRSP, respectively. Following Rhodes-Kropf, Robinson
and Viswanathan (2005), we merge data in the following way. To calculate and
decompose M/B, we first match fiscal year accounting data from Compustat with market
value data from CRSP measured three months after the fiscal year-end. An SEO is
aligned with this match of Compustat and CRSP data if the issuance occurs at least one
month after the date that CRSP market value is measured. If the issuance occurs between
the fiscal year-end and one month after the CRSP market value measurement date, we
7
To be included in the final sample, an issuing firm must have enough Compustat
and CRSP data to calculate the three components of the M/B ratio. We exclude firms that
only issue secondary shares as well as utility companies with SIC codes between 4910
and 4949, closed-end funds (SIC between 6720 and 6739) and REITs (SIC 6798). If a
firm issues primary shares more than once within a three-year period, then only the first
issue is included. The final sample has 4325 observations. Table 1 reports the number of
SEOs in our final sample by year over the period 1970 to 2004.
3. Empirical methodology
The rational and behavioral theories of stock price performance around SEOs
offer alternative explanations for high pre-issue market-to-book ratios. Behavioral theory
suggests that equity issues are more likely when firm market value, M, exceeds its true
value, V. Real investment theory suggests that equity issues are more likely after
investment opportunities move into the money resulting in a higher true value-to-book
ratio (V/B). This distinction underlies our rationale for employing the RKRF (2005)
methodology for decomposing M/B into misvaluation (M/V) and growth option (V/B)
components as follows:
(2) m b ( m v ) (v b )
where lower case letters indicate logarithms of the respective variables. 2 If markets know
the future growth opportunities, discount rates, and cash flows, then the term (m – v)
2
We adopt the same notation and our discussion below closely mirrors that in RKRV (2005).
8
should be zero. If markets make mistakes in estimating discounted future cash flows, or
markets do not have information that managers have, then (m–v) will capture the
determining an estimate of true firm value, v. For estimation purposes, for each firm i in
The first two terms on the right hand side of Eq. (3), collectively referred to as
total error, capture the misvaluation component of the market-to-book ratio. The first
term, mit v( it ; jt ) , referred to as firm-specific error, measures the difference between
market value and fundamental value estimated by firm accounting data it and
3
As RKRV note, the term, m–v, may or may not correspond to an asset-pricing sense of mispricing, since it
can be caused either by behavioral biases or by information asymmetry.
9
t, jt , differ from long-run sector multiples, j . This difference reflects the extent to
which the whole sector (or, possibly, the entire market) may be misvalued at time t.
With respect to the error terms in Eq. (3), two points are worth noting here. First,
from current and long-run industry-average growth and discount rates. In section 4.2, we
show that the high error components we document for SEO firms are more likely due to
misvaluation than to such deviations. Second, although essential to the research question
investigated by RKRV4, the decomposition of the error term into firm-specific and time-
series sector components is less informative about the hypotheses we investigate. Thus,
we focus much of our analysis on firm-specific error and total error (i.e., the combination
difference between firm value implied by the vector of long-run sector multiples and
book value. This measure can be interpreted as the investment opportunity component of
estimate v ( it ; jt ) and v( it ; j ) . The models differ only with respect to the
accounting items that are included in the accounting information vector, it . To save
space, we focus on RKRV’s third model, which includes book value (b), net income (NI)
and market leverage ratio (LEV) in the accounting information vector it .5 Expressing
4
RKRV test theories of mergers where industry misvaluation plays a central role.
5
The first model in RKRV (2005) includes only book value; the second model includes book value and net
income. Our results are robust to using either of these models.
10
(4) mit 0 jt 1 jt bit 2 jt ln( NI ) it 3 jt I ( 0 ) ln( NI ) it 4 jt LEVit it
value (NI)+ along with a dummy variable, I (0 ) , to indicate when net income is negative.
CRSP/Compustat firms according to the 12 Fama and French industry classifications and
run annual, cross-sectional regressions for each industry and generate estimated industry
accounting multiples for each year t, ̂ jt .6 The estimated value of v ( it ; jt ) is the fitted
v(bit , NI it , LEVit ; ˆ 0 jt , ˆ 1 jt , ˆ 2 jt , ˆ 3 jt , ˆ 4 jt )
(5)
ˆ 0 jt ˆ 1 jt bit ˆ 2 jt ln( NI ) it ˆ 3 jt I ( 0) ln( NI ) it ˆ 4 jt LEVit
To calculate the long-term sector multiples, j , we average, over time, the ̂ jt ’s from
of v( it ; j ) is then the fitted value of Eq. (4) using the j ’s:
v(bit , NI it , LEVit ; 0 j , 1 j , 2 j , 3 j , 4 j )
(6)
0 j 1 j bit 2 j ln( NI ) it 3 j I ( 0) ln( NI ) it 4 j LEVit
With respect to our long-run post-issue stock price performance tests, it is useful
at this point to note that in calculating j , the time series average of the yearly sector
multiples, we use information that is not available to the market at time t. Thus, our
11
managers, but unknown to the market at time t. This implies that our measure of time-
Table 2 presents the time-series averages of the regression coefficients for Eq. (4)
for the 12 Fama and French industries. The results are similar to those reported in Table
4 of Rhodes-Kropf, Robinson and Viswanathan (2005). The table reports that the average
adjusted-R2 for these regressions ranges from 82% to 92%, which shows that within an
industry, the three accounting variables explain a large majority of the cross-sectional
4. Empirical findings
This section presents results from a battery of tests aimed at providing evidence
on the rational and behavioral theories of SEOs. We proceed in three steps. In section
decomposition into the error and growth option components for our sample of SEO firms
and for a comparison sample of non-issuing firms. In section 4.2, we present evidence on
the use of proceeds by examining the relation between pre-issue M/B components and
post-issue investment decisions. Our objective here is to provide insight on the error
components of the M/B ratio, and further examine how investment funding needs and
the relation between the pre-issue misvaluation and growth opportunity components of
M/B and the long-run post-issue stock price performance of the issuing firms.
12
4.1. Market-to-book ratios of issuing firms: Investment opportunities vs. misvaluation
components of M/B for our sample of SEO firms and for a comparison sample of all non-
issuing CRSP/Compustat firms. The table shows that the average (log) M/B ratio for the
issuing firms is 0.95, while the average ratio for all CRSP/Compustat firms is only 0.42.
This is consistent with prior findings that SEO firms have relatively high pre-issue M/B
ratios. High pre-issue market-to-book ratios are also consistent with evidence that
With respect to the individual components, Panel A shows that the average firm-
specific error, time-series sector error and long-run value-to-book ratio for the sample of
issuing firms is 0.27, 0.06 and 0.41, respectively; each is significantly different from zero
and significantly larger than the respective averages for all non-issuing firms in the
substantially larger fraction of issuing firm market-to book ratios (35%) as compared to
of M/B, Panel B presents the distribution of the sample of SEO firms sorted across firm-
specific error and long-run value-to-book quartiles where quartile breakpoints are formed
using all CRSP/Compustat firms for each fiscal year. With respect to firm-specific error,
7
By design, the average firm-specific error of all CRSP/Compustat firms is zero since it is measured as the
regression residual, it , from Eq. (4). This follows since we estimate v ( it ; jt ) as the fitted value
from the annual cross-sectional regression for each industry. Thus, the firm-specific error,
mit v ( it ; jt ) , is simply the regression residual.
13
39% of the issuing firms are in the highest CRSP/Compustat quartile, while only 14% are
in the lowest quartile. For long-run value-to-book, 36% of the SEO firms are from the
highest quartile with only 19% coming from the lowest.8 Panel C reports the distribution
of SEO sample firms sorted across total error and long-run value-to-book quartiles and
In summary, the evidence in this subsection is consistent with the possibility that
both misvaluation and the need to fund positive net present value investments influence
the SEO decision. The tendency for issuing firms to have high pre-issue long-run value-
to-book ratios suggests that that these firms issue to satisfy investment needs. The
tendency for issuing firms to have market values in excess of what would be expected
industry growth and discount rates, or both. We present evidence in the next two sections
suggesting that the large error components we observe for our sample of issuing firms
reflect overvaluation.
Previous literature (Loughran and Ritter (1997)) shows that issuing firms, on
average, have high levels of investment following SEOs. However, we should expect to
observe differences in the use of proceeds, depending upon the motivation for
8
Note that 11% of our SEO firms are in both firm-specific error and long-run value-to-book quartiles 1 and
2 which suggests that they are not overvalued and have low investment opportunities. Issuance by these
firms suggests that either managers make mistakes when assessing true firm value and growth options, that
managers are exhibiting empire-building behavior and/or that our three M/B components are imperfect
measures of misvaluation and investment opportunities.
14
undertaking an SEO. More specifically, assuming managers act in the best interest of
existing shareholders, we should expect to see more debt reduction when SEOs are
motivated by stock price overvaluation and more investment when SEOs are motivated
by growth options coming into the money. In this section, we investigate the use of issue
proceeds by examining the relation between post-issue investment and pre-issue levels of
the misvaluation and growth option components of M/B. Our goal here is to provide
evidence on the extent to which the error components of M/B reflect misvaluation and
Weisbach (2006) and track seven accounting variables that potentially capture the use of
acquisitions, inventory, total assets, cash and reduction of long-term debt for up to four
years following the SEO. To control for firm size, we scale all accounting variables by
book assets in the fiscal year prior to the SEO. For the income statement and cash flow
statement items (R&D, capital expenditures, acquisitions and reduction in long-term debt
as measured by Compustat data items 46, 128, 129 and 114 respectively), we calculate
the accumulation in each variable since the SEO, scaled by book assets prior to the SEO:
V
i 1
i / Asset 0 , where V is the accounting variable being measured and year 0 is the
fiscal year-end just prior to year of the SEO. For the balance sheet variables (inventory,
cash and total assets as measured by Compustat data items 3, 1, and 6 respectively), we
measure the cumulative change in each variable since the SEO: (Vi V0 ) / Asset 0 , for i =
1 to 4.
15
4.2.1. Univariate analysis of post-issue investments across components of market-to-book
components of the market-to-book ratio. Panels A, B and C of Table 4 report the mean
normalized increase for each accounting variable for quartiles based on firm-specific
First, comparing across panels, post-issue R&D and capital expenditures are both
reported in Panel C, R&D and capital expenditures both increase monotonically as the
long-run value-to-book ratio increases; differences between quartiles 4 and 1 are highly
significant at all horizons for both variables. In contrast, we do not observe such a
relation when R&D and capital expenditures are measured across quartiles of firm-
specific error as reported in Panel A. This finding is more consistent with the
of firm-specific deviation from industry average growth and discount rates. That is, we
should not expect to observe greater post-issue investment as the degree of overvaluation
increases. The results using total error are somewhat mixed but are generally consistent.
Second, and also consistent with the view that the error component reflects
misvaluation, we find that firms with high firm-specific error and high total error are
more likely to spend issue proceeds on debt-reduction. At both the one- and two-year
horizon, long-term debt reduction increases monotonically as both firm-specific error and
16
total error increases; differences between quartiles 4 and 1 are highly significant in both
cases. In contrast, we find no relation between debt-reduction and the long-run value-to-
In summary, the univariate analysis suggests that both misvaluation and the need
to fund positive NPV projects motivate firms to issue equity. Firms with high investment
opportunities appear to issue to finance R&D and capital expenditures, while firms with
high valuation errors appear to use relatively cheaper equity to substitute for debt. We
note that acquisitions, cash levels, inventories and total assets are all positively related to
investment may be influenced by factors not reflected in the M/B components. The level
of issue proceeds, the amount of other sources of funds generated within the firm, firm
size, industry and year effects may all distort the univariate findings. In the next section,
the relation between components of the pre-issue M/B ratio and post-issue use of
proceeds. We regress changes in the seven accounting variables (measured over one-,
two-, three- and four-year post-issue horizons) on the long-run value-to-book and error
components of M/B while controlling for primary capital raised in the SEO, other sources
17
of funds generated within the firm, firm size, and fixed effects for year and industry. 9 To
avoid the impact of outliers, we take the log of the scaled accounting variables plus one.
For each accounting variable, we run the following regression for each post-issue
horizon:
(7)
Pr imaryCap OtherCapt
Yt 1 Firm 2 LongRun 3 Sector 4 ln 1 5 ln 1
TotalAsset 0 TotalAsset 0
2001 11
6 ln(TotalAsset 0 ) YrDummy IndustryDummy
i 1970
i
j 1
j
where
t
Yt ln (Vi / TotalAsset 0 ) 1 for V = R&D, capital expenditure, long-term debt
i 1
Firm, Sector, and LongRun refer to the three components of the pre-issue M/B ratio.
t
OtherCapt = ln [( (total sources of fundst – PrimaryCapital) / TotalAsset0) + 1] where
i 1
total sources of funds include internally generated cash from continuing operations,
9
In an earlier version of their paper, Kim and Weisbach (2006) include the proceeds from secondary shares
sold in conjunction with the SEO as a control variable. In results that are not reported here, we re-run the
regression controlling for proceeds from secondary shares and find similar results. We note that in more
than half of our sample, secondary shares are not issued.
10
We use Compustat data item 112 as total sources of funds. If it is missing, we calculate total sources of
funds as sum of funds from operations (data item 110), sale of property, plant and equipment (data item
107), long term debt issuances (data item 111), and sale of common and preferred stock (data item 108).
18
Panel A of Table 5 presents the regression estimates of Eq. (7). Several results are
of interest. First, we find evidence that post-issue investment is positively related to the
pre-issue level of growth options. More specifically, for the capital expenditure and
R&D regressions, the coefficients on LongRun are positive and significant at all horizons.
This evidence is consistent with the predictions of real investment theory that equity
issues are timed after an increase in the net present value of investment opportunities.11
of M/B. The coefficients on Firm in the capital expenditure and R&D regressions are
generally insignificant (we do observe one significant coefficient in the R&D regression
but the sign is negative.) This evidence is consistent with the interpretation of the firm-
that the firm-specific error component reflects firm-specific deviations from industry
average growth and discount rates, is not supported. The alternative interpretation is also
not supported by a test of the equality of coefficients on Firm and LongRun; we reject at
negatively related to long-run value-to-book. These findings suggest that firms with
greater investment opportunities invest more, whereas firms with high valuation errors
are more likely to pay down debt. We also find that post-issue changes in cash positions
11
Although not the focus of our paper, we note that this pattern is not suggestive of empire building of the
type discussed in Titman, Wei and Xie (2004), i.e., at least in our SEO sample we find that a firm’s
investment level is positively correlated with its long-run value-to-book ratio, a proxy for positive NPV
investment opportunities.
19
three out of four horizons. These findings bolster our conclusion that firm-specific error
we substitute total error for firm-specific error and time-series sector error. The
error reported in Panel A. It results here support the interpretation of total error as
For a sense of the economic significance of our findings we note that a one
in R&D spending, and a $4.9 million increase in capital expenditures over the four years
following the SEO.13 In contrast, this increase in long-run value-to-book results $8.2
million less spending on long-term debt reduction. Increasing firm-specific error by one
standard deviation has a minimal impact on R&D and capital expenditures, but results in
a $3.6 million increase in long-term debt reduction over the four years following the
equity offering.
It has been widely documented that SEO firms underperform various benchmarks
by about 5% per year in the five years subsequent to issuance (Ritter (2003)). The
12
The coefficients on Sector in the R&D and capital expenditure regressions are puzzling: time-series
sector error, like firm-specific error, is negatively correlated with R&D expenditure, but it is positively
correlated with capital expenditure, as is the case for long-run value-to-book. Still, as we show in Panel B,
the sum of firm-specific error and sector error (total error) appears to reflect misvaluation. We note that
time-series sector error is the smallest component of M/B ratio (on average consists of only 6% of SEO
firms’ M/B ratio).
13
We use the median SEO firm’s book assets prior to issuance, 132.6 million, as TotalAsset 0. The standard
deviations of SEO firms’ firm-specific error, time-series sector error, long-run value-to-book are 0.706,
0.253, and 0.741, respectively.
behavioral explanation for “underperformance” is that the market is slow to recognize
that SEO firms are overvalued. Alternatively, Carlson, Fisher and Giammarino (2005)
argue that low post-issue returns reflect a decrease in firm risk due to the conversion of
risky growth options into less risky assets in place. Zhang (2005) argues that SEO firms
have low required rates of return due to exogenous factors. Both real investment theories
predict that the post-issue returns are negatively correlated with the level of post-issue
investment. Thus, the behavioral theories predict that firms that are more overvalued
should have lower post-issue abnormal returns, while the real investment theories predict
that firms with higher investment opportunities should have lower post-issue abnormal
returns, as they are the firms that invest most after issuance. In this section, we test these
two hypotheses by looking at the relation between post-issue stock returns and pre-issue
respectively, calculate abnormal returns for each quartile portfolio and compare returns
across quartiles.
Following Mitchell and Stafford (2000) and Brav, Geczy and Gompers (2000),
among others, we use calendar-time factor regressions to measure long-run stock price
performance. For each firm-specific error, total error and long-run value-to-book
quartile, for every month from January 1975 to December 2003, we form equal-weighted
(EW) and value-weighted (VW) portfolios of firms that issued seasoned equity in the past
3 years (or 5 years) and belong to that specific quartile. The dependent variable is the
portfolio excess return of the quartile portfolio over the one-month T-bill rate. We use the
Fama and French (1993) three-factor model and the Carhart (1997) four-factor model,
21
and measure portfolio abnormal performance using the intercept from the factor
regressions.
Table 6 presents the post-issue abnormal stock price performance for quartiles
classified by firm-specific error (Panel A), total error (Panel B) and long-run value-to-
book (Panel C). For ease of exposition we focus on the 3-year results obtained using the
Fama and French model. The 5-year results and the results using the Carhart 4-factor
model are qualitatively similar although weaker on a few dimensions; we discuss there
specific error and post-issue abnormal returns that is consistent with the behavioral view.
the highest versus lowest firm-specific error quartiles: issuing firms in the lowest firm-
specific error quartile have average abnormal return that are not significantly different
from zero: -0.11% per month (-3.9% after 3 years) whereas issuing firms in the highest
returns: -0.54% per month (-19.44% after 3 years). The pattern is generally the same,
though less pronounced, for the EW 5-year portfolios. Also, we do not observe statistical
The VW portfolio results are generally consistent with misvaluation, but not as
strong as our findings using EW portfolios. Overall, the VW SEO portfolios in the
lowest firm-specific error quartile have the highest abnormal returns (which are positive
though insignificantly different from zero), while the SEO portfolios in the highest firm-
22
specific error quartile have significantly negative abnormal returns (with the exception of
the 5-year portfolio using Carhart four-factor model.) We also note that the average
Panel B of Table 6 reports post-issue returns across quartiles of total error (which
equals firm-specific error plus time-series sector error.) As mentioned earlier, because
time-series sector error contains forward-looking information it does not allow for as
clean a test of the behavioral explanation of low post-issue returns. However, time-series
sector error may reflect inside information held by managers. Thus, total error is a more
biases and asymmetric information. Consistent with this, Panel B shows qualitatively
similar, but more pronounced, results as compared to the breakdown based on firm-
specific error alone. These results support the notion that managers try to time the market
to issue equity when they believe the stock and the industry is overvalued, and that
managers have more information about true value of the stock than outside investors.
quartile portfolios. We have shown in Tables 4 and 5 that issuing firms in the highest
expenditures after issuance than firms in the lowest quartile, but here we see no evidence
that issuing firms in the highest quartile have lower post-issue returns than firms in the
lowest quartile. In fact, in many cases, the average post-issue return to firms in the
highest long-run book-to-value quartile is higher than that of firms in the lowest quartile.
14
Loughran and Ritter (1999), Brav, Geczy and Gompers (2000), among others, have shown that EW and
VW portfolios may generate different abnormal returns and have debated the pros and cons of each
method. Here our goal is to investigate whether valuation errors influence the issuance decision and future
stock returns, not to quantify wealth impact on firms after issuance. Therefore, we believe equal-weighting
may be more appropriate.
23
This evidence does support explanations of post-issue stock price performance put
this section. First, evidence that firms in the high long-run value-to-book quartile invest
assets in place, issuing firms may also contemporaneously be adding growth options.
Thus, R&D investment may mitigate post-issue risk-reduction of the type suggested by
Carlson, Fisher and Giammarino (2006); this may explain why we do not observe lower
post-issue returns for the high long-run value-to-book issuers. A second caveat is that
other factors may also contribute to the low post-issue returns. This is suggested in
particular by the fact that firms in the lowest CRSP/Compustat firm-specific error quartile
positive post-issue abnormal returns. While this may be due to a selection bias in that
managers are reluctant to issue when the equity is undervalued, it may also reflect
decreased firm leverage ratios and increased stock liquidity after issuance as suggested in
Eckbo, Masulis and Norli (2000). Thus, while we find evidence that misvaluation prior
exclude the possibility that other factors also play a role. Finally, we recognize the
possibility that our measure of firm-specific error may be correlated with risk factors that
are not captured by the Fama and French and Carhart models. In that case, our study
24
5. Summary
This paper provides evidence on behavioral and rational explanations of stock price
performance around seasoned equity offerings. Using the Rhodes-Kropf, Robinson and
misvaluation and growth option components, we find that issuing firms have both greater
non-issuing firms. Issuing firms that are identified as more overvalued tend to decrease
long-term debt, increase cash holdings and earn lower post-issue abnormal returns. In
contrast, firms with greater growth opportunities invest more aggressively in R&D and
capital expenditures and do not experience more negative post-issue stock price
performance. These results are more consistent with the behavioral explanations for SEO
underperformance, and show that managers have more information about true firm value
than outside investors and act to maximize current shareholder’s wealth. The results do
not support theories that link post-issue performance with investment activities.
25
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27
Table 1
Number of seasoned equity offerings
This table reports the number of SEOs by year. All SEO information is from the SDC database for the years
1970 to 2004. To be included in the final sample, a SEO firm must have enough Compustat and CRSP data
to decompose its market-to-book ratio as described in Section 3.2. We exclude firms that only issue
secondary shares, utility companies with SIC codes between 4910 and 4949, closed-end funds (SIC codes
between 6720 and 6739) and REITs (SIC code 6798). If a firm issues primary shares more than once
within a three-year period, then only the first issue is included.
28
Table 2
Time-series average conditional regression multiples
This table reports the time-series average multiples from regression Eq. (4) in Section 3.4. The dependent variable is the natural log of market value (M). The
independent variables are the natural log of book value of equity (B), the natural log of the absolute value of net income (NI+), a dummy variable indicating when
the net income is negative (I(<0) ) and leverage (LEV). The regression is estimated cross-sectionally at the industry-year level for each of the Fama and French 12
industries from fiscal year 1969 to 2003. The subscripts i, j and t refer to firm, industry and year, respectively. E t (ˆ k ) is the time-series average regression
multiple for the kth accounting variable. We also report the Fama-Macbeth standard errors below the average estimated multiples. The reported R 2 is the average
adjusted-R2 for each industry.
Et (ˆ 0 ) 2.26 2.43 2.06 2.10 2.52 2.32 2.59 2.32 2.18 2.51 1.99 2.22
0.07 0.11 0.07 0.08 0.06 0.06 0.15 0.14 0.06 0.05 0.05 0.06
E t (ˆ 1 ) 0.62 0.58 0.66 0.68 0.59 0.61 0.62 0.79 0.66 0.60 0.58 0.62
0.01 0.02 0.01 0.02 0.03 0.02 0.02 0.03 0.01 0.02 0.01 0.01
Et (ˆ 2 ) 0.31 0.30 0.28 0.25 0.36 0.34 0.29 0.18 0.29 0.34 0.39 0.31
0.01 0.02 0.01 0.01 0.02 0.01 0.02 0.03 0.01 0.02 0.01 0.01
E t (ˆ 3 ) 0.00 -0.02 -0.04 -0.04 -0.01 -0.07 0.04 -0.15 -0.06 -0.10 -0.23 -0.06
0.02 0.02 0.01 0.03 0.03 0.01 0.10 0.11 0.01 0.02 0.02 0.01
Et (ˆ 4 ) -2.66 -2.53 -2.30 -2.25 -3.00 -2.64 -2.38 -2.68 -2.28 -2.68 -1.12 -2.05
0.08 0.11 0.09 0.13 0.10 0.10 0.18 0.24 0.06 0.09 0.04 0.07
R2 0.85 0.83 0.87 0.87 0.86 0.85 0.87 0.92 0.87 0.88 0.85 0.85
29
Table 3
Firm-level decomposition of market-to-book ratios
Panel A reports the decomposition of market-to-book ratios at the firm-level for our sample of SEO firms
and for a comparison sample of all non-SEO CRSP/Compustat firms over the period 1970 to 2004. The
column t(diff) reports the t-statistic for the test that SEO firms have the same average market-to-book ratio
(or component) as the non-SEO CRSP/Compustat comparison firms. Panel B shows the distribution of the
SEO sample across firm-specific error and long-run value-to-book quartiles. We report the percentage of
SEO firms that belong to each quartile. The quartile breakpoints for firm-specific error and long-run value
to book are generated from the universe of all (SEO plus non-SEO) CRSP/Compustat firms for each fiscal
year. Panel C shows the distribution of the SEO sample across total error and long-run value-to-book
quartiles.
Panel B: Distribution of SEO sample across firm-specific error and value-to-book quartiles
Long-run value-to-book
Firm-specific error Low Quartile 2 Quartile 3 High Total
Low 2% 2% 4% 7% 14%
Quartile 2 3% 4% 6% 8% 21%
Quartile 3 5% 7% 7% 8% 27%
High 10% 7% 8% 13% 39%
Total 19% 20% 25% 36% 100%
Panel C. Distribution of SEO sample across total error and value-to-book quartiles
Long-run value-to-book
Total error Low Quartile 2 Quartile 3 High Total
Low 2% 2% 4% 6% 14%
Quartile 2 3% 4% 6% 8% 20%
Quartile 3 5% 7% 7% 9% 27%
High 10% 7% 9% 13% 39%
Total 19% 20% 25% 36% 100%
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Table 4
Average post-issue increases in assets and expenditures by M/B components
Panels A, B and C of this table report average post-issue increases in assets and expenditures by firm-
specific error, total error and long-run value-to-book quartiles, respectively. Increases in expenditures
4
(R&D, capital expenditure, long-term debt reduction and acquisition) are calculated as V
i 1
i / Asset 0 .
4
Increases in assets (cash, inventory and total assets) are calculated as (V V ) / Asset
i 1
i 0 0 , where V is
the variable being measured, year 0 is the fiscal year-end just prior to the SEO issuance day, and year i is
number of years after year 0. The columns Diff and t(diff) report the difference and statistical significance,
respectively in mean expenditure between quartiles 4 and 1. The means reported here are winsorized at
0.5% for each tail to remove influential outliers.
31
4 1.51 2.02 1.86 2.41 0.90 3.85
32
Panel B: Total error (=firm-specific error plus time-series sector error)
Total error quartiles
33
Panel C: Long-run value-to-book
Long-run value-to-book quartiles
34
Table 5
The effect of M/B components on post-issue increases in assets and expenditures
Panel A presents the regression results showing how each of the three components of M/B (firm-specific error, sector
error and long-run value-to-book) affects post-issue increases in assets and expenditures. The dependent variable is
t
Yt ln (Vi / TotalAsset 0 ) 1 for V= R&D, capital expenditure, LT debt reduction and acquisition, and
i 1
Yt ln ((Vt V0 ) / TotalAsset 0 ) 1 for V=cash, inventory and total assets. Panel B reports regression results
when M/B is decomposed into two components: total error (=firm-specific error plus sector error) and long-run value-
to-book. Bold letters indicate statistical significance at 5% level.
Panel A:
Pr imaryCap OtherCapt
Yt 1 FirmSpec 2 LongRun 3 Sector 4 ln 1 5 ln
1 6 ln(TotalAsset
TotalAsset 0 TotalAsset 0
Firm- Long run Primary Other Total p-value
specific VtB Sector Cap Cap Asset %
V t β1 β2 β3 β4 β5 β6 β1= β2 Adj.R2 n
∑R&D 1 (0.01) 0.05 (0.06) 0.14 0.06 0.00 0.00 0.48 1,962
2 (0.01) 0.09 (0.10) 0.29 0.10 0.01 0.00 0.57 1,812
3 (0.01) 0.12 (0.12) 0.40 0.15 0.02 0.00 0.59 1,630
4 (0.01) 0.15 (0.16) 0.47 0.17 0.02 0.00 0.61 1,450
∑CAPEX 1 (0.00) 0.02 0.03 0.06 0.12 (0.00) 0.00 0.29 3,269
2 0.01 0.04 0.06 0.17 0.18 0.00 0.00 0.38 3,081
3 0.01 0.06 0.04 0.22 0.24 0.01 0.00 0.41 2,766
4 0.01 0.07 0.02 0.25 0.25 0.01 0.00 0.41 2,489
∑LT Debt 1 0.01 (0.04) (0.01) (0.08) 0.27 (0.02) 0.00 0.33 3,180
Reduction 2 0.03 (0.06) 0.02 (0.16) 0.31 (0.02) 0.00 0.37 3,093
3 0.03 (0.08) 0.02 (0.22) 0.38 (0.03) 0.00 0.40 2,726
4 0.04 (0.11) 0.08 (0.22) 0.43 (0.03) 0.00 0.43 2,427
∑Acquisition 1 (0.00) (0.01) 0.03 0.03 0.13 (0.00) 91.29 0.16 3,128
2 0.01 (0.01) 0.03 0.04 0.17 (0.00) 31.57 0.19 2,836
3 0.01 (0.01) 0.03 0.08 0.19 (0.00) 27.01 0.20 2,472
4 0.02 (0.01) 0.06 0.10 0.20 0.00 11.64 0.21 2,227
∆Cash 1 0.01 (0.00) (0.01) 0.87 0.24 0.02 11.07 0.72 3,307
2 0.03 0.00 (0.03) 0.71 0.25 0.03 4.98 0.51 3,143
3 0.02 0.02 (0.05) 0.56 0.25 0.02 63.06 0.41 2,856
4 0.03 0.03 (0.11) 0.52 0.25 0.02 80.26 0.37 2,588
∆Inventory 1 (0.00) (0.00) 0.01 0.05 0.04 (0.00) 63.40 0.12 3,239
2 (0.01) 0.00 0.00 0.10 0.08 (0.01) 31.63 0.19 3,074
3 (0.01) 0.00 (0.02) 0.10 0.11 (0.01) 20.14 0.21 2,789
4 (0.01) 0.00 (0.03) 0.12 0.12 (0.01) 41.42 0.22 2,523
∆Total 1 0.00 0.04 0.11 0.94 0.50 0.02 0.01 0.74 3,308
Assets 2 0.04 0.06 0.15 0.82 0.58 0.02 21.63 0.58 3,148
3 0.03 0.08 0.10 0.62 0.64 0.01 2.49 0.53 2,859
4 0.03 0.09 (0.01) 0.52 0.63 0.01 2.49 0.46 2,589
35
Panel B:
Pr imaryCap OtherCapt
Yt 1TotalError 2 LongRun 3 ln 1 4 ln 1 5 ln(TotalAsset 0 )
TotalAsset 0 TotalAsset 0 i
This table reports calendar-time factor regression results of portfolios consisting of firms that issue equity in the prior three (five) years and belong to each firm-
specific error (long-run value to book) quartile as defined in Panel B of Table 3. Quartile breakpoints are formed using all CRSP/Compustat firms, such that
different quartiles have different numbers of SEO firms (quartile 1 has least number of SEO firms and quartile 4 has most SEO firms). Every month from
January 1975 to December 2003, we form equal-weighted (EW) and value-weighted (VW) portfolios of firms that issued seasoned equity in the past 3 years (or 5
years) and belong to that specific quartile. The dependent variable is the excess return of the quartile portfolio over one-month T-bill rate. We use the Fama and
French (1993) three-factor model and Carhart (1997) four-factor model as our factor models, and measure portfolio underperformance as the intercept (α) from
the factor regressions. *, and ** indicate significance at 5% and 1% level respectively.
Panel A: Calendar-time factor regressions for SEO firms by firm-specific error quartile
Firm-specific error FF 3 Factor Model CARHART 4 Factor Model
Adj. Adj.
Quartile Portfolio α (%) MKT SMB HML 2 α (%) MKT SMB HML UMD
R R2
Low EW 3 yr -0.11 1.32 0.96 -0.08 0.79 0.09 1.29 0.96 -0.13 -0.19 0.79
2 3 yr -0.17 1.18 0.97 0.01 0.84 -0.04 1.16 0.97 -0.02 -0.12 0.84
3 3 yr -0.31* 1.17 0.89 0.09 0.89 -0.15 1.15 0.89 0.05 -0.15 0.89
High 3 yr -0.54** 1.28 0.82 -0.07 0.90 -0.27* 1.25 0.82 -0.13 -0.25 0.92
Low EW 5 yr -0.11 1.27 0.99 0.03 0.83 0.04 1.25 1.00 -0.01 -0.15 0.83
2 5 yr -0.18 1.17 1.00 0.04 0.88 -0.09 1.16 1.01 0.02 -0.10 0.88
3 5 yr -0.19 1.20 0.82 0.13 0.91 -0.07 1.19 0.83 0.10 -0.12 0.92
High 5 yr -0.43** 1.27 0.83 0.06 0.91 -0.20 1.24 0.85 0.00 -0.23 0.93
Low VW 3 yr 0.05 1.30 0.76 -0.53 0.72 0.08 1.30 0.76 -0.54 -0.03 0.72
2 3 yr -0.26 1.22 0.75 -0.05 0.78 -0.22 1.21 0.75 -0.06 -0.04 0.78
3 3 yr -0.32* 1.14 0.30 -0.15 0.84 -0.31* 1.14 0.30 -0.15 -0.01 0.84
High 3 yr -0.32** 1.12 0.02 -0.24 0.87 -0.32** 1.12 0.02 -0.24 0.00 0.87
Low VW 5 yr 0.02 1.24 0.87 -0.49 0.78 0.05 1.24 0.87 -0.50 -0.03 0.78
2 5 yr -0.21 1.19 0.66 -0.17 0.84 -0.20 1.19 0.66 -0.17 -0.01 0.84
3 5 yr -0.19 1.16 0.24 -0.08 0.89 -0.21 1.16 0.24 -0.08 0.02 0.89
High 5 yr -0.21* 1.08 0.05 -0.15 0.89 -0.17 1.08 0.06 -0.16 -0.04 0.89
37
Panel B: Calendar-time factor regressions for SEO firms by total error quartile
Total error (Firm+Sector) FF 3 FACTOR CARHART 4 FACTOR
Adj. Adj.
Quartile Portfolio α (%) MKT SMB HML α (%) MKT SMB HML UMD
R2 R2
Low EW 3 yr 0.02 1.30 1.02 -0.04 0.79 0.25 1.26 1.02 -0.10 -0.21 0.80
2 3 yr -0.12 1.18 0.99 0.09 0.85 0.05 1.16 0.99 0.05 -0.17 0.86
3 3 yr -0.25* 1.17 0.88 -0.02 0.91 -0.16 1.16 0.88 -0.04 -0.09 0.91
High 3 yr -0.64** 1.30 0.81 -0.05 0.89 -0.34** 1.26 0.81 -0.12 -0.29 0.91
Low EW 5 yr 0.01 1.24 1.06 0.06 0.83 0.18 1.22 1.08 0.01 -0.18 0.83
2 5 yr -0.04 1.14 0.94 0.04 0.89 0.08 1.13 0.95 0.01 -0.12 0.90
3 5 yr -0.21 1.21 0.85 0.11 0.92 -0.12 1.20 0.86 0.08 -0.09 0.92
High 5 yr -0.53** 1.28 0.81 0.06 0.90 -0.29** 1.25 0.84 0.00 -0.25 0.92
Low VW 3 yr -0.07 1.27 0.86 -0.27 0.72 -0.10 1.28 0.86 -0.27 0.03 0.72
2 3 yr -0.25 1.20 0.60 -0.05 0.75 -0.20 1.19 0.60 -0.06 -0.05 0.75
3 3 yr -0.12 1.10 0.36 -0.33 0.83 -0.25 1.12 0.36 -0.29 0.13 0.83
High 3 yr -0.33** 1.12 0.03 -0.25 0.87 -0.30* 1.12 0.03 -0.26 -0.03 0.87
Low VW 5 yr 0.06 1.22 0.94 -0.22 0.79 0.02 1.23 0.94 -0.21 0.04 0.79
2 5 yr -0.15 1.13 0.57 -0.11 0.83 -0.17 1.14 0.56 -0.11 0.02 0.83
3 5 yr -0.03 1.16 0.34 -0.17 0.87 -0.10 1.17 0.33 -0.15 0.08 0.87
High 5 yr -0.28** 1.08 0.05 -0.17 0.89 -0.22* 1.08 0.06 -0.19 -0.06 0.89
38
Panel C: Calendar- time factor regressions for SEO firms by long- run value-to-book quartile
Long run value-to-book FF 3 FACTOR CARHART 4 FACTOR
Adj.
Quartile Portfolio α (%) MKT SMB HML Adj. R 2 α (%) MKT SMB HML UMD
R2
Low EW 3 yr -0.40 1.21 0.94 0.59 0.69 -0.11 1.17 0.94 0.52 -0.27 0.71
2 3 yr -0.41** 1.16 0.60 0.35 0.80 -0.20 1.13 0.60 0.30 -0.19 0.82
3 3 yr -0.31* 1.22 0.75 -0.13 0.89 -0.16 1.20 0.76 -0.17 -0.14 0.89
High 3 yr -0.30 1.26 1.13 -0.39 0.90 -0.05 1.23 1.13 -0.44 -0.23 0.91
Low EW 5 yr -0.35* 1.26 0.83 0.65 0.82 -0.16 1.24 0.85 0.61 -0.20 0.83
2 5 yr -0.38** 1.20 0.56 0.47 0.87 -0.24* 1.18 0.58 0.44 -0.15 0.88
3 5 yr -0.34** 1.19 0.81 0.01 0.90 -0.21 1.18 0.83 -0.02 -0.14 0.90
High 5 yr -0.18 1.25 1.14 -0.34 0.90 0.03 1.23 1.16 -0.39 -0.22 0.91
Low VW 3 yr -0.43 1.15 0.39 0.45 0.60 -0.33 1.14 0.39 0.42 -0.10 0.60
2 3 yr -0.41* 1.11 0.07 0.25 0.71 -0.19 1.08 0.08 0.20 -0.20 0.73
3 3 yr -0.10 1.16 0.11 -0.41 0.80 -0.18 1.17 0.11 -0.40 0.07 0.80
High 3 yr -0.14 1.09 0.38 -0.81 0.86 -0.21 1.10 0.38 -0.80 0.07 0.86
Low VW 5 yr -0.35* 1.17 0.19 0.34 0.75 -0.30 1.17 0.19 0.33 -0.05 0.75
2 5 yr -0.30* 1.13 -0.01 0.31 0.78 -0.16 1.11 0.01 0.28 -0.14 0.79
3 5 yr -0.18 1.10 0.17 -0.35 0.85 -0.18 1.10 0.17 -0.36 -0.01 0.85
High 5 yr -0.03 1.08 0.39 -0.74 0.88 -0.02 1.08 0.39 -0.75 -0.01 0.88
39