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Abstract

We examine the extent to which investment opportunities and/or mispricing motivates equity

issuance decisions and contributes to low post-issue stock returns. Using a methodology

developed in Rhodes-Kropf, Robinson, and Viswanathan (2005) to decompose market-to-book

ratios into misvaluation and growth option components, we find that issuing firms are both

overvalued and have greater growth opportunities relative to a comparison sample of non-issuing

firms. Issuing firms with greater growth opportunities invest more aggressively in capital

expenditures and R&D after the SEO, but do not experience lower post-issue abnormal stock

returns. In contrast, issuing firms with greater mispricing tend to decrease long-term debt and/or

increase cash holdings, and do earn lower post-issue abnormal returns. Our findings are more

consistent with behavioral explanations for post-issue stock price underperformance.

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1. Introduction

It is well-documented that firms conducting seasoned equity offerings (SEOs) experience

significant stock price run-ups in the year prior to the offering and low stock returns over the

subsequent three to five years. Two alternative explanations of this pattern in returns have

appeared in the literature. The behavioral view is that the pre-issuance run-up reflects investor

overreaction to recent trends in performance, that managers are motivated to issue equity when

firms are overvalued, and that investors are slow to recognize and incorporate information

conveyed by SEO announcements.1

More recently, real 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 moving 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. Li, Livdan, and Zhang (2008), using

a Q-theoretic framework, argues that firms issue equity to finance investment projects induced

by low discount rates, and because of decreasing returns to scale, the increased investment leads

to lower marginal product of capital and thereby lower expected returns, which explains the post-

SEO underperformance. Both of the rational theories predict that firms increase investment after

SEOs and that there is a negative relation between investment level and post-issue stock returns.2

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In this paper, we provide evidence on these alternative explanations using a methodology

developed in Rhodes-Kropf, Robinson, and Viswanathan (2005, hereafter 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. HighM/Bratios can be viewed both as a sign of overvaluation, consistent

with the behavioral view, or as a sign of high growth options, consistent with the investment-

based rational theories. By decomposing issuing firmM/Bratios, 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/Bratios into

three components: firm-specific error, time-series sector error, and long-run value-to-book.3

Thefirm-specific errorcomponent measures firm-specific deviations from valuations implied by

current sector (industry) accounting multiples, and is intended to capture the extent to which the

firm is misvalued relative to its contemporaneous industry peers. The time-series sector error

component measures valuation deviations when contemporaneous sector accounting multiples

differ from long-run sector multiples. This component is used as a measure of whether the

sector, or possibly the entire market, is overvalued. The long-run value-to-book component

measures the value implied by long-run sector accounting multiples relative to book value; it is

used as a proxy for growth opportunities

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Two aspects of the RKRV methodology affect our empirical testing strategy. First,

although estimating industry misvaluation is essential to the research question investigated by

RKRV, the time-series sector error component is less informative about the hypotheses we

investigate.4 For this reason, and because of econometric issues that we discuss in the paper, our

tests of the behavioral view focus on potential misvaluation as reflected in thefirm-specific error

component ofM/B.5Second, there are potential model misspecification concerns that can make it

difficult to draw clear inferences from our findings. For example, a firm with highfirm-specific

error may not be overvalued, but instead may simply have greater growth opportunities than

other firms in its industry. Thus, an important part of our empirical testing strategy aims at

providing evidence on the extent to which the firm-specific error and long-run value-to-book

components reflect misvaluation and growth options, respectively, and can thereby serve as

useful metrics in our analysis of post-issue stock price performance.

Our empirical analysis 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 comparison sample of non-issuing

firms. This finding suggests that SEO decisions may be motivated by either high levels of

misvaluation, high levels of growth opportunities, or both.

Second, to provide evidence on the usefulness of the RKRV methodology as well as

provide insight on managerial motives for issuing equity we examine the relation between the

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be positively related to the pre-issue level of growth options and uncorrelated with the level of

misvaluation. To the extent that thefirm-specific errorcomponent ofM/Breflects misvaluation,

there should be no relation between this error term and post-issue investment. Similarly, to the

extent that the long-run value-to-bookcomponent reflects the level of growth options, we should

expect to observe a positive relation between this growth option component and post-issue

investment.

To investigate post-issue investment, we follow the approach in Kim and Weisbach

(2006) 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.6 We regress the changes in these accounting

variables on the components of theM/Bratio while controlling for the amount of 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:

Post-issue investment in capital expenditures and R&D is positively related to the

long-run value-to-book component, and unrelated to the firm-specific error

component ofM/B.

Debt reduction is positively related to the firm-specific error component and

negatively related to the long-run value-to-bookcomponent ofM/B.

P i h i h i i i i l l d h fi ifi

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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 results from earlier studies (Graham and Harvey (2001), Kim

and Weisbach (2006), Elliot, Koeter-Kant, and Warr (2007), and DellaVigna and Pollet (2008))

suggesting that equity issue decisions are motivated by both misvaluation and financing needs.

The evidence is also consistent with the interpretation of the firm-specific error and long-run

value-to-bookcomponents ofM/Bas measures of misvaluation and growth options, respectively,

and thus paves the way for our examination of the alternative explanations of low post-issue

stock price performance.

Our last set of tests focus on the relation between post-issue stock price performance and

pre-issue components ofM/B. Behavioral theory predicts that post-issue stock returns should be

negatively correlated with the degree of overpricing at the time of issuance. In contrast, real

investment theory predicts a negative relation between post-issue stock returns and investment.

In these tests, we separate issuing firms into quartiles based on the misvaluation (firm-specific

error) and growth option (long-run value-to-book) components of M/B and then calculate long-

run post-issue abnormal returns for each quartile portfolio using calendar time factor regressions.

Our results are as follows:

We find a negative relation between the misvaluation component of M/B and

t i t i i fi ith hi h i l ti h ti t

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In contrast, we find no relation between the growth option component ofM/Band

post-issue returns; issuing firms with high levels of growth options do not have

lower post-issue abnormal returns than issuing firms with lower levels of growth

options. This evidence, taken in conjunction with our finding that issuing firms

with more growth options have higher levels of post-issue investment, is not

supportive of the real investment explanations of low post-issue stock returns.

Finally, we note that several previous studies of SEOs find that stock price

underperformance is primarily concentrated in small firms and argue that the post-issue

performance anomaly may be caused by asset-pricing model deficiencies when it comes to

valuing small firms.7 In robustness checks, we separate our sample of issuing firms into two size

groups: the small subsample includes all issuing firms with pre-issuance market capitalizations

below the 20% size breakpoint of NYSE stocks; the big subsample includes all other issuing

firms. We find that the negative relation between post-issue returns and the misvaluation

component of M/B holds for both size subsamples. For example, big firms with high

misvaluation components exhibit significant post-issue stock price underperformance, while

small firms with low misvaluation components do not underperform. These results suggest

that the stock price performance around SEOs is not simply a small firm effect; i.e., firm level

mispricing appears to be a stronger indicator of post-issue underperformance.

Th i d f th i i d f ll S ti 2 d ib th l

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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 match Compustat

accounting data for fiscal year twith CRSP market value data measured three months after the

fiscal year-end. The pre-SEO M/B ratio and its components are calculated using this match of

Compustat and CRSP data if the issuance takes place four months after the fiscal year-end (i.e.,

one month after the CRSP market value data is measured). Otherwise, the SEO is matched with

data from fiscal year t-1.

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/Bratio. We exclude firms that only issue

secondary shares as well as utility companies (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. 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 Market to book decomposition methodology

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concerns with the RKRV methodology (model misspecification and look-ahead bias) and how

these are addressed in our study.

3.1. Decomposing the market-to-book ratio

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 value-to-book ratio (V/B). This distinction underlies our

rationale for employing the RKRV methodology for decomposing M/Binto misvaluation (M/V)

and growth option (V/B) components as follows:

(1) M/B M/Vx V/B

which, in log form, can be written as

(2) )()( bvvmbm +

where lower case letters indicate logarithms of the respective variables.8 If markets know the

future growth opportunities, discount rates, and cash flows, then the term (m v) should be zero.

If markets make mistakes in estimating discounted future cash flows, or markets do not have

information that managers have, then (mv) will capture the misvaluation component of the

market-to-book ratio.

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expressed as a linear function of observable firm-specific accounting information, it , and a

vector of corresponding accounting multiples, . The RKRV methodology employs both a

vector of contemporaneous time-taccounting multiples, jt , and a vector of long-run accounting

multiples,j

, such that the market-to-book ratio for firm iat time tcan be further decomposed

into three components as follows:

(3)44 344 21444 3444 2144 344 21

booktovaluerunlong

itjit

errortor

jitjtit

errorspecificfirm

jtitititit bvvvvmbm

++= );();();();(

sec

The first term on the right hand side of Eq. (3), );( jtitit vm , referred to as firm-

specific error, measures the difference between market value and fundamental value estimated

using firm-specific accounting data, it , and the contemporaneous sector accounting multiples,

jt , and is intended to capture the extent to which the firm is misvalued relative to its

contemporaneous industry peers. The second term, );();( jitjtit vv , referred to as time-

series sector error, measures the difference in estimated fundamental value when

contemporaneous sector accounting multiples at time t, jt , differ from long-run sector

multiples, j

, and is intended to capture the extent to which the industry (or, possibly, the entire

market) may be misvalued at time t. The third term, referred to as long-run value-to-book,

measures the difference between firm value (implied by the vector of long-run sector multiples)

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income (NI) and market leverage ratio (LEV) in the accounting information vector. 9 Expressing

market value as a simple linear model of these variables yields:

(4) ititjtitjtitjtitjtjtit LEVNIINIbm +++++= +