Behavioral and rational explanations of stock price performance around SEOs: *Evidence from a decomposition of market-to-book ratios
Michael G. Hertzel
Department of Finance
W. P. Carey School of Business
Arizona State University
Phone: (480) 965-6869
Department of Finance
W. P. Carey School of Business
Arizona State University
Phone: (480) 965-3131
First Draft: August 30, 2006
； 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
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 Rhodes-Kropf, Robinson and Viswanathan (2005) methodology to decompose market-to-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-
issue performance with investment activities.
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 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 choose to issue equity when firms are overvalued, and that investors are slow to recognize and incorporate information conveyed by SEO announcements. 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 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
1relation between investment level and future stock returns.
1 There are other theories that address post-issue stock price underperformance. Titman, Wei, and Xie (2004) argue managers are empire-builders and destroy firm value by overinvestment. Eckbo, Masulis, and Norli (2000) posit that SEO firms have lower risk levels due to lower leverage and higher stock liquidity after issuance. Brav, Geczy, and Gompers (2000) argue that SEO underperformance may reflect a return pattern in publicly traded small and high M/B firms. Finally, Fama (1998) argues that „underperformance‟
may be caused by model misspecification.
In this paper, we provide evidence on these alternative explanations using a methodology developed by 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. 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, consistent with the investment-based rational theories. By decomposing issuing firm 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-book. Firm-specific error measures firm-specific deviations from valuations implied by current sector accounting multiples, and is intended to capture the idiosyncratic 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. Long-run value-to-book measures value implied by long-run sector accounting multiples relative to book value; it is a proxy for growth opportunities.
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
motivated by either high levels of misvaluation, high levels of growth opportunities, or both.
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 sector error components of M/B reflect misvaluation, there should be no relation to
subsequent post-issue investment.
To investigate post-issue investment, we follow the approach of Kim and 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:
； Post-issue investment in capital expenditures and R&D is positively related to
the pre-issue level of long-run value-to-book, and unrelated to the firm-
specific error component of M/B.
； Debt reduction is positively related to firm-specific error and negatively
related to long-run value-to-book.
； Post-issue changes in cash positions are positively related to firm-specific
error, but unrelated to long-run value-to-book.
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 as a measure of misvaluation. These results hold when we measure misvaluation as the sum of firm-specific error and time-series sector 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 using calendar time factor regressions. Our results are as follows:
； We find no relation between long-run value-to-book ratios and post-issue
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
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.
； In contrast, we do find a relation between firm-specific error and post-
issue returns; issuing firms with high firm-specific error have more
negative post-issue abnormal returns. The results are stronger when we
measure misvaluation as the sum of firm-specific error and time-series
sector error. Evidence that more overvalued firms have lower post-issue
abnormal returns is consistent with the behavioral explanation of low post-
The remainder of the paper is organized as follows. Section 2 describes the sample selection procedure and the data. Section 3 describes our empirical methodology and Section 4 presents our findings. Section 5 concludes.
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 match the SEO with the previous year‟s information.
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
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 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:
~ (1) M/B M/V x V/B
which in log form can be written as
2where lower case letters indicate logarithms of the respective variables. 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 (m–v) will capture the
3misvaluation component of the market-to-book ratio.
3.2. Estimating market value
A critical element in identifying the components of the market-to-book ratio is determining an estimate of true firm value, v. For estimation purposes, for each firm i in
industry j at time t, v can be expressed as a linear function of firm-specific accounting information,, and a vector of corresponding accounting multiples, . As described ：，it
below, the RKRV methodology employs both a vector of contemporaneous time-t
accounting multiples,，, and a vector of long-run accounting multiples, ，. Thus, the jtj
market-to-book ratio for firm i at time t can be further decomposed as:
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, m；v(：;，), referred to as firm-specific error, measures the difference between ititjt
market value and fundamental value estimated by firm accounting data and ：it
，v(：;，)；v(：;，)contemporaneous sector accounting multiple. The second term, , jtitjtitj
2 We adopt the same notation and our discussion below closely mirrors that in RKRV (2005). 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.
referred to as time-series sector error, measures the difference in estimated fundamental
value when contemporaneous sector accounting multiples at time t, , differ from long-，jt
run sector multiples, . This difference reflects the extent to which the whole sector (or, ，j
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, in addition to misvaluation, the error components also reflect firm-specific deviations 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
4investigated by RKRV, 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 of firm-specific and time-series sector error.)
The third term,, is long-run value-to-book. It measures the v(：;，)；bitjit
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 the market-to-book ratio.
Rhodes-Kropf, Robinson and Viswanathan (2005) use three different models to
v(：;，)v(：;，)estimate and. The models differ only with respect to the accounting itjtitj
items that are included in the accounting information vector,. To save space, we focus ：it
on RKRV‟s third model, which includes book value (b), net income (NI) and market
4 RKRV test theories of mergers where industry misvaluation plays a central role.