Blog - Investing Notes

November 30, 2006 - When a Secondary Stock Offering Is (or Is Not) Bad News

Do firms issue more stock when their officers see compelling uses for new funds, or when these executives think company stock is overvalued? In the November 2006 draft of their paper entitled "Behavioral and Rational Explanations of Stock Price Performance around SEO's: Evidence from a Decomposition of Market-to-Book Ratios", Michael Hertzel and Zhi Li first use firm accounting data to decompose market-to-book ratios into misvaluation and growth opportunity components, and then examine how these components relate to company stock returns after secondary offerings. Using financial and stock return data for a sample of 4,325 seasoned equity offerings during 1970-2004, they conclude that:

• Firms issuing additional shares have a relatively high average market-to-book ratio, reflecting a mix of overvaluations and strong growth opportunities relative to the overall market.
• Firms with strong growth opportunities tend to use proceeds from secondary offerings to increase capital expenditures and R&D. Such firms do not exhibit abnormally low post-issue stock returns.
• In contrast, firms that are overvalued tend to use proceeds from secondary offerings to decrease long-term debt and increase cash. These firms do produce abnormally low post-issue stock returns. Equally weighted portfolios of stocks for the most overvalued quartile of issuing firms generate significantly negative returns of -0.54% per month (-19.4% after 3 years) over several years. Negative returns for value-weighted portfolios are less pronounced.
• Overall results are supportive of a misvaluation (behavioral) explanation for stock returns after secondary stock offerings.

In summary, secondary stock offerings are bad news for companies in financial management mode and neutral news for companies in growth mode. Firm accounting data indicate a company's mode.

A study of earnings management (via accruals) around secondary offerings, a mirror image of the study done for stock repurchases as described in our blog entry of 11/27/06, would be interesting. Do some firms (the misvalued ones above) use accruals to manage earnings upward prior to secondary offerings?

For related research, see Blog Synthesis: Buybacks and Secondaries.