Academic journal article Financial Management

IPO Underpricing, Firm Quality, and Analyst Forecasts

Academic journal article Financial Management

IPO Underpricing, Firm Quality, and Analyst Forecasts

Article excerpt

We find that IPO underpricing is positively related to post-IPO growth in sales and EBITDA, but is not significantly related to growth in earnings. Our evidence suggests that accrual reversals or earnings management may cause this inconsistency. We interpret the growth rates of sales and EBITDA as measures of firm quality, and conclude that our evidence supports the notion that IPO firms with greater underpricing are of better quality. Our tests on analysts 'earnings forecast errors show that analysts are less positively biased in their earnings forecasts for IPO firms that have greater underpricing.

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In this paper we examine the relation between initial public offering (IPO) underpricing and post-IPO growth rates of accounting performance variables. Previous research on IPOs suggests that IPO underpricing is related to the quality of the IPO firms (Allen and Faulhaber, 1989, Welch, 1989, Grinblatt and Hwang, 1989, and Rock, 1986). If we use growth rates of accounting performance variables (such as earnings) as measures of firm quality, then this suggestion implies a positive relation between IPO underpricing and growth rates. Our hypothesis is that IPO firms with greater underpricing should have higher post-IPO growth rates of accounting performance variables. However, rather than just concentrate on growth in earnings, we also include growth in EBITDA and growth in sales. Relative to earnings, these latter variables are more difficult for managers to manipulate. Thus, to reduce the possible contamination of our analysis by earnings management strategies, we consider the growth rates of earnings, EBITDA, and sales, and how they relate to IPO underpricing.

Consistent with our hypothesis, we find that underpricing is positively related to growth in sales and EBITDA in the five years following an IPO. These results suggest that the IPOs with greater underpricing have higher quality. We also find that IPO growth rates in earnings are much lower than the growth rates in sales and EBITDA. Further tests show that this inconsistency is likely caused by earnings management at the time of the IPO, which inflates earnings initially and thus reduces earnings growth rates in subsequent years. This result suggests that earnings growth rates may not be accurate measures of IPO firm quality compared to sales and EBITDA growth rates. We find that the firms with greater underpricing experience larger decreases in accruals after the first year. This finding implies that earnings management may also reduce the correlation between IPO underpricing and earnings growth rates.

We examine the accuracy of analysts' earnings forecasts to determine how analysts react to the relation between IPO growth rates and IPO underpricing. If analysts are misled by earnings management, they may predict higher future earnings for the IPOs with greater underpricing. Our test results do not support this conjecture.

The paper is organized as follows. In Section I, we review the relevant prior research and develop our hypotheses. We describe the sample and discuss sample characteristics in Section II. In Section III, we describe our tests conducted on the relation between IPO growth rates and IPO underpricing. We report our examination of analysts' earnings forecast errors in Section IV. Section V presents our conclusions.

I. Prior Research and Hypotheses Development

Numerous studies show that IPOs are underpriced (see, for example, Ibbotson, 1975, Ritter, 1984, Hanley, 1993, and others). One important rationale for the underpricing of IPOs is the "winner's curse" explanation introduced by Rock (1986). Rock argues that rationing will result if IPO demand is unexpectedly strong. Informed investors will attempt to buy shares only when an issue is underpriced. Uninformed investors do not know which issues will be underpriced or overpriced, and so they will be allocated only a fraction of the most desirable new issues, and allocated all of the least desirable new issues. …

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