Academic journal article Financial Management

The Information Effects of Analyst Activity at the Announcement of New Equity Issues

Academic journal article Financial Management

The Information Effects of Analyst Activity at the Announcement of New Equity Issues

Article excerpt

Stephen P. Ferris [*]

Myers and Majluf (1984) argue that informational asymmetry between managers and investors can explain the negative stock returns around the announcement of new equity. Using analyst following and consensus as proxies for information asymmetry, we observe that announcement period returns are significantly more negative for firms followed by fewer analysts and whose forecasts exhibit less consensus. Our findings hold after controlling for firm size and growth opportunities. Finally, we find evidence suggesting that analyst activity also influences firms' long-term performance. We conclude that the information role of security analysts partially explains the negative stock returns surrounding the announcement of new equity.

Current empirical research documents a significant decline in equity prices both around the announcement of a new equity issue and for the immediately subsequent years. Asquith and Mullins (1986) report that the mean announcement-period decline in equity value exceeds 30% of the projected value of the new equity offering. Mikkelson and Partch (1986) document a negative excess return of approximately 4% around the announcement of a common equity offering, and Barclay and Litzenberger (1988) report a 2.5% decline in equity values within three hours of the announcement of an issue. Sant and Ferris (1994) observe a 1.44% decline in equity values for a two-day period around the announcement of new equity for a sample of all-equity firms. Loughran and Ritter (1995) and Spiess and Affleck-Graves (1995) find that issuing firms underperform a matching sample of firms by at least 40% over the five-year period following the equity issue.

Several information-based models of security issuance might explain the consistently negative announcement-period stock price reaction. [1] These models are based on the hypothesis that the information sets of managers and insiders do not perfectly overlap with those of investors. For instance, Miller and Rock (1985) argue that since the firm's investment policy is fixed, the decision to issue equity signals poor earnings and cash flow. They predict a negative equity price reaction to the announcement of an equity issue. Similarly, Myers and Majluf (1984) contend that managers have superior information about the true value of the firm's assets in place and its future growth opportunities. They show that when managers believe their firm's equity is undervalued, they do not issue new equity. This decision not to issue maintains the value of existing shareholders' wealth. Conversely, managers issue equity when their firm's security is overpriced, resulting in a wealth transfer from new to current shareholders. A rational market, anticipating managers' opportunistic behavior, discounts the price of the issuing firm's equity.

Empirical evidence, such as that of Asquith and Mullins (1986), Dierkens (1991), Korajczyk, Lucas, and McDonald (1991), and Bayless and Chaplinsky (1996), indicates that information asymmetry between managers and outside investors is a robust explanation for the pattern of announcement-period returns around a new equity offering. Field (1995), Spiess and Affleck-Graves (1995), Loughran and Ritter (1997), and McLaughlin, Safieddine, and Vasudevan (1998) use a similar information-based argument to explain the long-run underperformance of issuing firms relative to a matched sample of nonissuers. [2]

Managers might attempt to mitigate the adverse selection problem faced by investors by issuing securities during periods of reduced information asymmetry. For example, Korajczyk, Lucas, and McDonald (1991) find that firms tend to issue equity after credible information releases and the market is most informed about the firms' quality. Bayless and Chaplinsky (1996) find that when there are low levels of information asymmetry (i.e., in hot markets) the announcement-period returns are significantly higher than in cold markets. …

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