Theoretically, the stock returns should correlate positively with operating performance. Poor performing firms are expected to have depressed stock prices. Thus, operating performance explains the stock performance of the firm. A number of studies have shown the stock market response to the issue of seasoned equity. The evidence is unanimous across several economic environments that there is a negative stock returns following equity issuance transactions. However, our understanding of the level of operating performance at the time and subsequent to equity issues is limited. Anecdotally, negative stock returns are expected to reflect deteriorating operating performance of the firms. Thus, from market timing standpoint, high operating performance should reflect the stock price run-up and high market-to-book ratio of equity issuing firms. Similarly, as stock price declines after the equity issuance transactions, operating performance is expected to equally deteriorate to give support to the underlying reasons for the adverse market reactions. In the context of issuance method, it can be argued that issuance method that mimics the market timing or information asymmetry theory should demonstrate similar reactions and effects as the equity offerings. Thus, high market-to-book ratio, stock price run-up and high operating performance should precede the announcement of the equity issues.
Empirical research covering this thesis include but not limited to Healy and Palepu (1990) who find no earnings effects following equity issues. They contend that SEO do not convey new information about earnings. However, Loughran and Ritter (1997) demonstrate that operating performance of equity issuing firms is significantly high prior to the issuance date. These firms subsequently report deteriorating performance that reflects the decline in stock returns. Teoh et al. (1998) as well as Rangan (1998) also assert that the
activities of firms „managing their earnings‟ in the lead up to the issuance decision underperform. Similar effects can be investigated when equity issues are disintegrated into the different issuance methods available to firms, especially in the UK. Kabir and Roosenboom (2003) study rights issues in the Netherlands and find that firms experience significant stock price decline at the
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announcement of rights offerings. Rights offerings are the dominant flotation method in the Netherlands unlike UK where firms have choice among rights issues, open offers and private placement including variants of these methods. This compares well with the US where firm commitment is the only method adopted for equity issuing transactions. This study differs markedly from Kabir and Roosenboom (2003) since it considers three equity issuance methods that are available to UK firms. I explore the effects of differential operating performance on the choice of equity issuance methods among UK firms. Their study covers the period from 1984 to 1995 for a total 67 rights issues (final sample of 58 issues) conducted by 62 different companies listed on the Amsterdam Stock Exchange. Rights issuing firms record announcement date abnormal return of -2.0% which decreases further to -2.8% in the next two days. Consistent with the stock price decline, operating performance subsequently deteriorates. This shows that negative stock return is not an anomaly but indicate market perception of the adverse operating performance after the issuance activity. Using return on assets measures such as net income to total assets, EBITDA to total assets as well as return on sales metrics like net income to sales and EBITDA to sales, they find consistent negative operating performance over 5-years after the equity issues. Information asymmetry between firms and shareholders explain this trend but they find no evidence of rights issues in response to favourable market conditions.
Also, differences in type of firms can account for the post-issue performance of firms conducting private placement. The equity issuance literature is replete with evidence that overvalued firms underperform the market subsequent to the issuance decisions. The work by Baker and Wurgler (2002) highlights the long run effects of mispricing on capital structure. Other studies such as Dong et al (2012), also find evidence in support of the overvaluation-performance relationship. As noted earlier Hertzel et al (2002), provide consistent relationship between stock returns and operating performance following equity issues. Chi and Gupta (2009) also assert that overvalued firms are more likely to engage in earnings management that explains the subsequent underperformance. However, differences such as the degree of overvaluation
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and/or the level of growth opportunities can distinguish firms in terms of the level of underperformance.
Using a sample of 371 private placements between the period 1980 and 2000, Chou et al. (2009) explain the post-issue performance of private placements in relation to growth opportunities. High growth firms are more likely to manage earnings (Skinner and Sloan, 2002; McNichols, 2002). Thus, the perception for firms to engage in earnings management stimulates the adverse effects of private placements on stock returns. Market reactions reflect the notion that firms cannot maintain the high reported earnings prior to the equity issues. High growth opportunities evoke both management and investor optimism about the prospects of the firm (Hertzel et al, 2002; Marciukaityte et al, 2005). Overall, they find that high growth firms record negative 3-year abnormal stock returns between -15% and -37% that is consistent with the poor operating performance within the same time period. However, the cross-sectional regression of the abnormal returns is too simplistic since it does not capture the effects of factors such as issue discount, the level of demand and the other corporate governance factors.
Moreover, firms that manage earnings always struggle to maintain the same level of performance. Earnings that are backed by actual revenue generating activities are likely to be repeated in subsequent years. However, managed earnings are not consistent with the underlying business prospects. Chen et al. (2010) find evidence that firms that conduct private placement overstate their earnings prior to the announcement. Investors are unable to detect the excessive accruals in the earnings but subsequent earnings reversal causes the stock price to decline. These earnings reversals imply the firm is unable to sustain or justify the prior period earnings because the core business and revenue generating activities deviate from the reported figures. This phenomenon is consistent with the poor operating performance that occurs in the long run after the announcement of the private placement.
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3.5. Testable Hypotheses
The evidence on financing decisions in the literature is varied and wide. Evidence in support of market timing asserts the overriding effects of valuation in determining the decision to issue equity or repurchase at specific times. For instance, Baker and Wurgler (2002) affirm that market timing enables companies to issue equity at high prices and repurchase at low prices. Hence, a coherent understanding of market timing prospects should occur at the point where at high (low) stock prices firms are also significantly overvalued (undervalued) to force equity issue (repurchase). Consequently, in a perfect and rational economic environment, market timing should generate immediate negative (positive) market reactions for equity issues (repurchase). Differences in the level of anticipated operating performance should explain the choice of equity issuance method.