In addition to the abnormal returns, we also aim to examine potential variables that may display a relationship with the abnormal returns. The below variables are rooted in previous literature regarding SEO firms’ stock performance. The hypotheses below will be tested for both short- and long-run stock performance.
3.3.1 Firm Size
In line with previous research with similar purposes of this thesis, firm size is defined by market capitalization. Compared to smaller firms, large firms generally experience less information asymmetry, which results in lower transaction costs for potential investors and more correctly valued shares (Stoll & Whaley, 1983). In other words, it is more difficult for larger firms to exploit windows of opportunity and hence, they should experience less underperformance than smaller firms, both in the short- and long-run. Brav et al. (2000) and Spiess & Affleck-Graves (1995) confirm this and document that in their studies, smaller firms perform the worst following an equity issue. Furthermore, due to their findings, Brav et al. (2000) argue that the significant underperformance can potentially be explained purely by the size-effect relating to smaller firms, rather than the equity issue itself.
However, other studies have documented that smaller, high-growth issuing firms perform better than large issuing firms. Cooney & Kalay (1993) explain this by referring to the extreme growth potential of smaller, successful firms and the opportunity for these firms to grow substantially relative to their original size. Nonetheless, we argue the following:
Hypothesis: The market capitalization of an issuing firm is positively related to the abnormal returns, both in the short- and long-run.
3.3.2 Relative Size of the Issue
Previous research has documented a negative relation between the size of the issue and the announcement returns (e.g. Asquith & Mullins, 1986; Masulis & Korwar, 1986; Choe, Masulis &
Nanda 1993). These findings are in accordance with the signaling theory (e.g. Jensen & Meckling, 1976; Leland & Pyle, 1977) since the possibility that management’s shareholdings will be diluted as consequence of a share issuance is increased given a larger sized issuance. As a result, investors relate the issuance as a negative signal. Furthermore, Gajewski & Ginglinger (2002) explain the underperformance owing to a larger issue size due to asymmetric information. An overvaluation of the shares will lead to more incentives to issue a larger amount of shares, and this larger issue has a negative impact in the long-run. Although previous research has focused on the issue size itself, we will put it in relation to the market capitalization of the issuing firm. This creates a ratio which should enable a suitable comparison between firms of different sizes. We argue that it is reasonable that larger
firms undertake larger equity issues in absolute numbers compared to smaller firms. However, these issues might prove smaller, when put in relation to the market capitalization. Therefore, the relative size might be better to depict the magnitude of an issue for a respective firm. As a larger issue, ceteris paribus, implies a larger relative size of the issue, the findings of previous research regarding the issue size should therefore be relevant for a comparison with our variable. This leads us to the following hypothesis:
Hypothesis: The relative size of the issue is negatively related to the abnormal returns of issuing firms, both in the short- and long-run.
3.3.3 Book-to-Market (B2M)
B2M is a ratio that puts a firm’s book value of equity in relation to its market value of equity. Hence, if the ratio is lower than one, the stock is overvalued by the markets. This implies that the market potentially views the future of the firm as profitable, since the market value is higher than the actual book value. However, some studies have documented the opposite relationship, namely that low B2M ratios generate lower returns (e.g. Daniel & Titman, 2006; Fama & French, 1992). The results are explained by the simple fact that these firms are more expensive due to their high valuation. For announcement returns, Denis (1994) documents that the announcement returns were negative for firms with low B2M values, although the return decline was less severe compared to firms with high B2M values. Jeanneret (2005) documents similar results and explains the phenomenon by reduced agency costs. As growth firms face many profitable investment opportunities, managers’ incentive to over-invest or to consume perks is reduced. In contrast, Loughran & Ritter (1995) report that a large portion of the issuing firms in their sample displayed low B2M ratios at the time of the issue. However, by including the B2M as an independent variable, Loughran & Ritter found that the long-run underperformance of SEO firms is consistent regardless of B2M ratio. Still, we form the following hypothesis:
Hypothesis: The book-to-market is positively related to the abnormal returns of issuing firms, both in the short- and long-run.
3.3.4 Frequent Issuers
Billett, Flannery & Garfinkel (2011) argue that the key factor determining long-run stock performance is how frequent a firm raises external capital, rather than if a firm raises external capital. With external capital, the authors refer to for instance SEOs, and debt issues. They argue that firms raising external capital several times significantly underperform compared to firms only raising external capital once.
In contrast with Loughran & Ritter (1995), Billet et al. are not able to prove a significant long-run underperformance for firms raising external capital only once. Spiess & Affleck-Graves (1995) test their findings with frequent issuers compared to firms issuing equity once, but found no difference in the results. A potential reason for the varying results between Spiess & Affleck-Graves and Billet et al.
could be that the latter tests all types of external financing and not only equity issues. Furthermore, Brav et al. (2000) argue that the negative relationship between equity issues and long-run stock performance can potentially be explained by firms that repeatedly require external financing in order to survive as they are not performing better once the capital is raised. This would imply that firms issuing equity several times (i.e. frequent issuers) are not able to generate sufficient internal funds (ibid).
Although the above studies discuss the long-run stock performance, it can be applied to announcement returns as well. If Brav et al.’s (2000) arguments hold, a firm announcing additional SEOs could imply that the firm still is in a tight financial situation, despite the first SEO, which would entail negative reactions. Thus:
Hypothesis: Frequent issuers are negatively related to the abnormal returns of issuing firms, both in the short- and long-run.
3.3.5 Momentum
In line with the pecking order theory, equity offerings are expected to follow a period of good stock performance (Myers & Majluf, 1984). The stock return momentum (i.e. stock price run-up) has been extensively researched in relation to announcement returns and numerous scholars have found a negative relationship (e.g Masulis & Korwar, 1986; Bayless & Chaplinsky, 1996; Choe et al., 1993;
Denis, 1994). This is explained by investors’ interpretation of the pre-SEO stock return momentum as a proxy for the private information managers possess regarding the true value of the firm. In other words, the higher the return momentum, the greater is the probability that the stock is overpriced at the time of
the issue. De Bondt & Thaler (1985) examine the impact of pre-announcement return behavior on the long-run performance. Their findings are in compliance with the overreaction hypothesis, stating that prior ‘losers’ outperform ‘winners’ over the 3 years following to a new event fueled by marked excess returns in the second and third year. This leads to:
Hypothesis: The momentum factor is positively related to the abnormal returns of issuing firms, both in the short- and long-run.
3.3.6 Industry
Asquith & Mullins (1986) as well as Masulis & Korwar (1986) detect more negative market reactions for industrial than for public utility firms and base these findings on the strict regulation imposed on public utility firms which suggests lower discretion for management to time SEOs. For the long-run however, Spiess & Affleck-Graves (1995) test the relationship between different industries and their subsequent long-run performance but they find no significant differences. However, according to Loughran & Ritter (1995), industry-specific differences in asymmetric information can potentially provide different results since managers choose to issue equity when the stock is overvalued. As an example, the authors use “hot” industries (e.g. the IT-industry in the late 1990s) and argue that this might lead to more SEOs and consequently long-run underperformance compared to other industries.
In addition, Loughran & Ritter claim that high-tech industries might demand more capital to cover R&D costs, as these costs do not generate revenue during certain periods, requiring those firms to issue equity more frequently. Despite these arguments, we argue:
Hypothesis: The industry is related to the abnormal returns of issuing firms in the short-run, but it is not related to the abnormal returns in the long-run.
4 Methodology
The following chapter has the objective to give an understanding of the methodology employed in order to answer our research questions. Initially, the scientific approach and sample selection are discussed. Subsequently, the chapter introduces the methodologies employed to measure announcement returns and long-run stock performance as well as the examined variables.