IPO Underpricing, Firm Quality, and Analyst Forecasts

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IPOUnderpricing, Firm Quality, andAnalyst ForecastsSteven X. Zheng and David A. Stangeland*We find that IPO underpricing is positively related to post-IPO growth in sales and EBITDA, butis not significantly related to growth in earnings. Our evidence suggests that accrual reversals orearnings management may cause this inconsistency. We interpret the growth rates of sales andEBITDA as measures offirm quality, and conclude that our evidence supports the notion that IPOfirms with greater underpricing are of better quality. Our tests on analysts 'earnings forecast errorsshow that analysts are less positively biased in their earnings forecasts for IPO firms that havegreater underpricing.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 IPOunderpricing 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 performancevariables (such as earnings) as measures of firm quality, then this suggestion implies a positiverelation between IPO underpricing and growth rates. Our hypothesis is that IPO firms with greaterunderpricing 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 EBITDAand growth in sales. Relative to earnings, these latter variables are more difficult for managers tomanipulate. Thus, to reduce the possible contamination of our analysis by earnings managementstrategies, we consider the growth rates of earnings, EBITDA, and sales, and how they relate to IPOunderpricing.Consistent with our hypothesis, we find that underpricing is positively related to growth in salesand EBITDA in the five years following an IPO. These results suggest that the IPOs with greaterunderpricing have higher quality. We also find that IPO growth rates in earnings are much lowerthan the growth rates in sales and EBITDA. Further tests show that this inconsistency is likelycaused by earnings management at the time of the IPO, which inflates earnings initially and thusreduces earnings growth rates in subsequent years. This result suggests that earnings growth ratesmay not be accurate measures of IPO firm quality compared to sales and EBITDA growth rates. Wefind that the firms with greater underpricing experience larger decreases in accruals after the firstyear. This finding implies that earnings management may also reduce the correlation between IPOunderpricing and earnings growth rates.We examine the accuracy of analysts' earnings forecasts to determine how analysts react to therelation between IPO growth rates and IPO underpricing. If analysts are misled by earningsWe thank Mark Huson, participants at the 2005 Northern Finance Association Conference, and, in particular Bill Christie(the Editor) and an anonymous referee for helpful comments and suggestions. The authors gratefully acknowledge thecontribution of Thompson Financial for providing earnings forecast data, available through I/B/E/S (Institutional BrokersEstimate System).*Steven X Zheng is an Assistant Professor of Finance and David A. Stangeland is the CMA Professor of Strategic FinancialManagement at the University of Manitoba in Winnipeg, Manitoba, Canada.Financial Management * Summer 2007 * pages 45 - 64This content downloaded on Tue, 12 Mar 2013 17:41:08 PMAll use subject to JSTOR Terms and Conditions
46 Financial Management * Summer 2007management, they may predict higher future earnings for the IPOs with greater underpricing. Ourtest results do not support this conjecture.The paper is organized as follows. In Section I, we review the relevant prior research anddevelop 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 IPOunderpricing. We report our examination of analysts' earnings forecast errors in Section IV.Section V presents our conclusions.I. Prior Research and Hypotheses DevelopmentNumerous 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 resultif IPO demand is unexpectedly strong. Informed investors will attempt to buy shares onlywhen an issue is underpriced. Uninformed investors do not know which issues will beunderpriced or overpriced, and so they will be allocated only a fraction of the most desirablenew issues, and allocated all of the least desirable new issues. Faced with this adverse selectionproblem, uninformed investors will usually submit purchase orders only ifIPOs are underpricedenough to compensate them for the bias in the allocation of new issues. Beatty and Ritter(1986), Koh and Walter (1989), and others provide empirical evidence consistent with Rock's(1986) model.One implication of Rock's model is that greater underpricing will result for firms that informedinvestors identify as having good quality. Several other papers have similar predictions. Thesignalling models in Allen and Faulhaber (1989), Welch (1989), and Grinblatt and Hwang (1989)suggest that in order to signal their good quality, IPO firms are intentionally underpriced. In thesemodels, the IPO firm itself knows its prospects best. The firms with the most favorable prospectsfind it optimal to signal their type by underpricing their initial issue, because they can expect torecoup the cost of underpricing in subsequent seasoned issues. Low-quality firms must invest inimitation expenses to appear to be high-quality firms; and with some probability this imitation isdiscovered between offerings (Welch, 1989). The underpricing ofhigh-quality firms at the initialpublic offering adds sufficient signaling costs to the imitation expenses of low-quality firms andmakes the expected gain from imitation negative. Thus, low-quality firms abandon the imitationstrategy and voluntarily reveal their quality. This argument implies that low-quality firms do notunderprice their IPOs as much as do high-quality firms, so investors correctly perceive underpricingas a signal of the firm's quality.If we use growth rates of accounting performance measures as indicators of firm quality, thenthe models we cite above imply that IPO underpricing should be positively related to these growthrates. Therefore, we hypothesize that IPO underpricing should be positively related to growthrates in sales, EBITDA, and earnings. This hypothesis is consistent with the results in Chung, Li,and Yu (2005) that IPO underpricing is positively related to the fraction of the offer price that isaccounted for by the present value of growth opportunities.II. Sample and Data DescriptionIn this section we describe the sample, the growth rates of accounting performance variablesfor the IPOs in the sample, and the changes in accruals for the IPOs.This content downloaded on Tue, 12 Mar 2013 17:41:08 PMAll use subject to JSTOR Terms and Conditions
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IPO Underpricing, Firm Quality, and Analyst Forecasts

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