Post offering earnings performance of firms that issue seasoned equity: the role of growth opportunities.

The significant negative stock price reaction to the announcement of seasoned equity offering (SEO), well documented in several studies summarized in Smith (1986), has been attributed to negative information about the prospect of the issuing firm. To formalize this information effect, Myers and Majluf (1984) develop the overvaluation hypothesis. This hypothesis suggests that in an asymmetric information world where managers possess superior information about the value of their firm, they have an incentive to issue new equity when their firm is overvalued. Consequently, the market interprets the SEO announcement as unfavorable information about the issuing firm and thus revises the value of the issuing firm downward upon the announcement. Further empirical support for this overvaluation hypothesis can be found in Loughran and Ritter (1995) and Spiess and Affleck-Grave (1995) which show that issuing firms experience substantial and significant stock price underperformance over an extended period of five years following their SEOs.

In an attempt to examine the information content of SEO, Hansen and Crutchley (1990) find significant decline in the earnings performance of issuing firms. They also find a significant negative relationship between the relative issue size and the post offering earnings performance, and conclude that their findings are consistent with the earnings downturn hypothesis. Further evidence on the negative earnings performance is reported by Patel, Emery and Lee (1993), who conclude that their findings are consistent with the overvaluation hypothesis of Myers and Majluf (1984). In addition, Brous (1992) and Jain (1992) find that security analysts significantly lower their forecasts on short term earnings of issuing firms in response to the SEO announcement. On the other hand, Healy and Palepu (1990) find significant increase in the stock beta, resulting from significant increase in business risk, of issuing firms. They do not observe any significant change in the earnings performance of issuing firms.

While selling overvalued securities can be the motivation for firms to issue seasoned equity, it is not necessarily the case. Seasoned equity offerings can also be motivated by a need to finance profitable investments, especially in the case of growth firms that have superior investment opportunities. Therefore, while addressing the question on the information content of SEO one must consider the growth opportunities of issuing firms. The theoretical relationship between growth opportunities and the information content of SEO has been postulated in asymmetric information models by Ambarish, John and Williams (1987) and by Cooney and Kalay (1993).(1) These models show that the SEO announcement could indicate positive information associated with superior growth opportunities of the issuing firm, and thus could lead to a positive stock price reaction.

Ambarish et al. (1987) distinguish between the information content of the SEO announcement for the value of assets-in-place and the value of growth opportunities. When growth opportunities are the major source of information asymmetry, as in the case of growth firms, the decision to issue conveys favorable information about the firm and a positive stock price reaction is expected. On the other hand, if assets-in-place are the dominating source of information asymmetry, as in the case of mature firms, the decision to issue conveys unfavorable information about the firm and a negative stock price reaction is expected. Cooney and Kalay (1993) also present the scenario where the announcement effect and the information content of SEO can be favorable. In their refinement of Myers and Majluf's (1984) model, they allow the existence of negative NPV investments and show that the greater the variability of possible project values, the greater the possibility of a positive reaction to the SEO announcement. Since the variability of possible project values is greater for firms with more growth opportunities, Cooney and Kalay (1993) thus illustrate the possibility of a favorable stock price reaction and information content for firms with growth opportunities. In other words, both models suggest a positive relationship between the growth opportunities of issuing firms and the information content of seasoned equity offerings.

The empirical relationship between growth opportunities and the stock price reaction to the SEO announcement has been studied by Pilotte (1992) and Denis (1994). Pilotte (1992) finds that the stock price reaction is significantly and positively related to measures of growth opportunities, including Tobin's q. However, he does not find a significant positive stock price reaction for growth firms. Denis (1994) finds that the stock price reaction for low growth firms is significantly negative, whereas the reaction for high growth firms is insignificantly negative. In summary, although there are some empirical support for a positive relationship between growth opportunities and the stock price reaction to the SEO announcement, the support is at most weak.

Empirical support for a relationship between growth opportunities and the long run post offering stock price underperformance of issuing firms is strong but the direction runs opposite to that predicted by Ambarish et al. (1987), and Cooney and Kalay (1993). In addition, Spiess and Affleck-Grave (1995) find that the degree of post offering stock price underperformance is greater among issuing firms that are in the lowest capitalization value quintile and/or the lowest book-to-market value ratio quintile. Using Tobin's q to classify issuing firms into growth and mature firms, Lee (1993) finds that growth firms experience greater and more permanent stock price underperformance than mature firms subsequent to their SEOs. These studies suggest that long run post offering stock price performance of issuing firms is negatively related to the growth potential of issuing firms.

The findings of a positive but weak impact of growth opportunities on the stock price reaction to the SEO announcement, and a negative but significant impact of growth opportunities on the long run post offering stock price performance, demand further examination on the role of growth opportunities in the information content of seasoned equity offerings.

The objective of this study is to provide further evidence on the role of growth opportunities in the information content of seasoned equity offerings by examining the earnings and operating performance of issuing firms. This study extends earlier empirical studies on earnings …