Negative Reactions to Common Stock Offerings

Negative reactions to common stock offerings - does it make sense?

There are two types of common stock offerings - primary and secondary offerings. A primary offering of common stock by a firm on an exchange is a company's first foray onto the capital markets. A secondary offering is a follow-on offering made by a firm whose stock is already trading on a public market.

In the first case, there is ample evidence that initial public offerings (IPOs) underperform the market over the long run (Brav and Gompers, 1997). Initially, there is an "overshoot" in terms of excitement over the prospects of a new firm, which will typically lead to disappointment and negative returns: "investors are periodically overoptimistic about the earnings potential of young growth companies" (Ritter, 1981). "Underpricing" (Brav and Gompers, 1997) contributes to this underperformance phenomenon by driving initial share prices to far higher levels than they should have ever attained at the outset.

When considering secondary offerings, the market will typically react negatively simply because such offerings, by increasing the number of shares traded on the market, dilute ownership - and in the long run this will typically translate into lower market returns, unless the company does phenomenally well and increases value at a much higher rate (so that sometimes such IPOs will be considered to be a signal for better things to come). Research has demonstrated, however, that over the long run secondary offerings significantly underperform the markets. The effect is exacerbated by "managers exploiting "windows of opportunity" by issuing overvalued shares" (Clarke Dunbar and Kahle, 2004).

What should you know as an investor?
Stay away from IPOs...

ragingacademic

References

Brav, Alon, and Gompers, Paul A. (1997). Myth or Reality? The Long-Run Underperformance of Initial Public Offerings: Evidence from Venture and Nonventure Capital-Backed Companies. Journal of Finance, Dec, Vol. 52 Issue 5, p1791-1821

Clarke, J., Dunbar, C. and Kahle, K. (2004). Journal of Business, Jul, Vol. 77 Issue 3, p575-603

Ritter, Jay R. (1991). The Long-run Performance of Initial Public Offerings. Journal of Finance, Mar, Vol. 46 Issue 1, p3