Mispricing of Initial Public Offerings (IPOs): The Role of Accounting Information

Abstract

I examine the role of accounting information in the end-of-first day overpricing of IPO stocks. Sloan (1996) and Teoh et al. (1998) suggest earnings-based explanations for the mispricing while Healy and Palepu (1990) suggest a risk-based explanation. In view of the conflicting explanations for the end-of-first-day mispricing of IPOs from prior studies, I first examine which possible explanation (earnings-based vs. other) is consistent with my sample IPO firms. For this task, I employ the methodology first suggested by Bernard et al. (1997). This involves an examination of post-IPO abnormal returns. The results of my main tests using all my sample IPO firms suggest that, on average, the mispricing of IPOs is consistent with earning-based explanations. That is, the mispricing arises from market participants failing to incorporate the implication of pre-IPO earnings components for future earnings as in Sloan (1996). However, life cycle tests discussed later suggest that this result may be driven by growth firms.

I extend my examination to investigate the role of life cycle in IPO mispricing since life cycle has been offered as a possible explanation (e.g., Liu 2008) but the role of life cycle is largely unexplored. Thus, I examine possible mechanisms by which life cycle could affect IPO pricing. I examine two specific research questions. The first question is whether life cycle has any effect on IPO mispricing beyond affecting the relative proportion of accruals and cash flows. In this regard, I find no evidence that life cycle stage explains post-IPO abnormal returns, whether used alone in a regression explaining post-IPO returns, or used together with accrual and cash flow ranks. The second question I address is whether life cycle affects the form of mispricing (earnings-based vs. other) and I document some evidence that life cycle moderates the type of mispricing. Specifically, the mispricing of growth- (mature-) stage sample IPO firms is (is not) consistent with earnings-based explanations. My evidence regarding the mispricing of decline-stage firms is mixed: the timing and associations tests provide evidence that the mispricing of decline-stage firms is consistent with earnings-based explanations; the combined test provides evidence consistent with other explanations. Thus, it seems that earnings play a role in the mispricing of decline stage IPOs but not in the Sloan (1996) sense.

This evidence has implications for the role of earnings in explaining future prospects, and hence value, of a firm. Specifically, it raises questions about why investors seemingly do a poor job of predicting the future prospects of growth and decline stage firms using current period earnings information when the opposite seems to be true for mature firms. Regulators might be interested to know what disclosures would mitigate this problem.