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Information disclosed in IPO prospectuses bears little relationship to stock price, study finds

August 1, 2003

For more information, contact: Benjamin Haimowitz, HHaimowitz@aol.com

As if the Securities and Exchange Commission doesn't have enough to occupy it these days, a new study suggests the agency will do well to re-examine the filing requirements for initial public offerings, the process by which privately-owned firms take their stock public.

The study, presented at the 2003 annual meeting of the Academy of Management (Seattle, Aug. 3-6), finds "virtually no evidence that investment bankers utilize information reported in the prospectus filing or which is otherwise publicly available, when setting the offering price or the offering spread."

"The offering may be called public, but in key respects it seems to have more to do with private knowledge not available to the average investor than with what is in the prospectus," comments Catherine Daily of Indiana University, who carried out the research with Indiana colleague Dan R. Dalton and S. Trevis Certo of Texas A&M University.

The study finds little relationship between the offering spread or offering price of IPO shares and the information most commonly found in prospectuses -- including whether or not the CEO is the company's founder, how much equity the CEO has in the firm, how many members there are on the board and how many other boards they sit on, what proportion of the firm's stock is held by venture capitalists, and how profitable the firm is.

"Given that investment bankers evidently incorporate none of these factors in setting the offer price spread and...offer price," Daily and her colleagues state, "we wonder if oversight bodies such as the SEC should re-examine their filing requirements and perhaps consider requiring additional, or different, information at the time of the IPO registration."

A second study presented at the Academy of Management meeting also investigates the effect of a variety of factors on IPO valuations (firms' market capitalization at the end of the first day of trading). The study's principal author, Eric Jackson, who did research on IPOs as a doctoral student at Columbia University, says that the information most useful in gauging valuations is not well reported in many IPO prospectuses. Dr. Jackson is now VP of Strategy and Business Development for VoiceGenie, a Toronto software firm.

Jackson and his study co-author, Donald Hambrick of Penn State University, found that opening-day valuations of IPOs were best predicted by the number of top companies a firm's directors and top executives have been associated with -- whether top companies in the same industry or national blue-chip companies. Potential IPO investors will be hard-pressed to find detailed information of this kind in a prospectus, Dr. Jackson says.

"IPO prospectuses are very much a mixed bag in terms of providing detailed biographies of a firm's officers and directors," says Jackson. "About 45 percent are quite thorough. Another 20 percent are okay but not great. And the remaining 35 percent are of little use. Considering that the prestigious ties of the company's leaders contribute significantly to the stock price of IPO firms, the SEC could help investors by requiring fuller reporting of their backgrounds."

Prof. Daily and her colleagues based their findings on a review of 213 IPO prospectuses from 1996 and 1997, before the advent of the Internet bubble and the anomalies associated with it. Through a survey of the documents, they sought to gauge the relationship between the information most frequently found there and two variables -- 1) the offer price spread -- that is, the investment bank's preliminary estimate of the stock's price expressed as a range between a high and low value; and 2) the offer price, at which the investment bank sold stock to initial investors on the opening day of trading.

Boiling the most frequently provided information down to 10 variables, the investigators found that only one of the 10 (the proportion of outsiders on the board of the IPO firm) had a significant effect on the offer price spread and only two of the 10 (firm size and age) had a significant effect on the offer price.

Why the lack of relationship between information and price? Daily notes that investment banks have frequently been criticized for pushing the offering price of IPOs to an artificially low level so that favored clients of the banks reap rich rewards when the stock rises to a more appropriate price. A plausible interpretation of the study's findings, she says, is that "low price trumps data."

"In any event," she adds, "the study certainly casts doubt on the usefulness of IPO prospectuses, even though the SEC requires that a host of information be disclosed in them. If the intent is to help investors ascertain the prospects for the IPO firm, it would seem sensible to incorporate more of the factors on which investment bankers rely in their pricing decisions."

The Academy of Management, founded in 1936, is the largest organization in the world devoted to management research and teaching. It has over 13,000 members in 90 countries, including some 9,000 in the United States. The academy's 2003 annual meeting drew some 6,000 scholars and practitioners to Seattle for more than 1,000 sessions on a host of issues relating to corporate organization, the workplace, technology development, and other management-related subjects.

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