JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS Vol. 45, No. 4, Aug. 2010, pp.

935958
COPYRIGHT 2010, MICHAEL G. FOSTER SCHOOL OF BUSINESS, UNIVERSITY OF WASHINGTON, SEATTLE, WA 98195
doi:10.1017/S002210901000030X
Behavioral and Rational Explanations of Stock
Price Performance around SEOs: Evidence
from a Decomposition of Market-to-Book
Ratios
Michael G. Hertzel and Zhi Li

Abstract
We examine the extent to which investment opportunities and/or mispricing motivate eq-
uity issuance and contribute to post-issue stock underperformance. We decompose market-
to-book ratios into misvaluation and growth option components and nd that issuing rms
are both overvalued and have greater growth opportunities relative to nonissuers. Firms
with greater growth opportunities invest more in capital expenditures and research and de-
velopment (R&D) after issuance but do not experience lower post-issue stock returns. In
contrast, issuing rms with greater mispricing tend to decrease long-term debt and/or in-
crease cash holdings and do earn lower returns. Our ndings are consistent with behavioral
explanations for post-issue stock price underperformance.
I. Introduction
It is well documented that rms conducting seasoned equity offerings (SEOs)
experience signicant stock price run-ups in the year prior to the offering and low
stock returns over the subsequent 35 years. Two alternative explanations of this
pattern in returns have appeared in the literature. The behavioral view is that the

Hertzel, michael.hertzel@asu.edu, Carey School of Business, Arizona State University, PO Box

873906, Tempe, AZ 85287; Li, zli1@tulane.edu, Freeman School of Business, Tulane University, 7
McAlister Dr., New Orleans, LA 70118. We thank Murray Carlson, Jeffrey Coles, Werner DeBondt,
Erik Devos (FMA discussant), Stephan Dieckmann, Mark Huson, Michael Lemmon, Evgeny
Lyandres, Paul Malatesta (the editor), Spencer Martin, Wayne Mikkelson, Micah Ofcer, Mitchell
Petersen, Jay Ritter (associate editor and referee), David Robinson (AFAdiscussant), Sunil Wahal, and
seminar participants at Arizona State University, Claremont McKenna College, the DePaul University
and Federal Reserve Bank of Chicago joint research seminar, Lancaster University, the University of
Alberta, the University of Florida, the University of Oklahoma, the 2007 Financial Management Asso-
ciation meeting, and the 2008 American Finance Association meeting for helpful comments. We also
thank Evgeny Lyandres for providing us with the investment factor. Hertzel gratefully acknowledges
nancial support from the Carey School of Business Deans Council of 100.
935
936 Journal of Financial and Quantitative Analysis
pre-issuance run-up reects investor overreaction to recent trends in performance,
that managers are motivated to issue equity when rms are overvalued, and that
investors are slow to recognize and incorporate information conveyed by SEO
announcements.
1
More recently, real investment-based rational explanations have emerged.
Carlson, Fisher, and Giammarino (2006), using a real options approach, posit
that the pre-issue run-up reects growth options moving into the money, that
managers issue equity in order to invest in these growth options, and that lower
post-issue returns reect a decrease in rm risk as risky growth options are
converted into less risky assets in place. Li, Livdan, and Zhang (2009), using
a Q-theoretic framework, argue that rms issue equity to nance investment pro-
jects induced by low discount rates, and because of decreasing returns to scale,
the increased investment leads to lower marginal product of capital and thereby
lower expected returns, which explains the post-SEO underperformance. Both
of the rational theories predict that rms increase investment after SEOs and
that there is a negative relation between investment level and post-issue stock
returns.
2
In this paper, we provide evidence on these alternative explanations using a
methodology developed in Rhodes-Kropf, Robinson, and Viswanathan (RKRV)
(2005) that decomposes pre-issue market-to-book (MTB) ratios into misvalua-
tion and growth option components. Previous research has documented that SEO
rms have higher than average MTB ratios. High MTB ratios can be viewed both
as a sign of overvaluation, consistent with the behavioral view, or as a sign of high
growth options, consistent with the investment-based rational theories. By decom-
posing issuing rm MTB ratios, we are able to provide sharper tests of competing
predictions as well as evidence on the possibility that both explanations contribute
to the observed pattern in performance.
The RKRV (2005) methodology uses an accounting multiples approach to
break MTB ratios into three components: rm-specic error (FSE), time-series
sector error (TSSE), and long-run value-to-book (LRVTB).
3
The FSE component
1
We also include in the behavioral view the possibility that overvaluation at the time of the issue
reects asymmetric information (as in Myers and Majluf (1984)) but that investors underreact to the
signal conveyed by the issue announcement.
2
There are other theories that address post-issue stock price underperformance. Titman, Wei, and
Xie (2004) argue that managers are empire builders and destroy rm value by overinvestment. Eckbo,
Masulis, and Norli (2000) posit that SEO rms have lower risk levels due to lower leverage and higher
stock liquidity after issuance. Brav, Geczy, and Gompers (2000) argue that SEO underperformance
may reect a return pattern in publicly traded small and high market-to-book (MTB) rms. Finally,
Fama (1998) argues that underperformance may be caused by model misspecication. We address
issues raised by these alternative explanations in the paper.
3
We are not the rst to apply the RKRV (2005) approach. See, for example, Hoberg and Phillips
(2010), who use the method to measure industry-wide valuation relative to historical values, and
Campello and Graham (2007), who use a similar method to estimate fundamental Q using publicly
observed accounting data. Elliott, Ko eter-Kant, and Warr (2008) use a residual income approach to
decompose the MTB ratio, and Purnanandam and Swaminathan (2004) measure mispricing as devia-
tions from valuations based on industry peer multiples. We also note that the decomposition method
shares similarities with the Daniel and Titman (2006) accounting-based approach of decomposing
returns into tangible and intangible components.
Hertzel and Li 937
measures rm-specic deviations from valuations implied by current sector
(industry) accounting multiples and is intended to capture the extent to which
the rm is misvalued relative to its contemporaneous industry peers. The TSSE
component measures valuation deviations when contemporaneous sector acc-
ounting multiples differ from long-run sector multiples. This component is used
as a measure of whether the sector, or possibly the entire market, is overval-
ued. The LRVTB component measures the value implied by long-run sector ac-
counting multiples relative to book value; it is used as a proxy for growth
opportunities.
Two aspects of the RKRV (2005) methodology affect our empirical testing
strategy. First, although estimating industry misvaluation is essential to the merger
activity research question investigated by RKRV, the TSSE component is less in-
formative about the hypotheses we investigate. We therefore base our tests on the
behavioral view of potential misvaluation as reected in the FSE component of
MTB. Second, there are potential model misspecication concerns that can make
it difcult to draw clear inferences from our ndings. For example, a rm with
high FSE may not be overvalued, but instead may simply have greater growth
opportunities than other rms in its industry. Thus, an important part of our em-
pirical testing strategy aims at providing evidence on the extent to which the FSE
and LRVTB components reect misvaluation and growth options, respectively,
and can thereby serve as useful metrics in our analysis of post-issue stock price
performance.
Our empirical analysis proceeds in 3 steps. First, for a sample of 4,325 SEOs
over the 19702004 time period, we show that the pre-issue MTB ratio and its
components, on average, are signicantly larger for issuing rms than for a com-
parison sample of nonissuing rms. For example, the average FSE component
for the issuing rms is 0.27, which constitutes 28% of the average MTB ratio,
whereas the average FSE component for nonissuing rms is close to 0. The aver-
age LRVTB component is also higher at 0.59 relative to 0.39 for the comparison
sample. These ndings provide suggestive evidence that SEO decisions may be
motivated by either high levels of misvaluation, high levels of growth opportuni-
ties, or both.
Second, to provide evidence on the usefulness of the RKRV (2005) method-
ology as well as insight on managerial motives for issuing equity, we examine the
relation between the pre-issue components of the MTB ratio and the use of issue
proceeds. Assuming that managers act in the interests of long-term shareholders,
post-issue investment in real assets should be positively related to the pre-issue
level of growth options and uncorrelated with the level of misvaluation. To the
extent that the FSE component of MTB reects misvaluation, there should be no
relation between this error term and post-issue investment. Similarly, to the ex-
tent that the LRVTB component reects the level of growth options, we should
expect to observe a positive relation between this growth option component and
post-issue investment.
To investigate post-issue investment, we follow the approach in Kim and
Weisbach (2008) and examine post-SEO changes (over horizons of 14 years) in
7 accounting variables that likely capture the use of issue proceeds: capital ex-
penditures, research and development (R&D), total assets, debt reduction, cash,
938 Journal of Financial and Quantitative Analysis
acquisitions, and inventory.
4
We regress the changes in these accounting variables
on the components of the MTB ratio while controlling for the amount of primary
capital raised in the SEO, other sources of funds generated within the rm, rm
size, and xed effects for year and industry. This analysis yields the following
results:
i) Post-issue investment in capital expenditures and R&D is positively related
to the LRVTB component and unrelated to the FSE component of MTB.
ii) Debt reduction is positively related to the FSE component and negatively
related to the LRVTB component of MTB.
iii) Post-issue changes in cash positions are positively related to the FSE com-
ponent but unrelated to the LRVTB component of MTB.
These ndings suggest that rms with high levels of growth options invest more
in real assets, whereas rms with high valuation errors are more likely to pay
down debt and/or stockpile cash. This evidence is consistent with results from ear-
lier studies (Graham and Harvey (2001), Kim and Weisbach (2008), Elliott et al.
(2008), and DellaVigna and Pollet (2009)), suggesting that equity issue decisions
are motivated by both misvaluation and nancing needs. The evidence is also
consistent with the interpretation of the FSE and LRVTB components of MTB
as measures of misvaluation and growth options, respectively, and thus paves the
way for our examination of the alternative explanations of low post-issue stock
price performance.
Our last set of tests focuses on the relation between post-issue stock price
performance and pre-issue components of MTB. Behavioral theory predicts that
post-issue stock returns should be negatively correlated with the degree of over-
pricing at the time of issuance. In contrast, real investment theory predicts a neg-
ative relation between post-issue stock returns and investment under the rationale
that as growth options are converted to assets in place, the resulting reduction
in risk is reected in lower required returns. In these tests, we separate issuing
rms into quartiles based on the misvaluation (FSE) and growth option (LRVTB)
components of MTB and then calculate long-run post-issue abnormal returns for
each quartile portfolio using calendar time factor regressions. Our results are as
follows:
i) We nd a negative relation between the misvaluation component of MTBand
post-issue returns; issuing rms with high misvaluation have more negative
post-issue abnormal returns. For example, depending on the model speci-
cation, the average 3-year post-issue abnormal return for rms in the highest
mispricing quartile ranges from 9.7% to 19.4% as compared to a range of
3.9% to +3.2% for rms in the lowest mispricing quartile. Evidence that
more overvalued rms have lower post-issue abnormal returns is consistent
with the behavioral explanation of low post-issue returns.
4
Using a sample of public equity offerings from 38 countries, Kim and Weisbach (2008) inves-
tigate the extent to which market timing and investment nancing motivate equity offers. The study
focuses on how the ultimate use of capital raised varies with rm valuation and the extent to which
this variation is consistent with the alternative motives for equity offers. The study does not consider
the decomposition of MTB ratios or address alternative explanations for post-issue stock price perfor-
mance.
Hertzel and Li 939
ii) In contrast, we nd no relation between the growth option component of
MTB and post-issue returns; issuing rms with high levels of growth options
do not have lower post-issue abnormal returns than issuing rms with lower
levels of growth options. This evidence, taken in conjunction with our nding
that issuing rms with more growth options have higher levels of post-issue
investment, is not supportive of the real investment explanations of low post-
issue stock returns.
We note that several previous studies of SEOs nd that stock price under-
performance is primarily concentrated in small rms and argue that the post-issue
performance anomaly may be caused by asset pricing model deciencies when
it comes to valuing small rms (see Fama (1998), Brav et al. (2000), and Mitchell
and Stafford (2000), among others). In robustness checks, we separate our sample
of issuing rms into 2 size groups: The small rm subsample includes all issu-
ing rms with pre-issuance market capitalizations below the 20% size breakpoint
of NewYork Stock Exchange (NYSE) stocks; the large rm subsample includes
all other issuing rms. We nd that the negative relation between post-issue re-
turns and FSE continues to hold even after controlling for rm size. For example,
relative to the Fama and French (1993) 3-factor model benchmark, large rms
with high misvaluation components on average exhibit signicant 3-year post-
issue stock price underperformance of 13.7%, while small rms with low mis-
valuation components do not underperform. These results suggest that the stock
price performance around SEOs is not simply a small-rm effect (i.e., rm-level
mispricing appears to be a stronger indicator of post-issue underperformance).
Finally, Lyandres, Sun, and Zhang (2008) report that adding an investment
factor (INV) to the standard factor regressions eliminates the statistical signif-
icance of post-issue underperformance and reduces its magnitude by approxi-
mately 75%. This nding is interpreted as consistent with the investment-based
explanations of post-issue underperformance. When we include the INV in our
regressions, we similarly nd a reduction in the overall magnitude of post-issue
underperformance. However, we still observe the same negative correlation be-
tween FSE and post-issue abnormal returns; SEO rms with low FSE generally
have positive abnormal returns, while rms with high FSE signicantly underper-
form. Our ndings suggest that although the INV explains part of the underper-
formance anomaly, mispricing plays a statistically signicant and economically
important role.
II. Data
Our sample includes all rms, as identied from the Securities Data Com-
pany (SDC) database that conduct SEOs over the period 19702004. Accounting
information and stock price data are from Compustat and the Center for Research
in Security Prices (CRSP), respectively. Following RKRV (2005), we merge data
in the following way. To calculate and decompose MTB, we match Compustat
accounting data for scal year t with CRSP market value data measured 3 months
after the scal year-end. The pre-SEO MTB ratio and its components are calcu-
lated using this match of Compustat and CRSP data if the issuance takes place at
940 Journal of Financial and Quantitative Analysis
least 4 months after the scal year-end (i.e., 1 month after the CRSP market value
data are measured). Otherwise, the SEOis matched with data fromscal year t1.
To be included in the nal sample, an issuing rm must have enough Com-
pustat and CRSP data to calculate the 3 components of the MTB ratio. We exclude
rms that only issue secondary shares as well as utility companies (Standard In-
dustrial Classication (SIC) codes between 4910 and 4949), closed-end funds
(SIC codes between 6720 and 6739), and real estate investment trusts (REITs)
(SIC code 6798). If a rm issues primary shares more than once within a 3-year
period, then only the rst issue is included. The nal sample has 4,325 observa-
tions. Table 1 reports the number of SEOs in our nal sample by year over the
period 19702004.
TABLE 1
Number of Seasoned Equity Offerings
Table 1 reports the number of SEOs by year. All SEO information is from the SDC database for the years 19702004. To be
included in the nal sample, an SEO rm must have enough Compustat and CRSP data to decompose its market-to-book
ratio as described in Section III. We exclude rms that only issue secondary shares, utility companies with SIC codes
between 4910 and 4949, closed-end funds (SIC codes between 6720 and 6739), and REITs (SIC code 6798). If a rm
issues primary shares more than once within a 3-year period, then only the rst issue is included.
Year SEO Percent (%)
1970 15 0.3
1971 41 0.9
1972 42 1.0
1973 9 0.2
1974 12 0.3
1975 24 0.6
1976 44 1.0
1977 25 0.6
1978 47 1.1
1979 36 0.8
1980 118 2.7
1981 112 2.6
1982 75 1.7
1983 292 6.8
1984 49 1.1
1985 131 3.0
1986 141 3.3
1987 118 2.7
1988 40 0.9
1989 88 2.0
1990 71 1.6
1991 214 4.9
1992 173 4.0
1993 237 5.5
1994 156 3.6
1995 229 5.3
1996 285 6.6
1997 250 5.8
1998 170 3.9
1999 178 4.1
2000 173 4.0
2001 167 3.9
2002 166 3.8
2003 196 4.5
2004 201 4.6
Total 4,325 100.0
III. MTB Decomposition Methodology
This section describes the MTB decomposition methodology. Section III.A
provides an overview and our rationale for employing the decomposition method,
Hertzel and Li 941
Section III.B lays out the estimation procedures and presents summary statis-
tics, and Section III.C discusses 2 concerns with the RKRV (2005) methodology
(model misspecication and look-ahead bias) and how these are addressed in our
study.
A. Decomposing the MTB Ratio
The rational and behavioral theories of stock price performance around SEOs
offer alternative explanations for high pre-issue MTB ratios. Behavioral theory
suggests that equity issues are more likely when rm market value, M, exceeds
its true value, V. Real investment theory suggests that equity issues are more
likely after investment opportunities move into the money, resulting in a higher
value-to-book (VTB) ratio. This distinction underlies our rationale for employing
the RKRV (2005) methodology for decomposing MTB into misvaluation (MTV)
and growth option (VTB) components as follows:
MTB MTV VTB, (1)
which, in log form, can be written as
m b (m v) + (v b), (2)
where lower case letters indicate logarithms of the respective variables.
5
If mar-
kets know the future growth opportunities, discount rates, and cash ows, then
the term (m v) should be 0. If markets make mistakes in estimating discounted
future cash ows or do not have information that managers have, then (m v)
will capture the misvaluation component of the MTB ratio.
B. Estimating the Components of the MTB Ratio
Decomposing the MTB ratio, as depicted in equation (2), relies on determin-
ing an estimate of rm value, v. For estimation purposes, for each rm i in indus-
try j at time t, v can be expressed as a linear function of observable rm-specic
accounting information,
it
, and a vector of corresponding accounting multiples,
. The RKRV (2005) methodology employs both a vector of contemporaneous
time-t accounting multiples,
jt
, and a vector of long-run accounting multiples,

j
, such that the MTB ratio for rm i at time t can be further decomposed into 3
components as follows:
m
it
b
it
= m
it
v(
it
;
jt
)
. .
FSE
+v(
it
;
jt
) v(
it
;
j
)
. .
TSSE
+v(
it
;
j
) b
it
. .
LRVTB
. (3)
The rst term on the right-hand side of equation (3), m
it
v(
it
;
jt
), re-
ferred to as FSE, measures the difference between market value and fundamental
value estimated using rm-specic accounting data,
it
, and the contemporaneous
sector accounting multiples,
jt
, and is intended to capture the extent to which
5
We adopt the same notation, and our discussion below closely mirrors that in RKRV (2005).
942 Journal of Financial and Quantitative Analysis
the rm is misvalued relative to its contemporaneous industry peers. The second
term, v(
it
;
jt
) v(
it
;
j
), referred to as TSSE, measures the difference in esti-
mated fundamental value when contemporaneous sector accounting multiples at
time t,
jt
, differ from long-run sector multiples,
j
, and is intended to capture
the extent to which the industry (or, possibly, the entire market) may be mis-
valued at time t. The third term, referred to as LRVTB, measures the difference
between rm value (implied by the vector of long-run sector multiples) and book
value. This measure is interpreted as the investment opportunity component of the
MTB ratio.
RKRV (2005) use 3 different models to estimate v(
it
;
jt
) and v(
it
;
j
). The
models differ only with respect to the accounting items that are included in the
accounting information vector,
it
. To save space, we focus on RKRVs 3rd model,
which includes book value (b), net income (NI), and market leverage (LEV) ratio
in the accounting information vector.
6
Expressing market value as a simple linear
model of these variables yields
m
it
=
0jt
+
1jt
b
it
+
2jt
ln(NI)
+
it
+
3jt
I
(<0)
ln(NI)
+
it
+
4jt
LEV
it
+
it
, (4)
where, because NI can sometimes be negative, it is expressed as an absolute value
(NI)
+
along with a dummy variable, I
(<0)
, to indicate when NI is negative.
7
To calculate the contemporaneous accounting multiples,
jt
, each year we
group all CRSP/Compustat rms according to the 12 Fama and French industry
classications;
8
run annual, cross-sectional regressions (of equation (4)) for each
industry; and generate estimated industry accounting multiples for each year t,
jt
.
The estimated value of v(
it
;
jt
) is the tted value from regression equation (4):
v(b
it
, NI
it
, LEV
it
;
0jt
,
1jt
,
2jt
,
3jt
,
4jt
) (5)
=
0jt
+
1jt
b
it
+
2jt
ln(NI)
+
it
+
3jt
I
(<0)
ln(NI)
+
it
+
4jt
LEV
it
.
To calculate the long-run sector multiples,
j
, we average the
jt
s from the
annual regressions over the available years prior to the SEO (capped at 20 years).
9
The estimate of v(
it
;
j
) is then the tted value of equation (4) using the
jt
s:
6
The 1st model includes only book value; the 2nd model includes book value and NI. Our results
are robust to using either of these models. See RKRV (2005) for a discussion of the rationale behind
each of the individual models.
7
We use market capitalization (price shares outstanding) as our measure of the market value of
equity. Accounting variables are measured as follows: book value (data item 60), NI (data item 172),
LEV ratio (1 market equity/market value), where market value is measured as CRSP market equity
+ Compustat book assets (data item 6) deferred taxes (data item 74) book equity (data item 60).
8
The classication of the 12 industry classes is taken from Kenneth Frenchs Web site:
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data library.html.
9
This represents a departure from the RKRV (2005) method where the full time series is used
to calculate
j
. When the full time series of industry accounting multiples is used, the TSSE and
LRVTB components will contain forward-looking information that is not available to investors at
time t. RKRV argue that the forward-looking information could reect private information possessed
by rm managers. In an earlier version of the paper, we used the RKRV estimation method and found
similar (slightly stronger) results. However, the RKRV method can be problematic for our post-issue
performance tests, as the estimation and testing periods overlap. Our modied approach using past-
only data solves the look-ahead bias but may come at a cost in that it discards valuable information if
managers truly are motivated by asymmetric information when making SEO decisions. We also note
that estimates of the TSSE component are highly sensitive to estimation periods used to calculate
j
.
Hertzel and Li 943
v(b
it
, NI
it
, LEV
it
;
0jt
,
1jt
,
2jt
,
3jt
,
4jt
) (6)
=
0jt
+
1jt
b
it
+
2jt
ln(NI)
+
it
+
3jt
I
(<0)
ln(NI)

it
+
4jt
LEV
it
.
Table 2 presents the time-series averages (over scal years 19672003) of
the annual regression coefcients for equation (4) for the 12 Fama and French in-
dustries. The results are similar to those reported in Table 4 of RKRV (2005), with
book value and NI positively correlated with market value, and LEV negatively
correlated with market value.
10
The table reports that the average adjusted R
2
for
these regressions ranges from 83% to 93%, which shows that within an industry,
the 3 accounting variables explain a large majority of the cross-sectional variation
in rm market values in a given year.
11
TABLE 2
Time-Series Average Conditional Regression Coefcients
Table 2 reports the time-series average coefcients from regression equation (4) in Section III. The dependent variable is
the natural log of market value (m). The independent variables are the natural log of book value of equity (b), the natural
log of the absolute value of net income (NI)
+
, a dummy variable indicating when the NI is negative (I
(<0)
), and market
leverage (LEV). The regression is estimated cross-sectionally at the industry-year level for each of the 12 Fama and French
industries fromscal years 19672003. The subscripts i, j, and t refer to rm, industry, and year, respectively. Here, E
t
(
k
)
is the time-series average regression multiple for the kth independent variable. We also report the Fama-MacBeth (1973)
standard errors below the average estimated coefcients. The reported R
2
is the average adjusted R
2
for each industry.
(4) m
it
=
0jt
+
1jt
b
it
+
2jt
ln(NI)
+
it
+
3jt
I
(<0)
ln(NI)
+
it
+
4jt
LEV
it
+
it
.
Fama-French Industry Classication
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(
2
) 0.31 0.30 0.28 0.25 0.36 0.33 0.31 0.22 0.28 0.34 0.38 0.31
0.01 0.02 0.01 0.01 0.02 0.01 0.02 0.04 0.01 0.02 0.01 0.01
E
t
(
3
) 0.01 0.02 0.05 0.06 0.00 0.07 0.49 0.14 0.09 0.10 0.22 0.07
0.02 0.02 0.01 0.03 0.03 0.01 0.53 0.11 0.02 0.02 0.02 0.01
E
t
(
4
) 2.70 2.51 2.30 2.26 3.04 2.67 2.33 2.63 2.34 2.70 1.12 2.02
0.08 0.11 0.08 0.12 0.10 0.10 0.17 0.23 0.07 0.08 0.04 0.07
N 37 37 37 37 37 37 37 37 37 37 37 37
R
2
0.84 0.83 0.87 0.88 0.86 0.86 0.88 0.93 0.87 0.88 0.85 0.85
10
Although for purposes of consistency with RKRV (2005), we generally refer to the regression
coefcients from equation (4) as accounting multiples, the
1
and
2
slope coefcients also represent
the elasticity of rm value with respect to book equity and NI, respectively.
11
As suggested in Petersen (2009), Fama-MacBeth (1973) standard errors (as reported in Table 2)
can be downward biased due to unobserved rm effects. Thus, we also estimated clustered standard er-
rors using ordinary least squares (OLS) and found qualitatively similar results. Given that the focus of
the RKRV (2005) methodology is on the point estimates of the regression coefcients, this alternative
method of estimating standard errors does not affect the conclusions of our study.
944 Journal of Financial and Quantitative Analysis
C. Model Misspecication
A critical concern with the RKRV (2005) methodology is that, in addition
to misvaluation, the error components in equation (3) will also reect any errors
due to model misspecication. For example, a rm with high FSE may not be
overvalued but instead may simply have greater growth options and/or a lower
discount rate than other rms in its industry. Although we cannot rule out model
misspecication, we provide evidence (in Section IV) suggesting that the high
levels of FSE we document for our sample of SEO rms reect an important
misvaluation component.
IV. Empirical Findings
This section presents results from a battery of tests aimed at providing evi-
dence on the rational and behavioral theories of the pattern in stock price perfor-
mance around SEOs. We proceed in 3 steps. In Section IV.A we present summary
information on pre-issue MTB ratios and the decomposition into the error and
growth option components for our sample of SEO rms and for a comparison
sample of nonissuing rms. In Section IV.B we present evidence on the use of
proceeds by examining the relation between pre-issue MTBcomponents and post-
issue investment decisions. Our objective here is to provide insight regarding the
error component of the MTB ratio and to further examine how investment funding
needs and market timing motivate equity issuance decisions. In Section IV.C we
provide evidence on the relation between the pre-issue misvaluation and growth
option components of MTB and the long-run post-issue stock price performance
of the issuing rms.
A. MTB Ratios of Issuing Firms: Investment Opportunities versus
Misvaluation
Panel A of Table 3 reports summary information on the pre-issue MTB ratio
and the 3 components of MTB for our sample of SEO rms and for a comparison
sample of all nonissuing CRSP/Compustat rms. The table shows that the average
(log) MTB ratio for our sample of issuing rms is 0.95, while the average ratio
for all CRSP/Compustat rms is only 0.42. This evidence is consistent with prior
ndings that SEO rms have relatively high pre-issue MTB ratios; high pre-issue
MTB ratios are also consistent with earlier evidence that issuing rms experience
signicant stock price run-ups prior to issuance.
With respect to the components of MTB, Panel A of Table 3 shows that the
average FSE, TSSE, and LRVTB ratio for the sample of issuing rms are 0.27,
0.09, and 0.59, respectively; each is signicantly different from0 and signicantly
larger than the respective averages for all nonissuing rms in the CRSP/Compustat
universe. We also note that the error components constitute a substantially larger
fraction of issuing-rm MTB ratios (38%) as compared to the comparison sample
of nonissuers (7%).
To provide additional information on the relative magnitudes of the compo-
nents of MTB, Panel B of Table 3 presents the distribution of the sample of SEO
Hertzel and Li 945
TABLE 3
Firm-Level Decomposition of MTB Ratios
Panel A of Table 3 reports the mean of the market-to-book (MTB) ratio and of its 3 components at the rm level for our
sample of SEO rms and for a comparison sample of all non-SEO CRSP/Compustat rms over the period 19702004.
MTB is dened as the natural log of the ratio of market capitalization to book value of equity. The 3 components are rm-
specic error (FSE), time-series sector error (TSSE), and the long-run value-to-book (LRVTB). The estimation method for
the 3 components is presented in Section III. The column t(diff) reports the t-statistic for the test that the SEO rms have
the same average MTB ratio (or component) as the non-SEO CRSP/Compustat comparison rms. Panel B reports the
distribution of the SEO sample across FSE and LRVTB quartiles. We report the percentage of SEO rms that belong to
each quartile. The quartile breakpoints for FSE and LRVTB are generated from the universe of all CRSP/Compustat rms
for each scal year.
Panel A. Mean of MTB and Its 3 Components
SEO Firms Non-SEO Firms
Component Mean N Mean N t(diff)
MTB 0.95 4,325 0.42 159,927 32.35
FSE 0.27 4,325 0.01 159,475 24.89
TSSE 0.09 4,325 0.04 159,475 12.18
LRVTB 0.59 4,325 0.39 159,475 17.40
Panel B. Distribution of SEO Sample across FSE and VTB Quartiles
LRVTB
FSE Low Quartile 2 Quartile 3 High Total
Low 2% 2% 4% 7% 14%
Quartile 2 2% 4% 6% 8% 21%
Quartile 3 5% 7% 7% 8% 27%
High 10% 8% 8% 14% 39%
Total 19% 20% 24% 36% 100%
rms sorted across FSE and LRVTB quartiles, where quartile breakpoints are
formed using all CRSP/Compustat rms for each scal year. With respect to FSE,
39% of the issuing rms are in the highest CRSP/Compustat quartile, while only
14% are in the lowest quartile. For LRVTB, 36% of the SEO rms are from the
highest quartile, with only 19% coming from the lowest.
In summary, the evidence in this section is consistent with the possibility
that both market timing and capital budgeting needs inuence the SEO decision.
The tendency for issuing rms to have high pre-issue LRVTB ratios suggests that
these rms issue to satisfy investment needs. The tendency for issuing rms to
have market values in excess of fundamental values implied by industry account-
ing multiples can be interpreted as either misvaluation, model error, or possibly
both. We present evidence in the next 2 sections suggesting that the large FSE
components we observe for our sample of issuing rms reect overvaluation.
B. Use of Issue Proceeds: Investment versus Debt Reduction
Previous literature (Loughran and Ritter (1997)) shows that issuing rms,
on average, have high levels of investment following SEOs. However, we should
expect to observe differences in post-issue investment behavior, depending upon
the motivation for undertaking an SEO. More specically, assuming that man-
agers act in the best interests of long-term shareholders, we should expect to see
more debt reduction and/or increases in cash holdings when SEOs are motivated
by stock price overvaluation and more investment when SEOs are motivated by
capital budgeting needs. In this section we investigate the use of issue proceeds by
examining the relation between post-issue investment and pre-issue levels of the
946 Journal of Financial and Quantitative Analysis
error and growth option components of MTB. A primary goal here is to provide
evidence on the extent to which the FSE component of MTB reects misvalua-
tion and can thereby serve as a useful metric in our analysis of long-run post-issue
stock returns.
To provide evidence on post-issue investment, we follow the approach in
Kim and Weisbach (2008) and track 7 accounting variables that potentially cap-
ture the use of issue proceeds. We examine post-issue changes in R&D, capital
expenditures, acquisitions, inventory, total assets, cash, and reduction of long-
term debt for up to 4 years following the SEO. To control for rm size, we scale
all accounting variables by book assets in the scal year prior to the SEO. For the
income statement and cash ow statement items (R&D, capital expenditures, ac-
quisitions, and reduction in long-term debt as measured by Compustat data items
46, 128, 129, and 114, respectively), we calculate the accumulation in each vari-
able since the SEO, scaled by book assets prior to the SEO:

t
i=1
V/ASSET
0
, for
t = 1 to 4, where V is the accounting variable being measured and year 0 is the
scal year-end just prior to the year of the SEO.
12
For the balance sheet variables
(inventory, cash, and total assets as measured by Compustat data items 3, 1, and 6,
respectively), we measure the cumulative change in each variable since the SEO:
(V
t
V
0
)/ASSET
0
, for t = 1 to 4.
1. Univariate Analysis of Post-Issue Investments across Components of MTB
We start with a univariate analysis of how post-issue investment varies across
the pre-issue components of the MTB ratio. Panels A and B of Table 4 report the
mean normalized increase for each accounting variable for quartiles based on the
FSE and LRVTB components, respectively.
Although the univariate analysis does not hold other variables constant, sev-
eral results point to the interpretation of the FSE component of MTB as a useful
measure of misvaluation. First, comparing across panels, post-issue R&D and
capital expenditures are both strongly related to LRVTB (Panel B of Table 4), but
unrelated to FSE (Panel A). As reported in Panel B, R&D and capital expenditures
both increase monotonically as the LRVTB ratio increases; differences between
quartiles 4 and 1 are highly signicant at all horizons for both variables. In sharp
contrast, we do not observe such a relation when R&D and capital expenditures
are measured across quartiles of the FSE component, as reported in Panel A. This
nding is more consistent with the interpretation of FSE as a measure of misval-
uation as opposed to a measure of rm-specic deviation from industry average
growth and discount rates. That is, assuming managers act to maximize long-run
share price, we should not expect to observe greater post-issue investment as the
degree of pre-issue overvaluation increases.
13
Second, and also consistent with the view that the error component reects
misvaluation, we nd that rms with high FSE are more likely to spend issue
12
We delete observations where R&D (data item 46) is missing.
13
We would expect to observe greater post-issue investment when there is more misvaluation if
managers place a high weight on short-term stock price performance (Stein (1996)) or if managers
are attempting to maximize rm size. However, our ndings are not consistent with either of these
possibilities.
Hertzel and Li 947
proceeds on debt reduction. At both the 1- and 2-year horizons, long-term debt
reduction increases monotonically as FSE increases; differences between quar-
tiles 4 and 1 are highly signicant in both cases. In contrast, we nd no relation
between debt reduction and the growth option component of MTB. In summary,
the univariate analysis suggests that both misvaluation and the need to fund pos-
itive net present value (NPV) projects motivate rms to issue equity. Firms with
high investment opportunities appear to issue to nance R&D and capital ex-
penditures, while rms with high valuation errors appear to substitute relatively
cheaper equity for debt. We note that acquisitions, cash levels, inventories, and
total assets are all positively related to both components of the MTB ratio.
While the univariate analysis presented here is suggestive, there are limita-
tions. Post-issue investment may be inuenced by factors that are not reected in
the MTB components. The level of issue proceeds, the amount of other sources
of funds generated within the rm, rm size, industry, and year effects may all
distort the univariate ndings. In the next section we control for these factors in a
multivariate setting.
TABLE 4
Average Post-Issue Changes in Assets and Expenditures by MTB Components
Panels A and B of Table 4 report average post-issue changes in assets and expenditures by rm-specic error (FSE)
and long-run value-to-book (LRVTB) quartiles, respectively, for the sample of SEO rms from 1970 to 2004. Changes in
expenditures (R&D, capital expenditure, long-term debt reduction, and acquisition) are calculated as

t
i=1
V
i
/ASSET
0
.
Changes in assets (cash, inventory, and total assets) are calculated as (V
t
V
0
)/ASSET
0
, for t = 1 to 4, where V is the
variable being measured and year 0 is the scal year-end just prior to the SEO issuance day. The columns Diff(4 1) and
t(diff) report the difference and statistical signicance, respectively in mean expenditure between quartiles 4 and 1. The
means reported here are winsorized at 0.5% for each tail to remove inuential outliers.
Panel A. FSE
FSE Quartile
V t Low 2 3 High Diff(4 1) t(diff)

R&D 1 0.17 0.15 0.13 0.14 0.03 1.79

2 0.37 0.38 0.31 0.34 0.03 0.78
3 0.60 0.64 0.53 0.55 0.05 0.52
4 0.85 0.95 0.74 0.84 0.01 0.03

CAPEX 1 0.14 0.13 0.13 0.16 0.02 0.74

2 0.33 0.30 0.31 0.39 0.07 1.61
3 0.53 0.51 0.51 0.64 0.11 0.53
4 0.75 0.74 0.71 0.91 0.16 1.06

LT DEBT 1 0.08 0.13 0.14 0.17 0.09 6.53

REDUCTION 2 0.19 0.27 0.27 0.35 0.16 4.02
3 0.35 0.47 0.47 0.52 0.17 1.06
4 0.54 0.76 0.65 0.80 0.27 1.48

ACQUISITION 1 0.06 0.07 0.07 0.09 0.03 1.78

2 0.12 0.17 0.15 0.19 0.07 2.15
3 0.17 0.29 0.24 0.29 0.12 2.13
4 0.20 0.43 0.35 0.38 0.17 3.83
CASH 1 0.16 0.26 0.24 0.36 0.20 6.13
2 0.18 0.28 0.24 0.38 0.20 4.53
3 0.24 0.37 0.26 0.36 0.12 2.60
4 0.27 0.38 0.35 0.47 0.20 3.10
INVENTORY 1 0.04 0.06 0.05 0.06 0.02 2.89
2 0.09 0.12 0.11 0.12 0.02 2.26
3 0.13 0.20 0.17 0.17 0.04 1.71
4 0.16 0.26 0.21 0.23 0.07 2.70
TOTAL ASSETS 1 0.51 0.63 0.62 0.84 0.33 5.84
2 0.91 1.10 1.03 1.43 0.52 3.51
3 1.31 1.60 1.49 1.82 0.50 3.35
4 1.51 2.02 1.86 2.41 0.90 3.85
(continued on next page)
948 Journal of Financial and Quantitative Analysis
TABLE 4 (continued)
Average Post-Issue Changes in Assets and Expenditures by MTB Components
Panel B. LRVTB
LRVTB Quartile
V t Low 2 3 High Diff(4 1) t(diff)

R&D 1 0.03 0.05 0.08 0.23 0.21 19.58

2 0.07 0.10 0.18 0.57 0.50 20.36
3 0.11 0.17 0.30 0.95 0.84 14.93
4 0.17 0.26 0.45 1.37 1.21 14.25

CAPEX 1 0.08 0.13 0.15 0.17 0.09 10.00

2 0.18 0.28 0.36 0.44 0.26 8.90
3 0.30 0.44 0.59 0.73 0.43 7.61
4 0.45 0.64 0.82 1.02 0.56 6.11

LT DEBT 1 0.17 0.18 0.16 0.10 0.07 4.24

REDUCTION 2 0.33 0.37 0.32 0.21 0.12 3.77
3 0.50 0.57 0.54 0.37 0.14 1.33
4 0.71 0.80 0.87 0.57 0.13 0.74

ACQUISITION 1 0.05 0.07 0.08 0.08 0.03 2.62

2 0.11 0.15 0.16 0.20 0.09 4.16
3 0.16 0.23 0.24 0.35 0.19 4.76
4 0.22 0.31 0.34 0.46 0.24 2.93
CASH 1 0.03 0.05 0.16 0.64 0.60 17.60
2 0.04 0.07 0.17 0.69 0.64 12.03
3 0.06 0.07 0.19 0.72 0.66 11.22
4 0.07 0.08 0.24 0.84 0.77 9.60
INVENTORY 1 0.03 0.04 0.06 0.07 0.04 5.82
2 0.06 0.08 0.13 0.15 0.09 6.62
3 0.09 0.12 0.20 0.22 0.13 6.41
4 0.12 0.16 0.25 0.29 0.17 5.79
TOTAL ASSETS 1 0.23 0.36 0.56 1.25 1.02 18.58
2 0.47 0.69 1.01 2.01 1.55 7.66
3 0.66 1.03 1.42 2.65 1.99 10.54
4 0.88 1.28 1.86 3.23 2.34 8.14
2. Multivariate Analysis of the Use of Proceeds across Components of MTB
We use a regression approach similar to Kim and Weisbach (2008) to inves-
tigate the relation between components of the pre-issue MTB ratio and post-issue
use of proceeds. We regress changes in the 7 accounting variables (measured over
1-, 2-, 3-, and 4-year post-issue horizons) on the growth option and error com-
ponents of MTB while controlling for primary capital raised in the SEO, other
sources of funds generated within the rm, rm size, and xed effects for year
and industry. To avoid the impact of outliers, we take the log of the scaled ac-
counting variables plus 1.
For each accounting variable, we run the following regression for each post-
issue horizon:
Y =
1
FSE +
2
LRVTB +
3
TSSE +
4
ln
__
PRIMARY CAP
TOTAL ASSET
0
_
+ 1
_
(7)
+
5
ln
__
OTHER CAP
t
TOTAL ASSET
0
_
+ 1
_
+
6
ln(TOTAL ASSET
0
)
+
2001

i=1970

i
YR DUMMY +
11

j=1

j
INDUSTRY DUMMY,
Hertzel and Li 949
where Y =ln [((V
t
V
0
)/TOTAL ASSET
0
) + 1] for V =cash, inventory, and total
assets and Y = ln[(

t
i=1
V
i
/TOTAL ASSET
0
) + 1] for V = R&D, capital expen-
diture, long-term debt reduction, and acquisitions, for t = 1 to 4. FSE, TSSE, and
LRVTB refer to the 3 components of the pre-issue MTB ratio. PRIMARY CAP =
ln[(ISSUE PRICE PRIMARY SHARES OFFERED) / TOTAL ASSET
0
) + 1]
and OTHER CAP
t
= ln[(

t
i=1
_
TOTAL SOURCES OF FUNDS
t
PRIMARY
CAP
_
/TOTAL ASSET
0
) + 1], where total sources of funds include internally
generated cash from continuing operations, investment, and nancing activities.
14
Table 5 presents the regression estimates of equation (7). Several results are
of interest. First, we nd evidence that post-issue investment is positively related
to the pre-issue level of growth options. More specically, for the capital expendi-
ture and R&D regressions, the coefcients on LRVTB are positive and signicant
at all horizons. This evidence is consistent with the predictions of real investment
theory that equity issues are timed after an increase in the NPV of investment
opportunities.
15
Second, post-issue investment is unrelated to the FSE component of MTB.
The coefcients on FSE in the R&D and capital expenditure regressions are gen-
erally insignicant (we do observe 1 signicant coefcient in the R&Dregression,
but the sign is negative). This evidence is consistent with the interpretation of the
FSE component as a measure of misvaluation. The alternative interpretation, that
the FSE component reects rm-specic deviations from industry average growth
and discount rates, is not supported. The alternative interpretation is also not sup-
ported by a test of the equality of coefcients on FSE and LRVTB; we reject at
the 0.00 level that these coefcients are equal.
Third, post-issue debt reduction is positively related to the FSE component
and negatively related to the LRVTB component of MTB. This nding suggests
that rms with greater investment opportunities invest more, whereas rms with
higher valuation errors are more likely to pay down debt. We also nd that post-
issue changes in cash positions are signicantly positively related to FSE in the
rst 2 years after issuance, but unrelated to LRVTB for all horizons. This nding
bolsters our conclusion that the FSE component of MTB is a reasonable measure
of misvaluation.
For a sense of the economic signicance of our ndings on post-issue invest-
ment, we note that a 1-standard-deviation increase in LRVTB results in a $14.6
million increase in R&D spending, a $5.2 million increase in capital expenditures,
and an $8.0 million decrease in spending on long-term debt reduction over the 4
years following the SEO.
16
In contrast, increasing FSE by 1 standard deviation
14
We use Compustat data item 112 as our measure of total sources of funds. If missing, we calculate
total sources of funds as the sum of funds from operations (data item 110), sale of property, plant,
and equipment (data item 107), long-term debt issuances (data item 111), and sale of common and
preferred stock (data item 108).
15
Although not the focus of our paper, we note that this pattern is not suggestive of empire building
of the type discussed in Titman et al. (2004); that is, we nd that a rms investment level is positively
correlated with its LRVTB ratio, a proxy for positive NPV investment opportunities.
16
We use the median SEOrms book assets prior to issuance, $111.7 million, as TOTAL ASSET
0
.
The standard deviations of SEO rms FSE and LRVTB components are 0.72 and 0.75, respectively.
950 Journal of Financial and Quantitative Analysis
TABLE 5
The Effect of MTB Components on Post-Issue Changes in Assets and Expenditures
Table 5 presents regression results showing how each of the 3 components of MTB (rm-specic error (FSE), time-series
sector error (TSSE), and long-run value-to-book (LRVTB)) affects post-issue changes in assets and expenditures. The
dependent variable is Y
=
ln[

t
i=1
V
i
/TOTAL ASSET
0
) + 1] for V = R&D, capital expenditures, long-term debt reduction,
and acquisitions, and Y = ln[((V
t
V
0
)/TOTAL ASSET
0
) + 1] for V = cash, inventory, and total assets. The control
variables are primary capital (the proceeds from issued primary shares) and other sources of capital (internally generated
funds), both of which are normalized by total assets, and ln(TOTAL ASSETS). The sample period is from 1970 to 2004. We
adjust standard errors for year and rm-level clustering; the bold numbers indicate statistical signicance at the 5% level.
(7) Y =
1
FSE +
2
LRVTB +
3
TSSE +
4
ln

PRIMARY CAP
TOTAL ASSET
0

+ 1

+
5
ln

OTHER CAP
t
TOTAL ASSET
0

+ 1

+
6
ln(TOTAL ASSET
0
) +
2001

i=1970

i
YR DUMMY +
11

j=1

j
INDUSTRY DUMMY.
PRIMARY OTHER TOTAL
FSE LRVTB TSSE CAP CAP ASSET p-Value
Y t
1

2

3

4

5

6

1
=
2
Adj. R
2
n

R&D 1 (0.01) 0.05 (0.06) 0.14 0.05 0.00 0.00 0.48 1,962
2 (0.01) 0.09 (0.11) 0.29 0.10 0.01 0.00 0.57 1,812
3 (0.01) 0.13 (0.12) 0.40 0.15 0.02 0.00 0.59 1,630
4 (0.01) 0.16 (0.16) 0.46 0.17 0.02 0.00 0.61 1,450

CAPEX 1 (0.00) 0.02 0.04 0.06 0.12 (0.00) 0.00 0.29 3,269
2 0.01 0.04 0.08 0.18 0.18 0.00 0.00 0.38 3,081
3 0.01 0.05 0.06 0.23 0.24 0.01 0.00 0.41 2,766
4 0.02 0.06 0.06 0.25 0.25 0.01 0.01 0.41 2,489

LT DEBT 1 0.01 (0.04) (0.02) (0.08) 0.27 (0.02) 0.00 0.32 3,180
REDUCTION 2 0.03 (0.05) (0.01) (0.17) 0.31 (0.02) 0.00 0.36 3,093
3 0.03 (0.08) (0.03) (0.22) 0.38 (0.03) 0.00 0.40 2,726
4 0.04 (0.10) 0.00 (0.22) 0.43 (0.03) 0.00 0.43 2,427

ACQUISITION 1 (0.00) (0.01) 0.03 0.02 0.13 (0.00) 0.85 0.16 3,128
2 0.01 (0.01) 0.04 0.04 0.17 (0.00) 0.25 0.19 2,836
3 0.01 (0.02) 0.05 0.08 0.19 (0.00) 0.13 0.20 2,472
4 0.02 (0.02) 0.07 0.10 0.20 0.00 0.06 0.21 2,227
CASH 1 0.01 (0.00) 0.00 0.87 0.24 0.02 0.05 0.71 3,307
2 0.03 0.00 (0.02) 0.71 0.25 0.03 0.05 0.51 3,143
3 0.02 0.02 (0.03) 0.56 0.25 0.02 0.56 0.41 2,856
4 0.03 0.03 (0.06) 0.52 0.25 0.02 0.94 0.37 2,588
INVENTORY 1 (0.00) (0.00) 0.01 0.05 0.04 (0.00) 0.65 0.12 3,239
2 (0.01) 0.00 (0.00) 0.10 0.08 (0.01) 0.31 0.19 3,074
3 (0.01) 0.00 (0.02) 0.10 0.11 (0.01) 0.13 0.21 2,789
4 (0.01) (0.00) (0.02) 0.12 0.12 (0.01) 0.45 0.22 2,523
TOTAL 1 0.00 0.04 0.13 0.94 0.50 0.02 0.00 0.74 3,308
ASSETS 2 0.04 0.05 0.19 0.82 0.58 0.02 0.61 0.58 3,148
3 0.03 0.06 0.17 0.63 0.64 0.01 0.17 0.53 2,859
4 0.03 0.07 0.11 0.52 0.63 0.01 0.16 0.46 2,589
has only a minimal impact on R&D and capital expenditures but results in a $3.1
million increase in long-term debt reduction.
C. Long-Run Post-Issue Stock Price Performance across Components
of MTB
It has been widely documented that SEO rms underperform various bench-
marks by about 3.5%per year in the 5 years subsequent to issuance (Ritter (2003)).
The behavioral explanation for post-issue underperformance is that the market
is slow to recognize that SEO rms are overvalued. Alternatively, Carlson et al.
Hertzel and Li 951
(2006) argue that low post-issue returns reect a decrease in rm risk due to the
conversion of risky growth options into less risky assets in place. Li et al. (2009)
argue that low post-issue returns reect that SEO rms have low required rates of
return due to exogenous factors. Both of the real investment theories predict that
post-issue returns are negatively correlated with the level of post-issue investment,
after controlling for potential endogeneity associated with stock market feedback
effects. Thus, the behavioral theories predict that rms that are more overvalued
should have lower post-issue abnormal returns, while the real investment theories
predict that rms with greater investment opportunities should have lower post-
issue abnormal returns, as they are the rms that invest most after issuance. In this
section, we test these 2 hypotheses by examining the relation between post-issue
stock returns and pre-issue components of the MTB ratio. Specically, we sepa-
rate issuing rms into quartiles based on FSE and LRVTB, respectively, calculate
abnormal returns for each quartile portfolio, and compare returns across quartiles.
Following Loughran and Ritter (1995), Mitchell and Stafford (2000), and
Brav et al. (2000), among others, we use calendar-time factor regressions to mea-
sure long-run stock price performance. For each FSE and LRVTB quartile, for ev-
ery month from January 1973 to December 2004, we form equal-weighted (EW)
and value-weighted (VW) portfolios of rms that issued seasoned equity in the
previous 3 years and belong to that specic quartile. The dependent variable is the
portfolio excess return of the quartile portfolio over the 1-month T-bill rate. We
use the Fama and French (1993) 3-factor model and the Carhart (1997) 4-factor
model, and we measure portfolio abnormal performance using the intercept from
the factor regressions.
Table 6 presents the post-issue abnormal stock price performance for quar-
tiles ranked by FSE (Panel A) and LRVTB (Panel B). For ease of exposition, we
focus on the results obtained using the Fama-French (1993) 3-factor model. The
results using the Carhart (1997) 4-factor model are qualitatively similar although
weaker on a few dimensions; we discuss these results where relevant.
Panel A of Table 6 shows evidence of a negative relation between pre-issue
FSE and post-issue abnormal returns that is consistent with the behavioral view.
Specically, we observe that as FSE increases, the quartile portfolio abnormal re-
turns decrease monotonically. There is also a dramatic difference between returns
to rms in the highest versus lowest FSE quartiles: Issuing rms in the lowest FSE
quartile have average abnormal returns that are not signicantly different from
0 (0.11% per month, 3.9% after 3 years), whereas issuing rms in the high-
est FSE quartile have signicantly negative average post-issue abnormal returns
(0.54% per month, 19.4% after 3 years). The pattern is generally the same us-
ing the Carhart (1997) 4-factor model. The for the lowest rm-specic quartile
is positive, but it is signicantly negative for the highest FSE quartile. The VW
portfolio results are generally consistent with misvaluation, but not as strong as
our ndings using EW portfolios.
17
17
Loughran and Ritter (2000) and Brav et al. (2000), among others, have shown that EW and
VW portfolios may generate different abnormal returns and have debated the pros and cons of each
method. Our goal here is to investigate whether valuation errors inuence the issuance decision and
future stock returns, not to quantify the wealth impact on rms after issuance. Therefore, we believe
equal weighting may be more appropriate.
952 Journal of Financial and Quantitative Analysis
TABLE 6
Calendar-Time Factor Regressions for Firms with SEOs in the Prior 3 Years
Panels A and B of Table 6 report calendar-time factor regression results of portfolios consisting of rms that issue equity
in the prior 3 years and belong to each rm-specic error (FSE) and long-run value-to-book (LRVTB) quartile, respectively.
The quartile breakpoints are formed using all CRSP/Compustat rms. Every month from January 1973 to December 2004,
we form equal-weighted (EW) and value-weighted (VW) portfolios of rms that issued seasoned equity in the previous 3
years and belong to that specic quartile. The dependent variable is the monthly excess return of the quartile portfolio over
the 1-month T-bill rate. We use the Fama and French (1993) 3-factor model and the Carhart (1997) 4-factor model as our
factor models, and we measure portfolio underperformance as the intercept () from the factor regressions. *, **, and ***
indicate signicance at 10%, 5%, and 1% levels, respectively.
Panel A. Calendar-Time Factor Regressions for SEO Firms by FSE Quartile
FSE FF 3-Factor Model Carhart 4-Factor Model
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Low EW 0.11 1.32 0.96 0.08 0.79 0.09 1.29 0.96 0.13 0.19 0.79
2 0.17 1.18 0.97 0.01 0.84 0.04 1.16 0.97 0.02 0.12 0.84
3 0.31** 1.17 0.89 0.09 0.89 0.15 1.15 0.89 0.05 0.15 0.89
High 0.54*** 1.28 0.82 0.07 0.90 0.27** 1.25 0.82 0.13 0.25 0.92
Low VW 0.05 1.30 0.76 0.53 0.72 0.08 1.30 0.76 0.54 0.03 0.72
2 0.26 1.22 0.75 0.05 0.78 0.22 1.21 0.75 0.06 0.04 0.78
3 0.32** 1.14 0.30 0.15 0.84 0.31** 1.14 0.30 0.15 0.01 0.84
High 0.32*** 1.12 0.02 0.24 0.87 0.32*** 1.12 0.02 0.24 0.00 0.87
Panel B. Calendar-Time Factor Regressions for SEO Firms by LRVTB Quartile
LRVTB FF 3-Factor Model Carhart 4-Factor Model
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Low EW 0.48** 1.19 0.90 0.62 0.68 0.19 1.15 0.91 0.56 0.27 0.70
2 0.36** 1.19 0.64 0.34 0.80 0.17 1.16 0.64 0.29 0.18 0.81
3 0.34** 1.20 0.73 0.14 0.88 0.15 1.18 0.74 0.18 0.18 0.89
High 0.31** 1.28 1.14 0.37 0.89 0.08 1.25 1.14 0.43 0.22 0.91
Low VW 0.39* 1.14 0.29 0.39 0.59 0.24 1.12 0.29 0.36 0.14 0.60
2 0.39** 1.09 0.16 0.12 0.67 0.31 1.08 0.16 0.10 0.08 0.67
3 0.19 1.13 0.03 0.39 0.77 0.21 1.13 0.03 0.39 0.02 0.77
High 0.13 1.09 0.44 0.84 0.85 0.20 1.10 0.44 0.83 0.07 0.86
Panel B of Table 6 presents average abnormal returns for LRVTB quartile
portfolios. We have shown in Tables 4 and 5 that issuing rms in the highest
LRVTB quartile invest more aggressively in R&D and have greater capital ex-
penditures after issuance than rms in the lowest quartile, but here we see no
evidence that issuing rms in the highest quartile have lower post-issue returns
than rms in the lowest quartile. In fact, the average post-issue return to rms in
the highest LRVTB quartile is higher than that of rms in the lowest quartile for
both the EW and VW results. This evidence does not support the real-investment
explanations of low post-issue stock price performance put forward by Li et al.
(2009) and Carlson et al. (2006).
Figure 1 summarizes the central ndings of this section by showing the rela-
tion between post-issue abnormal returns and the pre-issue components of MTB.
For illustrative purposes, we focus on the EW results using the Carhart (1997) 4-
factor model. The gure shows the negative relation between post-issue abnormal
returns and the pre-issue error component contrasted against the lack of a relation
between post-issue returns and the pre-issue growth option component.
Hertzel and Li 953
FIGURE 1
Average Post-Issue Monthly Abnormal Returns across MTB Components
Figure 1 illustrates average monthly abnormal returns over the 3-year post-issue period for issuing rms that belong to
each rm-specic error (FSE) and long-run value-to-book (LRVTB) quartile. Every month from January 1973 to December
2004, we form equal-weighted (EW) portfolios of rms that issued seasoned equity in the previous 3 years and belong to
that specic quartile. We use the Carhart (1997) 4-factor model and measure portfolio underperformance as the intercept
() from the factor regressions.
1. Robustness Checks
Firm Size Analysis. As discussed earlier, previous literature has shown that
post-issue abnormal performance is concentrated in small rms and argues that
the SEO anomaly results from asset pricing model deciencies in pricing the
equity of small rms. We investigate the extent to which rm size affects the
pattern in post-issue abnormal performance that we document. This investigation
is motivated in part by evidence in Table 6 (the declining sort on slopes on SMB),
indicating that our high mispricing rms tend to be relatively larger rms.
To investigate, we separate our sample of issuing rms into 2 subsamples
based on rm size: The small rm subsample includes all issuing rms with
a market capitalization (before issuance) at or below the 20% size breakpoint
of NYSE stocks; all other issuing rms are in the large rm subsample.
18
Within each size subsample, we again sort the issuing rms into quartiles based
on FSE and examine whether the negative relation between the pre-issue error
component and post-issue abnormal returns still holds within each size group.
Although not reported in a table, we note that, consistent with previous studies,
equity issuance in our sample is concentrated in small rms: 53.6% of our sample
rms (2,319 SEO rms) have a market capitalization smaller than the 20% NYSE
breakpoint.
Table 7 presents the post-issue abnormal stock price performance for the FSE
quartiles that are formed within each size subsample. Panel A reports results for
the Fama-French (1993) 3-factor model; Panel B reports results using the Carhart
(1997) 4-factor model. We note rst that, consistent with previous studies, we nd
that smaller issuing rms tend to have greater post-issue underperformance; the
small SEO rms generally have lower post-issue abnormal returns compared
18
The size breakpoints are from Kenneth Frenchs Web site: http://mba.tuck.dartmouth.edu/pages/
faculty/ken.french/data library.html.
954 Journal of Financial and Quantitative Analysis
with their larger counterparts within each FSE quartile. However, within each size
subsample, rms with the lowest FSE do not, on average, have signicant negative
abnormal returns, while rms with high FSE signicantly underperform (with the
exception of the EW Carhart results for larger rms). This evidence suggests that
rm-level mispricing is a stronger predictor of future underperformance compared
with size (i.e., the SEO anomaly is not limited to small rms).
TABLE 7
Calendar-Time Factor Regressions for Firms with SEOs in the Prior 3 Years:
Firm Size Subsample Analysis
Table 7 reports calendar-time factor regression results of portfolios consisting of small and large rms, respectively, that
issued equity in the prior 3 years and belong to each rm-specic error (FSE) quartile, where quartile breakpoints are
formed using all CRSP/Compustat rms. Small rms are rms with pre-issue market capitalization that is smaller than the
20%breakpoints based on NYSE rms; large rms are rms that have pre-issue market capitalization bigger than the NYSE
20% breakpoints. Every month from January 1973 to December 2004, we form equal-weighted (EW) and value-weighted
(VW) portfolios of rms that issued seasoned equity in the previous 3 years and belong to that specic quartile and size
group. The dependent variable is the monthly excess return of the quartile portfolio over the 1-month T-bill rate. We use the
Fama and French (1993) 3-factor model and Carhart (1997) 4-factor model as our factor models, and measure portfolio
underperformance as the intercept () from the factor regressions. *, **, and *** indicate signicance at 10%, 5%, and 1%
levels, respectively.
Small Firms Large Firms
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Panel A. FF 3-Factor Model
Low EW 0.16 1.32 1.05 0.07 0.77 0.22 1.38 0.47 0.25 0.65
2 0.17 1.07 1.05 0.16 0.79 0.15 1.27 0.79 0.12 0.75
3 0.39* 1.15 1.22 0.13 0.78 0.20 1.18 0.56 0.04 0.86
High 0.83*** 1.30 1.28 0.08 0.84 0.38*** 1.29 0.58 0.12 0.89
Low VW 0.00 1.31 0.95 0.63 0.75 0.11 1.37 0.55 0.39 0.60
2 0.14 1.07 1.10 0.49 0.77 0.26 1.27 0.68 0.09 0.72
3 0.31 1.14 1.31 0.47 0.79 0.36** 1.14 0.20 0.10 0.83
High 0.50*** 1.21 1.13 0.40 0.85 0.33*** 1.12 0.01 0.22 0.86
Panel B. Carhart 4-Factor Model
Low EW 0.07 1.28 1.05 0.13 0.22 0.78 0.29 1.37 0.47 0.27 0.06 0.65
2 0.13 1.07 1.05 0.17 0.04 0.79 0.08 1.24 0.79 0.07 0.21 0.77
3 0.24 1.13 1.22 0.10 0.14 0.79 0.03 1.16 0.57 0.01 0.15 0.87
High 0.55*** 1.26 1.28 0.01 0.26 0.86 0.09*** 1.25 0.59 0.18 0.27 0.91
Low VW 0.01 1.31 0.95 0.63 0.01 0.75 0.18 1.36 0.56 0.41 0.07 0.60
2 0.27 1.09 1.10 0.46 0.12 0.77 0.17 1.26 0.68 0.07 0.08 0.72
3 0.34 1.15 1.31 0.46 0.03 0.79 0.33** 1.14 0.20 0.11 0.03 0.83
High 0.56*** 1.22 1.13 0.38 0.05 0.85 0.32*** 1.12 0.01 0.23 0.01 0.86
Investment Factor Analysis. Lyandres et al. (2008) show that adding an in-
vestment factor, which is long low investment stocks and short high investment
stocks, can explain a signicant fraction of the post-issue underperformance of
SEO rms.
19
They interpret their evidence as supportive of the investment-based
explanation of lowpost-issue stock price performance, but they also note that their
tests do not rule out mispricing stories. To investigate the INV explanation and
19
Lyandres et al. (2008) also show that the INV is sufcient to explain the portfolio returns com-
pared with the macroeconomic factor model proposed by Eckbo et al. (2000).
Hertzel and Li 955
its importance for our analysis, we reestimate post-issue abnormal returns adding
the INV to the 3- and 4-factor regressions considered earlier.
Table 8 presents the reestimated post-issue abnormal stock price perfor-
mance for quartiles ranked by FSE (Panel A) and LRVTB (Panel B). Consistent
with the ndings of Lyandres et al. (2008), the table shows that adding the INV
reduces the overall magnitude of post-issue underperformance. However, the de-
creasing trend of abnormal returns across FSE quartiles remains qualitatively un-
changed. Issuing rms in the lowest FSE quartiles have positive abnormal returns
in most cases, while rms in the highest FSE quartiles generally have signicant
negative abnormal returns. This nding suggests that mispricing contributes to
post-issue underperformance even after controlling for the potential investment
effect.
TABLE 8
Calendar-Time Factor Regressions Augmented with Investment Factor
for Firms with SEOs in the Prior 3 Years
Panels A and B of Table 8 report calendar-time factor regressions augmented with the investment factor (INV) for port-
folios consisting of rms that issued equity in the prior 3 years and belong to each rm-specic error (FSE) and long-run
value-to-book (LRVTB) quartile, where quartile breakpoints are formed using all CRSP/Compustat rms. Every month from
January 1973 to December 2004, we form equal-weighted (EW) and value-weighted (VW) portfolios of rms that issued
seasoned equity in the previous 3 years and belong to that specic quartile. The dependent variable is the excess return
of the quartile portfolio over the 1-month T-bill rate. We use the Fama and French (1993) 3-factor model and Carhart (1997)
4-factor model augmented with the Lyandres et al. (2008) INV as our factor models, and measure portfolio underperfor-
mance as the intercept () from the factor regressions. *, **, and *** indicate signicance at 10%, 5%, and 1% levels,
respectively.
Panel A. Calendar-Time Factor Regressions Augmented with Investment Factor for SEO Firms by FSE Quartile
FSE Augmented FF 3-Factor Model Augmented Carhart 4-Factor Model
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Low EW 0.19 1.27 0.94 0.08 0.45 0.79 0.27 1.26 0.95 0.12 0.15 0.32 0.80
2 0.05 1.16 0.97 0.01 0.18 0.84 0.01 1.15 0.97 0.02 0.11 0.09 0.84
3 0.10 1.13 0.88 0.09 0.33 0.89 0.03 1.13 0.88 0.06 0.13 0.23 0.90
High 0.24* 1.23 0.81 0.07 0.45 0.91 0.12 1.22 0.82 0.13 0.22 0.28 0.93
Low VW 0.35 1.25 0.75 0.53 0.47 0.72 0.33 1.25 0.75 0.52 0.02 0.49 0.72
2 0.13 1.19 0.75 0.05 0.22 0.78 0.12 1.19 0.75 0.05 0.02 0.20 0.78
3 0.30** 1.13 0.30 0.15 0.08 0.85 0.29** 1.13 0.30 0.15 0.01 0.07 0.85
High 0.30** 1.12 0.02 0.24 0.06 0.87 0.29** 1.12 0.02 0.24 0.00 0.06 0.87
Panel B. Calendar-Time Factor Regressions Augmented with Investment Factor for SEO Firms by LRVTB Quartile
LRVTB Augmented FF 3-Factor Model Augmented CARHART 4-Factor Model
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Low EW 0.09 1.13 0.89 0.63 0.57 0.69 0.03 1.11 0.90 0.57 0.23 0.39 0.70
2 0.04 1.12 0.63 0.35 0.59 0.82 0.01 1.11 0.63 0.31 0.13 0.48 0.82
3 0.14 1.17 0.73 0.14 0.30 0.89 0.05 1.16 0.73 0.17 0.16 0.17 0.89
High 0.17 1.26 1.14 0.37 0.22 0.90 0.05 1.24 1.14 0.43 0.22 0.05 0.90
Low VW 0.28 1.12 0.28 0.39 0.17 0.59 0.21 1.12 0.29 0.36 0.13 0.06 0.60
2 0.39* 1.09 0.16 0.12 0.02 0.67 0.33 1.09 0.16 0.10 0.08 0.04 0.67
3 0.13 1.12 0.02 0.39 0.09 0.77 0.15 1.12 0.02 0.38 0.04 0.12 0.77
High 0.13 1.09 0.44 0.84 0.00 0.85 0.17 1.09 0.44 0.82 0.08 0.06 0.86
Panel B of Table 8 presents the results for the LRVTB quartile portfolios.
Again, we nd that the overall magnitude of underperformance decreases with
the addition of the INV. However, the loadings on the INV appear to be incon-
sistent with the real investment story. Given our earlier ndings that rms in the
956 Journal of Financial and Quantitative Analysis
highest LRVTB quartile invest the most after issuance, the real investment theory
would predict that the coefcient of INV should be most negative for rms in
quartile 4 and relatively less negative for rms in quartiles 1 and 2 where post-
issue investment is not as great. Instead, we nd generally more negative loadings
for quartiles 1 and 2 and less negative loadings for quartile 4. Thus, although the
addition of the INV does explain a signicant portion of the post-issue underper-
formance, it is not clear from our ndings that increased investment is the channel
through which this effect occurs.
2. Caveats
We recognize several caveats with respect to the interpretation of the nd-
ings in this section. First, evidence that rms in the high LRVTB quartile invest
aggressively in R&D post-issue suggests that in addition to converting growth
options to assets in place, issuing rms may also contemporaneously be adding
growth options. Thus, R&D investment may mitigate post-issue risk reduction of
the type suggested by Carlson et al. (2006) and Lyandres et al. (2008); this may
explain why we do not observe lower post-issue returns for the high LRVTB is-
suers and the puzzling loadings on the INV.
20
A second caveat is that other factors
may also contribute to the low post-issue returns. This is suggested in particular
by the fact that rms in the lowest error quartiles (Panel A of Table 6), which
might be considered to be undervalued, do not have signicant positive post-
issue abnormal returns. While this may be due to a selection bias in that managers
are reluctant to issue when the equity is undervalued, it may also reect decreased
rm leverage ratios and increased stock liquidity after issuance, as suggested in
Eckbo et al. (2000). Thus, while we nd evidence that misvaluation prior to is-
suance contributes to the long-term underperformance of SEO stocks, we cannot
rule out the possibility that other factors also play a role. Finally, we recognize
the possibility that our measure of FSE may be correlated with risk factors that
are not captured by the Fama-French (1993) and Carhart (1997) models. In that
case, our study might help shed light on these factors.
V. Conclusion
In this paper, we examine the extent to which market timing and/or capi-
tal budgeting motivate equity issuance decisions and contribute to low post-issue
stock returns. We have 3 main ndings. First, using the Rhodes-Kropf, Robinson,
and Viswanathan (2005) methodology to decompose pre-issue market-to-book
(MTB) into misvaluation and growth option components, we nd that issuing
rms have greater mispricing and greater growth options relative to the overall
market. This nding is consistent with both the behavioral and rational explana-
tions of high pre-issue MTB ratios and suggests that both rm-level overvaluation
and nancing needs affect managerial decisions to issue equity.
20
Consistent with this possibility, Ritter (2003) reports that post-issuance SEO rms are highly
risky, with an average summed beta of 1.5 over the 3 years following issuance. Also consistent is
evidence in Denis and Kadlec (1994) showing no change in systematic risk following equity offerings.
Hertzel and Li 957
Second, we examine the relation between the use of issue proceeds and the
pre-issue components of the MTBratio and nd that issuing rms with larger error
components tend to pay down debt and/or stockpile cash, while rms with greater
growth option components invest more in R&D and capital expenditures. This ev-
idence suggests that the error and long-run value-to-book (LRVTB) components
of the MTB ratio capture different characteristics (misvaluation vs. growth op-
tions) of the issuing rms. The differential post-issue investment also bolsters our
conclusion that SEOs are motivated by both misvaluation and/or nancing needs.
Third, consistent with behavioral explanations for low post-issue stock re-
turns, we nd that post-issue abnormal stock returns are more negative for rms
that are more overvalued as measured by the pre-issue error component of MTB;
depending on the model specication, the average 3-year post-issue abnormal re-
turn for rms in the highest mispricing quartile ranges from 9.7% to 19.4% as
compared to a range of 3.9%to +3.2%for rms in the lowest mispricing quartile.
These differences are economically and statistically signicant and are robust to
rm size considerations and to inclusion of the Lyandres, Sun, and Zhang (2008)
investment factor (INV) in the standard factor regressions. In contrast to the mis-
pricing results, we nd no evidence of a relation between post-issue abnormal
returns and the pre-issue growth option component of MTB. This evidence, to-
gether with our nding that issuing rms with greater growth option components
tend to invest more post-issue, is not supportive of the real investment explana-
tions of low post-issue returns.
To summarize, our ndings identify rm-level misvaluation as an important
factor contributing to low post-issue returns.
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