Financial markets affect the economy in a fundamental way by facilitating the creation of capital. The market for initial public offerings (IPO) – also known as the “primary market” – is especially important because it allows fast-growing and innovative companies to raise the capital needed to pursue business opportunities, develop new technologies, and create jobs – all of which contribute to economic growth. A significant challenge for those companies is that the capital they raise is on average substantially less than what they are worth, a phenomenon known as underpricing. Studies show that underpricing reflects an information problem: Primary market valuation of IPOs is typically carried out using limited data and without access to the full range of information commonly available to public market investors (e.g., historical prices, corporate disclosure, and analyst reports). As such, IPO participants face significant valuation uncertainty.
In a recent study, I examine whether better access to public firm disclosures can affect IPO underpricing through information spillover. At the conceptual level, externalities can occur because corporate disclosure is a public good. Although disclosures are intended mainly to inform a publicly listed firm’s current and prospective shareholders, other parties (e.g., competitors, suppliers, consumers, employees) may also use the information disclosed. In that sense, corporate disclosures can generate externalities.
In the context of an IPO, peer disclosures can inform IPO investors in at least four ways.
- First, the most common method for valuing IPO firms is the comparable firm multiples. Peer disclosures help IPO investors identify the right firms to use in their comparables analysis. Qualitative disclosures from peer firms, especially the MD&A and the list of product-market peers, are particularly useful in selecting peers.
- Second, peer disclosures can complement the comparable firm multiples analysis. Fundamental analysis using valuation models is more challenging in IPO settings, primarily because IPO firms are being valued based on their growth opportunities rather than historical financials. Because accounting multiples produce noisy valuation numbers, investors might choose to place more weight on qualitative information disclosed by peers, especially for new-economy firms, which tend to have negative profits when going public. In those cases, earnings multiples are replaced by revenue multiples, which are known to produce unreliable estimates because of their sensitivity to capital structure and implementation details. As a result, investors rely more on qualitative disclosures.
- Third, peer disclosures provide context and help investors assess the validity of industry-wide forces, such as the total target market, competitive forces, and future opportunities in IPO prospectuses and roadshow presentations.
- Fourth, peer disclosures help investors better understand the use of IPO proceeds. Many firms use the IPO proceeds to expand to new businesses. Because the new businesses have not yet been established at the time of the IPO, the validity of their performance projections can be assessed based on disclosures from firms operating in those business areas.
I use a variety of settings to capture IPO investors’ access to disclosures by public peers. My main setting is the implementation of the EDGAR system. The SEC required that all public companies file to EDGAR in 10 pre-assigned groups from April 1993 through May 1996. IPO documents, such as S-1s, were not required to be filed on EDGAR until all already-public firms finished transitioning to EDGAR filings. An important advantage of this setting is that the staggered implementation was not based on industry. As a result, economically similar firms did not transition to EDGAR at the same time, creating variation in the number of firms filing on EDGAR within an industry over time and across industries. This variation provides a powerful setting to study information spillover by allowing me to accurately observe the public peers’ electronic disclosures available to IPO investors.
The key findings of my paper are, first, when more publicly traded peers start to file on EDGAR, IPO firm underpricing decreases. In terms of economic magnitude, a 1 percent increase in the number of peers filing on EDGAR reduces underpricing by roughly 10 basis points. Second, this finding is stronger when peer firms’ information quality is high, when alternative information sources are scarce, and when peer disclosures contain more industry-wide information. Third, increased equity-research coverage of public peers contributes to this finding.
In the last part of my study, I generalize this finding to other countries. I show that the implementation of centralized electronic disclosure systems (CEDS), which are central repositories that are similar to EDGAR in 28 countries, leads to similar results for overseas IPOs.
Together, the results suggest better dissemination of public firm disclosures can reduce frictions for private firms seeking to procure equity capital in the IPO market.
This post comes to us from Shawn Shi at Stanford Graduate School of Business. It is based on his recent article, “How Does Better Access to Public Firm Disclosures Affect Private Firm Financing?” available here.