Earnings Quality and International IPO Underpricing

The following post comes to us from Thomas Boulton of the Finance Department at Miami University, Scott Smart of the Finance Department at Indiana University, and Chad Zutter of the Finance Department at the University of Pittsburgh.

In the paper, Earnings Quality and International IPO Underpricing, forthcoming in The Accounting Review, we examine the impact of country-level earnings quality on IPO underpricing. When firms convert from private to public ownership through an initial public offering (IPO), they typically sell shares at a price that is below the market price that prevails once secondary market trading begins. This “underpricing” cost, which is prevalent in virtually every stock market around the world, is one of the largest costs that firms must bear when going public. Underpricing also varies widely between countries.

In our work, we trace international differences in underpricing to disclosure practices in different markets. Theory predicts that underpricing will be higher when information disparities between investors are greater. When accounting conventions in a particular market are transparent and informative, information disparities should be reduced, which in turn ought to reduce the underpricing cost of going public.

We measure the quality of earnings disclosures by public firms in 37 countries, and then we examine the correlation between country-level earnings quality measures and firm-level underpricing in a sample of 10,783 IPOs. A one standard deviation improvement in earnings quality reduces underpricing by 7.8 percentage points, which represents a significant decrease in the cost of going public. Our study contributes to a growing literature highlighting the importance of accounting disclosures to the development and functioning of capital markets around the world.

The full paper is available for download here.

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  1. Andrew Clearfield
    Posted Monday, December 27, 2010 at 12:17 pm | Permalink

    While I would not argue with these findings regarding the benefits of accounting transparency, it is also relevant to point out that IPOs are not supposed to be quite fully priced. If the bankers don’t leave something there for the initial investors in the offering, after a few such experiences, the investors won’t want to buy. A fully-priced IPO, in which the shares don’t quickly move to trade at a premium, is regarded as a failure, sometimes even by the issuer, but certainly by everyone else involved.

  2. Gene Massey
    Posted Tuesday, December 28, 2010 at 10:28 am | Permalink

    Absolutely true – underpricing is necessary, but ONLY in a typical IPO, not in the MediaShares/CinemaShares model, where shares can be sold to fans, customers, or the company’s affinity group through Direct Registration. The company’s IPO stock is sold directly to shareholders online, disintermediating the Underwriter, so the company can price it correctly. The company also gets to communicate directly with its massive online community (electronic disclosure through email) and can offer free product dividends worth the share purchase price, effectively setting the share value with the product dividend’s retail value.
    Gene Massey 310 871-3668 or [email protected]
    Watch the video: http://www.vimeo.com/14132796