Corporate Investment and Asset Price Dynamics: Implications for Post-SEO Performance

Empirical methods in corporate finance for some time focused on the short-term market reaction to corporate announcements. The associated theories rely heavily on market imperfections such as taxes, transaction costs, information issues and contracting problems to obtain short-term market reactions in a rational setting. A critical assumption in these environments is that managers are concerned with long-run or intrinsic market value. A more recent empirical literature explicitly examines the long-run performance of firms. If short-term reactions to an announcement reflect favorable information about the long-run, then this should be evident in long-term accounting performance. Long-run market returns, on the other hand, should not be abnormal. These predictions are often inconsistent with what has been found in the data, especially with regard to equity issuance. Loughran and Ritter (1995) and others find a 70% average price appreciation in the year prior to the announcement of an issue followed by a return of only 5% per year for five years after the issue. This is well below the returns on seemingly comparable firms. These empirical results about long-run performance exist in a theoretical vacuum. Corporate theory based on information transmission can give announcement effects, but has little to say about long-run returns (other than that they should not be abnormal). One recent conjecture that has gained a substantial following is the market timing or window of opportunity hypothesis. According to this conjecture, the market occasionally becomes unrealistically optimistic about the firm’s prospects, as reflected, for instance, in the 70% run up in price prior to issuance. Managers realize that the market is overly optimistic and take advantage of this window of opportunity by issuing securities at inflated prices. The poor accounting performance and low returns subsequent to the issue provides evidence that the market was overly optimistic. The purpose of our paper is to show how recent advances in dynamic asset pricing can deliver a rational theory of SEO underperformance. We develop a simple model of corporate investment that is capable of explaining the observed pattern of returns around equity issuance. We conclude that it is not the issuance of securities that is important, but the investment of the funds in real assets that drives security returns. The observed return pattern surrounding equity issues is consistent with the theoretically derived, dynamic, endogenously determined risk of the firm. We use firm level data to develop additional tests of the theory.