Jay R. Ritter

Investment Banking, Reputation, and the Underpricing of Initial Public Offerings

This paper develops and tests two propositions. We demonstrate that there is a monotone relation between the (expected) underpricing of an initial public offering and the uncertainty of investors regarding its value. We also argue that the resulting underpricing equilibrium is enforced by investment bankers, who have reputation capital at stake. An investment banker who ‘cheats’ on this underpricing equilibrium will lose either potential investors (if it doesn’t underprice enough) or issuers (if it underprices too much), and thus forfeit the value of its reputation capital. Empirical evidence supports our propositions.

Initial public offerings: International insights

Abstract This paper discusses evidence on the short-run and long-run performance of companies going public in many countries. Differences in average initial returns are analyzed in terms of binding regulations, contractual mechanisms, and the characteristics of the firms going public. The evidence suggests that the move in recent years by most East Asian countries to reduce regulatory interference in the setting of offering prices should result in less short-run underpricing in the 1990s than in the 1980s. Evidence is presented that companies successfully time their offerings for periods when valuations are high, with investors receiving low returns in the long-run. Implications for investors, issuers, and regulators are discussed.

Uniformly Least Powerful Tests of Market Efficiency

Defenders of market efficiency argue that anomalies involving long-term abnormal returns are not robust to alternative methodologies. We argue that because various methodologies use different weighting schemes, the magnitude of abnormal returns should differ, and in a predictable manner. Three problems are identified that cause low power in value-weighted three-factor time series regressions when abnormal returns following managerial actions are being estimated. We illustrate the sensitivities in the context of the new issues puzzle as well as with simulations. More generally, multifactor models as currently used do not, and cannot, test market efficiency.

Measuring abnormal performance: Do stocks overreact?

Abstract A highly controversial issue in financial economies is whether stocks overreact. In this paper we find an economically-important overreaction effect even after adjusting for size and beta. In portfolios formed on the basis of prior five-year returns, extreme prior losers outperform extreme prior winners by 5–10% per year during the subsequent five years. Although we find a pronounced January seasonal, our evidence suggests that the overreaction effect is distinct from tax-loss selling effects. Interestingly, the overreaction effect is substantially stronger for smaller firms than for larger firms. Returns consistent with the overeaction hypothesis are also observed for short windows around quarterly earnings announcements.

The costs of going public

Abstract This paper presents evidence regarding the two quantifiable components of the costs of going public: direct expenses and underpricing. Together, these costs average 21.22% of the realized market value of the securities issued for firm commitment offers and 31.87% for best efforts offers. For a given size offer, the direct expenses are of the same order of magnitude for both contract types, but the underpricing is greater for best efforts offers. An explanation of why some firms choose to use best efforts offers in spite of their apparent higher total costs is given.

Testing Theories of Capital Structure and Estimating the Speed of Adjustment

This paper examines time-series patterns of external financing decisions and shows that publicly traded U.S. firms fund a much larger proportion of their financing deficit with external equity when the cost of equity capital is low. The historical values of the cost of equity capital have long-lasting effects on firms’ capital structures through their influence on firms’ historical financing decisions. We also introduce a new econometric technique to deal with biases in estimates of the speed of adjustment toward target leverage. We find that firms adjust toward target leverage at a moderate speed, with a half-life of 3.7 years for book leverage, even after controlling for the traditional determinants of capital structure and firm fixed effects.

Investment Banking and Securities Issuance

This chapter analyzes the securities issuance process, focusing on initial public offerings (IPOs) and seasoned equity offerings (SEOs). The IPO literature documents three empirical patterns: 1) short-run underpricing; 2) long-run underperformance (although this is contentious); and 3) extreme time-series fluctuations in volume and underpricing. While the chapter mainly focuses on evidence from the USA, evidence from other countries is generally consistent with the USA patterns. A large literature explaining the short-run underpricing of IPOs exists, with asymmetric information models predominating. The SEO literature documents 1) negative announcement effects; 2) the setting of offer prices at a discount from the market price; 3) long-run underperformance; and 4) large fluctuations in volume. In addition to long-run underperformance relative to other stocks, there is some evidence that issuers succeed at timing their equity offerings for periods when future market returns are low. When examining a large class of corporate financing activities, including equity offerings, convertible bond offerings, bond offerings, open market repurchases, stock- and cash-financed mergers and acquisitions, and dividend increases or decreases, several patterns emerge. In general, the announcement effects are negative for activities that provide cash to the firm, and positive for activities that pay cash out of the firm. Furthermore, the market generally underreacts, in that long-run abnormal returns are usually of the same sign as the announcement effect. In spite of the large expenditure of resources on analyst coverage, there is little academic work emphasizing the importance of the marketing of financial securities. Only recently have papers begun to focus on the corporate financing implications if firms face variations in the cost of external financing due to the mispricing of securities by the market.

The Quiet Period Goes out with a Bang

We examine the expiration of the IPO quiet period, which occurs after the 25th calendar day following the offering. For IPOs during 1996 to 2000, we find that analyst coverage is initiated immediately for 76 percent of these firms, almost always with a favorable rating. Initiated firms experience a five-day abnormal return of 4.1 percent versus 0.1 percent for firms with no coverage. The abnormal returns are concentrated in the days just before the quiet period expires. Abnormal returns are much larger when coverage is initiated by multiple analysts. It does not matter whether a recommendation comes from the lead underwriter or not.

The Decline of Inflation and the Bull Market of 1982–1999

If stocks were severely undervalued in the late 1970s and early 1980s, then the bull market starting in 1982 was partly just a correction to more normal valuation levels. This paper tests the hypothesis that investors suffer from inflation illusion, resulting in the undervaluation of equities in the presence of inflation, with levered firms being undervalued the most. Using firm level data and a residual income/EVA model, we find evidence that errors in the valuation of levered firms during inflationary times result in depressed stock prices. Our misvaluation measure can be used with expected inflation to make statistically reliable predictions for real returns on the Dow during the subsequent year. Our model suggests that stocks were overvalued at the end of the 1990s.

Differences between European and American IPO Markets

This brief survey discusses recent developments in the European initial public offering (IPO) market. The spectacular rise and fall of the Euro NM markets and the growth of bookbuilding as a procedure for pricing and allocating IPOs are two important patterns. Gross spreads are lower and less clustered than in the USA. Unlike the USA, some European IPOs, especially those in Germany, have when-issued trading prior to the final setting of the offer price. Current research includes empirical studies on the valuation of IPOs and both theoretical and empirical work on the determinants of short-run underpricing.