Behavioral and rational explanations of stock price performance around SEOs:

Evidence from a decomposition of market-to-book ratios*

Michael G. Hertzel
Department of Finance
W. P. Carey School of Business
Arizona State University
Phone: (480) 965-6869
Email: michael.hertzel@asu.edu

Zhi Li
Department of Finance
W. P. Carey School of Business
Arizona State University
Phone: (480) 965-3131
Email: zhi.li.2@asu.edu

First Draft: August 30, 2006

*
We thank Stephan Dieckmann, David Robinson, Sunil Wahal and brown bag seminar participants
at Arizona State University for helpful comments.
 Behavioral and rational explanations of stock price performance around SEOs:
Evidence from a decomposition of market-to-book ratios

Abstract

This paper examines the extent to which investment opportunities and/or mispricing

motivates equity issues and contributes to low post-issue stock returns. Using the

Rhodes-Kropf, Robinson and Viswanathan (2005) methodology to decompose market-to-

book ratios into misvaluation and growth option components, we find that issuing firms

have both greater mispricing and greater long-run growth opportunities relative to the

overall market. Issuing firms with greater mispricing tend to decrease long-term debt and

earn lower post-issue abnormal returns. In contrast, firms with greater growth

opportunities invest more aggressively in R&D and capital expenditures and do not

experience more negative post-issue stock price performance. Our results are more

consistent with behavioral explanations for SEO underperformance, and show that

managers have more information about true firm value than outside investors and act to

maximize current shareholder’s wealth. The results do not support theories that link post-

issue performance with investment activities.

2
1. Introduction

It is well-documented that firms conducting seasoned equity offerings (SEOs)

experience significant stock price run-ups in the year prior to the offering and low stock

returns over the subsequent five years. Two alternative explanations of this pattern in

returns have appeared in the literature. The behavioral view is that the pre-issuance run-

up reflects investor overreaction to recent trends in performance, that managers choose to

issue equity when firms are overvalued, and that investors are slow to recognize and

incorporate information conveyed by SEO announcements. More recently, real

investment based rational explanations have emerged. Carlson, Fisher and Giammarino

(2006), using a real options approach, posits that the pre-issue run-up reflects growth

options coming into the money, that managers issue equity in order to invest in these

growth options, and that lower post-issue returns reflect a decrease in firm risk as risky

growth options are converted into less risky assets in place. Zhang (2005), using a Q-

theoretic framework, argues that the pre-issue run-up reflects a decrease in the required

return on capital that causes more investment opportunities to become positive NPV

projects, that firms issue equity to finance these investment projects, and that low post-

issue stock returns reflect the decreased required return on capital. Both of the rational

theories predict that firms increase investment after SEOs and that there is a negative

relation between investment level and future stock returns. 1

In this paper, we provide evidence on these alternative explanations using a

methodology developed by Rhodes-Kropf, Robinson and Viswanathan (2005, hereafter

1
There are other theories that address post-issue stock price underperformance. Titman, Wei, and Xie
(2004) argue managers are empire-builders and destroy firm value by overinvestment. Eckbo, Masulis, and
Norli (2000) posit that SEO firms have lower risk levels due to lower leverage and higher stock liquidity
after issuance. Brav, Geczy, and Gompers (2000) argue that SEO underperformance may reflect a return
pattern in publicly traded small and high M/B firms. Finally, Fama (1998) argues that ‘underperformance’
may be caused by model misspecification.

3
RKRV) that decomposes pre-issue market-to-book (M/B) ratios into misvaluation and

growth option components. Previous research has documented that SEO firms have

higher than average market-to-book ratios. High M/B 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 decomposing issuing firm

M/B 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 methodology uses an accounting multiples approach to break M/B into

three components: firm-specific error, time-series sector error, and long-run value-to-

book. Firm-specific error measures firm-specific deviations from valuations implied by

current sector accounting multiples, and is intended to capture the idiosyncratic

misvaluation component of the M/B ratio. Time-series sector error measures valuation

deviations when contemporaneous sector multiples differ from long-run sector multiples.

This component indicates whether the sector, or possibly the entire market, is overvalued.

Long-run value-to-book measures value implied by long-run sector accounting multiples

relative to book value; it is a proxy for growth opportunities.

Our empirical testing methodology proceeds in three steps. First, for a sample of

4325 seasoned equity offerings over the 1970 to 2004 time period, we show that all three

components of M/B, on average, are significantly larger for issuing firms than for a

control sample of non-issuing firms. This finding suggests that SEO decisions may be

motivated by either high levels of misvaluation, high levels of growth opportunities, or

both.

4
 Second, we examine the relation between the use of issue proceeds and the pre-

issue components of the market-to-book ratio. The goal of this analysis is to provide

evidence on the extent to which the error components of M/B reflect misvaluation and

can thereby serve as useful metrics in our analysis of post-issue stock price performance.

Assuming that managers act in the interest of existing 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. If the firm-specific error and time-series

sector error components of M/B reflect misvaluation, there should be no relation to

subsequent post-issue investment.

To investigate post-issue investment, we follow the approach of Kim and

Weisbach (2005) and examine post-SEO changes (over horizons of 1 to 4 years) in seven

accounting variables that likely capture the use of issue proceeds: capital expenditures,

R&D, total assets, debt-reduction, cash, acquisitions and inventory. We regress the

changes in these accounting variables on the three components of the M/B ratio while

controlling for primary capital raised in the SEO, other sources of funds generated within

the firm, firm size, and fixed effects for year and industry. This analysis yields the

following results:

 Post-issue investment in capital expenditures and R&D is positively related to

the pre-issue level of long-run value-to-book, and unrelated to the firm-

specific error component of M/B.

 Debt reduction is positively related to firm-specific error and negatively

related to long-run value-to-book.

5
  Post-issue changes in cash positions are positively related to firm-specific

error, but unrelated to long-run value-to-book.

These findings suggest that firms with high levels of growth options invest more in real

assets, whereas firms with high valuation errors are more likely to pay down debt and/or

stockpile cash. This evidence is consistent with the interpretation of firm-specific error

as a measure of misvaluation. These results hold when we measure misvaluation as the

sum of firm-specific error and time-series sector error.

Our last set of tests focus on the relation between post-issue stock price

performance and pre-issue components of M/B. The real investment theories predict a

negative relation between investment level and future stock returns. In contrast,

behavioral theory predicts that post-issue stock returns should be negatively correlated

with the degree of overpricing at the time of issuance. In these tests we separate issuing

firms into quartiles based on firm-specific error and long-run value-to-book and then

calculate long-run (3- and 5-year) post-issue abnormal returns for each quartile portfolio

using calendar time factor regressions. Our results are as follows:

 We find no relation between long-run value-to-book ratios and post-issue

abnormal returns, i.e., issuing firms with high levels of growth options do

not have lower post-issue abnormal returns than issuing firms with lower

levels of growth options. This evidence taken in conjunction with our

finding that issuing firms 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.

6
  In contrast, we do find a relation between firm-specific error and post-

issue returns; issuing firms with high firm-specific error have more

negative post-issue abnormal returns. The results are stronger when we

measure misvaluation as the sum of firm-specific error and time-series

sector error. Evidence that more overvalued firms have lower post-issue

abnormal returns is consistent with the behavioral explanation of low post-

issue returns.

The remainder of the paper is organized as follows. Section 2 describes the

sample selection procedure and the data. Section 3 describes our empirical methodology

and Section 4 presents our findings. Section 5 concludes.

2. Data

Our sample includes all firms, as identified from the SDC database, which

conduct SEOs over the period 1970 to 2004. Accounting information and stock price

data are from Compustat and CRSP, respectively. Following Rhodes-Kropf, Robinson

and Viswanathan (2005), we merge data in the following way. To calculate and

decompose M/B, we first match fiscal year accounting data from Compustat with market

value data from CRSP measured three months after the fiscal year-end. An SEO is

aligned with this match of Compustat and CRSP data if the issuance occurs at least one

month after the date that CRSP market value is measured. If the issuance occurs between

the fiscal year-end and one month after the CRSP market value measurement date, we

match the SEO with the previous year’s information.

7
 To be included in the final sample, an issuing firm must have enough Compustat

and CRSP data to calculate the three components of the M/B ratio. We exclude firms that

only issue secondary shares as well as utility companies with SIC codes between 4910

and 4949, closed-end funds (SIC between 6720 and 6739) and REITs (SIC 6798). If a

firm issues primary shares more than once within a three-year period, then only the first

issue is included. The final sample has 4325 observations. Table 1 reports the number of

SEOs in our final sample by year over the period 1970 to 2004.

3. Empirical methodology

3.1. Decomposing the market-to-book ratio

The rational and behavioral theories of stock price performance around SEOs

offer alternative explanations for high pre-issue market-to-book ratios. Behavioral theory

suggests that equity issues are more likely when firm 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 true value-to-book

ratio (V/B). This distinction underlies our rationale for employing the RKRF (2005)

methodology for decomposing M/B into misvaluation (M/V) and growth option (V/B)

components as follows:

(1) M/B  M/V x V/B

which in log form can be written as

(2) m  b  ( m  v )  (v  b )

where lower case letters indicate logarithms of the respective variables. 2 If markets know

the future growth opportunities, discount rates, and cash flows, then the term (m – v)
2
We adopt the same notation and our discussion below closely mirrors that in RKRV (2005).

8
should be zero. If markets make mistakes in estimating discounted future cash flows, or

markets do not have information that managers have, then (m–v) will capture the

misvaluation component of the market-to-book ratio.3

3.2. Estimating market value

A critical element in identifying the components of the market-to-book ratio is

determining an estimate of true firm value, v. For estimation purposes, for each firm i in

industry j at time t, v can be expressed as a linear function of firm-specific accounting

information,  it , and a vector of corresponding accounting multiples,  . As described

below, the RKRV methodology employs both a vector of contemporaneous time-t

accounting multiples,  jt , and a vector of long-run accounting multiples,  j . Thus, the

market-to-book ratio for firm i at time t can be further decomposed as:

mit  bit  mit  v( it ; jt )  v( it ; jt )  v( it ; j )  v ( it ; j )  bit

                   
(3) firm sec tor long  run
              
total

The first two terms on the right hand side of Eq. (3), collectively referred to as

total error, capture the misvaluation component of the market-to-book ratio. The first

term, mit  v( it ; jt ) , referred to as firm-specific error, measures the difference between

market value and fundamental value estimated by firm accounting data  it and

contemporaneous sector accounting multiple  jt . The second term,

v ( it ; jt )  v ( it ; j ) , referred to as time-series sector error, measures the difference in

estimated fundamental value when contemporaneous sector accounting multiples at time

3
As RKRV note, the term, m–v, may or may not correspond to an asset-pricing sense of mispricing, since it
can be caused either by behavioral biases or by information asymmetry.

9
t,  jt , differ from long-run sector multiples,  j . This difference reflects the extent to

which the whole sector (or, possibly, the entire market) may be misvalued at time t.

With respect to the error terms in Eq. (3), two points are worth noting here. First,

in addition to misvaluation, the error components also reflect firm-specific deviations

from current and long-run industry-average growth and discount rates. In section 4.2, we

show that the high error components we document for SEO firms are more likely due to

misvaluation than to such deviations. Second, although essential to the research question

investigated by RKRV4, the decomposition of the error term into firm-specific and time-

series sector components is less informative about the hypotheses we investigate. Thus,

we focus much of our analysis on firm-specific error and total error (i.e., the combination

of firm-specific and time-series sector error.)

The third term, v( it ; j )  bit , is long-run value-to-book. It measures the

difference between firm value implied by the vector of long-run sector multiples and

book value. This measure can be interpreted as the investment opportunity component of

the market-to-book ratio.

Rhodes-Kropf, Robinson and Viswanathan (2005) use three 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 RKRV’s third model, which includes book value (b), net income (NI)

and market leverage ratio (LEV) in the accounting information vector  it .5 Expressing

market value as a simple linear model of these variables yields:

4
RKRV test theories of mergers where industry misvaluation plays a central role.
5
The first model in RKRV (2005) includes only book value; the second model includes book value and net
income. Our results are robust to using either of these models.

10
 (4) mit   0 jt  1 jt bit   2 jt ln( NI ) it   3 jt I ( 0 ) ln( NI ) it   4 jt LEVit   it

where, because net income can be negative sometimes, it is expressed as an absolute

value (NI)+ along with a dummy variable, I (0 ) , to indicate when net income is negative.

To identify the contemporaneous accounting multiples  jt , each year we group

CRSP/Compustat firms according to the 12 Fama and French industry classifications and

run annual, cross-sectional regressions for each industry and generate estimated industry

accounting multiples for each year t, ̂ jt .6 The estimated value of v ( it ; jt ) is the fitted

value from regression Eq. (4):

v(bit , NI it , LEVit ; ˆ 0 jt , ˆ 1 jt , ˆ 2 jt , ˆ 3 jt , ˆ 4 jt )
(5)
 ˆ 0 jt  ˆ 1 jt bit  ˆ 2 jt ln( NI ) it  ˆ 3 jt I (  0) ln( NI ) it  ˆ 4 jt LEVit

To calculate the long-term sector multiples,  j , we average, over time, the ̂ jt ’s from

the annual regressions:  j  1 / T 

t
 jt for all  k , where k=0, 1, 2, 3, 4. Our estimate

of v( it ; j ) is then the fitted value of Eq. (4) using the  j ’s:

v(bit , NI it , LEVit ;  0 j ,  1 j ,  2 j ,  3 j ,  4 j )
(6)
  0 j   1 j bit   2 j ln( NI ) it   3 j I (  0) ln( NI ) it   4 j LEVit

With respect to our long-run post-issue stock price performance tests, it is useful

at this point to note that in calculating  j , the time series average of the yearly sector

multiples, we use information that is not available to the market at time t. Thus, our

measure of long-run value v( it ; j ) could reflect information possessed by firm

6
We use market capitalization (price * shares outstanding) as our measure of the market value of equity, m.
Accounting variables are measured as follows: book value (data item 60), net income (data item 172),
market leverage (1-market equity/market value), where market value is measured as CRSP market equity
plus Compustat book assets (data item 6) minus deferred taxes (data item 74) minus book equity (data item
60).

11
managers, but unknown to the market at time t. This implies that our measure of time-

series sector error, v( it ; jt )  v( it ; j ) , could be a form of misvaluation due to

information asymmetry and not necessarily a reflection of behavioral biases. We return

to this issue in Section 4.3.

Table 2 presents the time-series averages of the regression coefficients for Eq. (4)

for the 12 Fama and French industries. The results are similar to those reported in Table

4 of Rhodes-Kropf, Robinson and Viswanathan (2005). The table reports that the average

adjusted-R2 for these regressions ranges from 82% to 92%, which shows that within an

industry, the three accounting variables explain a large majority of the cross-sectional

variation in firm market values in a given year.

4. Empirical findings

This section presents results from a battery of tests aimed at providing evidence

on the rational and behavioral theories of SEOs. We proceed in three steps. In section

4.1, we present summary information on pre-issue market-to-book ratios and the

decomposition into the error and growth option components for our sample of SEO firms

and for a comparison sample of non-issuing firms. In section 4.2, we present evidence on

the use of proceeds by examining the relation between pre-issue M/B components and

post-issue investment decisions. Our objective here is to provide insight on the error

components of the M/B ratio, and further examine how investment funding needs and

market-timing motivate equity issuance decisions. In section 4.3, we provide evidence on

the relation between the pre-issue misvaluation and growth opportunity components of

M/B and the long-run post-issue stock price performance of the issuing firms.

12
4.1. Market-to-book ratios of issuing firms: Investment opportunities vs. misvaluation

Panel A of Table 3 reports summary information on M/B and the three

components of M/B for our sample of SEO firms and for a comparison sample of all non-

issuing CRSP/Compustat firms. The table shows that the average (log) M/B ratio for the

issuing firms is 0.95, while the average ratio for all CRSP/Compustat firms is only 0.42.

This is consistent with prior findings that SEO firms have relatively high pre-issue M/B

ratios. High pre-issue market-to-book ratios are also consistent with evidence that

issuing firms experience significant stock price run-ups prior to issuance.

With respect to the individual components, Panel A shows that the average firm-

specific error, time-series sector error and long-run value-to-book ratio for the sample of

issuing firms is 0.27, 0.06 and 0.41, respectively; each is significantly different from zero

and significantly larger than the respective averages for all non-issuing firms in the

CRSP/Compustat universe. We also note that the error components constitute a

substantially larger fraction of issuing firm market-to book ratios (35%) as compared to

the comparison sample of nonissuers (2%).7

To provide additional information on the relative magnitudes of the components

of M/B, Panel B presents the distribution of the sample of SEO firms sorted across firm-

specific error and long-run value-to-book quartiles where quartile breakpoints are formed

using all CRSP/Compustat firms for each fiscal year. With respect to firm-specific error,

7
By design, the average firm-specific error of all CRSP/Compustat firms is zero since it is measured as the
regression residual,  it , from Eq. (4). This follows since we estimate v ( it ; jt ) as the fitted value
from the annual cross-sectional regression for each industry. Thus, the firm-specific error,
mit  v ( it ; jt ) , is simply the regression residual.

13
39% of the issuing firms are in the highest CRSP/Compustat quartile, while only 14% are

in the lowest quartile. For long-run value-to-book, 36% of the SEO firms are from the

highest quartile with only 19% coming from the lowest.8 Panel C reports the distribution

of SEO sample firms sorted across total error and long-run value-to-book quartiles and

shows results that are similar to those reported in Panel B.

In summary, the evidence in this subsection is consistent with the possibility that

both misvaluation and the need to fund positive net present value investments influence

the SEO decision. The tendency for issuing firms to have high pre-issue long-run value-

to-book ratios suggests that that these firms issue to satisfy investment needs. The

tendency for issuing firms to have market values in excess of what would be expected

from contemporaneous and long-run industry multiples can be interpreted as either

misvaluation or firm-specific deviations from contemporaneous and long-run average

industry growth and discount rates, or both. We present evidence in the next two sections

suggesting that the large error components we observe for our sample of issuing firms

reflect overvaluation.

4.2. Use of issue proceeds: Investment versus debt-reduction

Previous literature (Loughran and Ritter (1997)) shows that issuing firms, on

average, have high levels of investment following SEOs. However, we should expect to

observe differences in the use of proceeds, depending upon the motivation for

8
Note that 11% of our SEO firms are in both firm-specific error and long-run value-to-book quartiles 1 and
2 which suggests that they are not overvalued and have low investment opportunities. Issuance by these
firms suggests that either managers make mistakes when assessing true firm value and growth options, that
managers are exhibiting empire-building behavior and/or that our three M/B components are imperfect
measures of misvaluation and investment opportunities.

14
undertaking an SEO. More specifically, assuming managers act in the best interest of

existing shareholders, we should expect to see more debt reduction when SEOs are

motivated by stock price overvaluation and more investment when SEOs are motivated

by growth options coming into the money. In this section, we investigate the use of issue

proceeds by examining the relation between post-issue investment and pre-issue levels of

the misvaluation and growth option components of M/B. Our goal here is to provide

evidence on the extent to which the error components of M/B reflect misvaluation and

can thereby serve as useful metrics in our analysis of post-issue returns.

To provide evidence on post-issue investment, we follow the approach in Kim and

Weisbach (2006) and track seven accounting variables that potentially capture 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 four

years following the SEO. To control for firm size, we scale all accounting variables by

book assets in the fiscal year prior to the SEO. For the income statement and cash flow

statement items (R&D, capital expenditures, acquisitions and reduction in long-term debt

as measured by Compustat data items 46, 128, 129 and 114 respectively), we calculate

the accumulation in each variable since the SEO, scaled by book assets prior to the SEO:

V
i 1
i / Asset 0 , where V is the accounting variable being measured and year 0 is the

fiscal year-end just prior to year of the SEO. 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: (Vi  V0 ) / Asset 0 , for i =

1 to 4.

15
4.2.1. Univariate analysis of post-issue investments across components of market-to-book

We start with a univariate analysis of how post-issue investment varies across

components of the market-to-book ratio. Panels A, B and C of Table 4 report the mean

normalized increase for each accounting variable for quartiles based on firm-specific

error, total error and long-run value-to-book, respectively.

Although a univariate analysis is necessarily preliminary, several results point to

the interpretation of the error component of M/B as a useful measure of misvaluation.

First, comparing across panels, post-issue R&D and capital expenditures are both

strongly related to long-run value-to-book, but unrelated to firm-specific error. As

reported in Panel C, R&D and capital expenditures both increase monotonically as the

long-run value-to-book ratio increases; differences between quartiles 4 and 1 are highly

significant at all horizons for both variables. In contrast, we do not observe such a

relation when R&D and capital expenditures are measured across quartiles of firm-

specific error as reported in Panel A. This finding is more consistent with the

interpretation of firm-specific error as a measure of misvaluation as opposed to a measure

of firm-specific deviation from industry average growth and discount rates. That is, we

should not expect to observe greater post-issue investment as the degree of overvaluation

increases. The results using total error are somewhat mixed but are generally consistent.

Second, and also consistent with the view that the error component reflects

misvaluation, we find that firms with high firm-specific error and high total error are

more likely to spend issue proceeds on debt-reduction. At both the one- and two-year

horizon, long-term debt reduction increases monotonically as both firm-specific error and

16
total error increases; differences between quartiles 4 and 1 are highly significant in both

cases. In contrast, we find no relation between debt-reduction and the long-run value-to-

book component of M/B.

In summary, the univariate analysis suggests that both misvaluation and the need

to fund positive NPV projects motivate firms to issue equity. Firms with high investment

opportunities appear to issue to finance R&D and capital expenditures, while firms with

high valuation errors appear to use relatively cheaper equity to substitute for debt. We

note that acquisitions, cash levels, inventories and total assets are all positively related to

both components of the M/B ratio.

While the univariate analysis is suggestive, there are limitations. Post-issue

investment may be influenced by factors not reflected in the M/B components. The level

of issue proceeds, the amount of other sources of funds generated within the firm, firm

size, industry and year effects may all distort the univariate findings. In the next section,

we control for these factors in a multivariate setting.

4.2.2. Multivariate analysis of the use of proceeds across components of market-to-book

We use a regression approach similar to Kim and Weisbach (2005) to investigate

the relation between components of the pre-issue M/B ratio and post-issue use of

proceeds. We regress changes in the seven accounting variables (measured over one-,

two-, three- and four-year post-issue horizons) on the long-run value-to-book and error

components of M/B while controlling for primary capital raised in the SEO, other sources

17
of funds generated within the firm, firm size, and fixed effects for year and industry. 9 To

avoid the impact of outliers, we take the log of the scaled accounting variables plus one.

For each accounting variable, we run the following regression for each post-issue

horizon:

(7)

 Pr imaryCap    OtherCapt  
Yt  1 Firm   2 LongRun   3 Sector   4 ln    1   5 ln    1
 TotalAsset 0    TotalAsset 0  
2001 11
  6 ln(TotalAsset 0 )   YrDummy    IndustryDummy
i 1970
i
j 1
j

where

Yt  ln ((Vt  V0 ) / TotalAsset 0 )  1 for V = Cash, inventory, total assets and

 t 
Yt  ln (Vi / TotalAsset 0 )  1 for V = R&D, capital expenditure, long-term debt
 i 1 

reduction and acquisitions.

Firm, Sector, and LongRun refer to the three components of the pre-issue M/B ratio.

t
OtherCapt = ln [(  (total sources of fundst – PrimaryCapital) / TotalAsset0) + 1] where
i 1

total sources of funds include internally generated cash from continuing operations,

investment and financing activities.10

9
In an earlier version of their paper, Kim and Weisbach (2006) include the proceeds from secondary shares
sold in conjunction with the SEO as a control variable. In results that are not reported here, we re-run the
regression controlling for proceeds from secondary shares and find similar results. We note that in more
than half of our sample, secondary shares are not issued.
10
We use Compustat data item 112 as total sources of funds. If it is missing, we calculate total sources of
funds as 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).

18
 Panel A of Table 5 presents the regression estimates of Eq. (7). Several results are

of interest. First, we find evidence that post-issue investment is positively related to the

pre-issue level of growth options. More specifically, for the capital expenditure and

R&D regressions, the coefficients on LongRun are positive and significant at all horizons.

This evidence is consistent with the predictions of real investment theory that equity

issues are timed after an increase in the net present value of investment opportunities.11

Second, post-issue investment is unrelated to the firm-specific error component

of M/B. The coefficients on Firm in the capital expenditure and R&D regressions are

generally insignificant (we do observe one significant coefficient in the R&D regression

but the sign is negative.) This evidence is consistent with the interpretation of the firm-

specific error component as a measure of misvaluation. The alternative interpretation,

that the firm-specific error component reflects firm-specific deviations from industry

average growth and discount rates, is not supported. The alternative interpretation is also

not supported by a test of the equality of coefficients on Firm and LongRun; we reject at

the 0.00 level that these coefficients are equal.

Third, post-issue debt-reduction is positively related to firm-specific error and

negatively related to long-run value-to-book. These findings suggest that firms with

greater investment opportunities invest more, whereas firms with high valuation errors

are more likely to pay down debt. We also find that post-issue changes in cash positions

are positively related to firm-specific error, but unrelated to long-run value-to-book in

11
Although not the focus of our paper, we note that this pattern is not suggestive of empire building of the
type discussed in Titman, Wei and Xie (2004), i.e., at least in our SEO sample we find that a firm’s
investment level is positively correlated with its long-run value-to-book ratio, a proxy for positive NPV
investment opportunities.

19
three out of four horizons. These findings bolster our conclusion that firm-specific error

is a reasonable measure of misvaluation.12

Panel B of Table 5 reports estimates of a second regression specification in which

we substitute total error for firm-specific error and time-series sector error. The

regression coefficients on total error are qualitatively similar to those on firm-specific

error reported in Panel A. It results here support the interpretation of total error as

another measure of misvaluation.

For a sense of the economic significance of our findings we note that a one

standard deviation increase in long-run value-to-book results in a $13.1 million increase

in R&D spending, and a $4.9 million increase in capital expenditures over the four years

following the SEO.13 In contrast, this increase in long-run value-to-book results $8.2

million less spending on long-term debt reduction. Increasing firm-specific error by one

standard deviation has a minimal impact on R&D and capital expenditures, but results in

a $3.6 million increase in long-term debt reduction over the four years following the

equity offering.

4.3. Long-run post-issue stock price performance across components of market-to-book

It has been widely documented that SEO firms underperform various benchmarks

by about 5% per year in the five years subsequent to issuance (Ritter (2003)). The

12
The coefficients on Sector in the R&D and capital expenditure regressions are puzzling: time-series
sector error, like firm-specific error, is negatively correlated with R&D expenditure, but it is positively
correlated with capital expenditure, as is the case for long-run value-to-book. Still, as we show in Panel B,
the sum of firm-specific error and sector error (total error) appears to reflect misvaluation. We note that
time-series sector error is the smallest component of M/B ratio (on average consists of only 6% of SEO
firms’ M/B ratio).
13
We use the median SEO firm’s book assets prior to issuance, 132.6 million, as TotalAsset 0. The standard
deviations of SEO firms’ firm-specific error, time-series sector error, long-run value-to-book are 0.706,
0.253, and 0.741, respectively.
behavioral explanation for “underperformance” is that the market is slow to recognize

that SEO firms are overvalued. Alternatively, Carlson, Fisher and Giammarino (2005)

argue that low post-issue returns reflect a decrease in firm risk due to the conversion of

risky growth options into less risky assets in place. Zhang (2005) argues that SEO firms

have low required rates of return due to exogenous factors. Both real investment theories

predict that the post-issue returns are negatively correlated with the level of post-issue

investment. Thus, the behavioral theories predict that firms that are more overvalued

should have lower post-issue abnormal returns, while the real investment theories predict

that firms with higher investment opportunities should have lower post-issue abnormal

returns, as they are the firms that invest most after issuance. In this section, we test these

two hypotheses by looking at the relation between post-issue stock returns and pre-issue

components of the market-to-book ratio. Specifically, we separate issuing firms into

quartiles based on firm-specific error, total error and long-run value-to-book,

respectively, calculate abnormal returns for each quartile portfolio and compare returns

across quartiles.

Following Mitchell and Stafford (2000) and Brav, Geczy and Gompers (2000),

among others, we use calendar-time factor regressions to measure long-run stock price

performance. For each firm-specific error, total error and long-run value-to-book

quartile, for every month from January 1975 to December 2003, we form equal-weighted

(EW) and value-weighted (VW) portfolios of firms that issued seasoned equity in the past

3 years (or 5 years) and belong to that specific quartile. The dependent variable is the

portfolio excess return of the quartile portfolio over the one-month T-bill rate. We use the

Fama and French (1993) three-factor model and the Carhart (1997) four-factor model,

21
and measure portfolio abnormal performance using the intercept from the factor

regressions.

Table 6 presents the post-issue abnormal stock price performance for quartiles

classified by firm-specific error (Panel A), total error (Panel B) and long-run value-to-

book (Panel C). For ease of exposition we focus on the 3-year results obtained using the

Fama and French model. The 5-year results and the results using the Carhart 4-factor

model are qualitatively similar although weaker on a few dimensions; we discuss there

results where relevant.

Panel A of Table 6 shows evidence of a negative relation between pre-issue firm-

specific error and post-issue abnormal returns that is consistent with the behavioral view.

Specifically, we observe that as firm-specific error increases, portfolio abnormal returns

decrease monotonically. There is also a dramatic difference between returns to firms in

the highest versus lowest firm-specific error quartiles: issuing firms in the lowest firm-

specific error quartile have average abnormal return that are not significantly different

from zero: -0.11% per month (-3.9% after 3 years) whereas issuing firms in the highest

firm-specific error quartile have significantly negative average post-issue abnormal

returns: -0.54% per month (-19.44% after 3 years). The pattern is generally the same,

though less pronounced, for the EW 5-year portfolios. Also, we do not observe statistical

significance for the 5-year Carhart results.

The VW portfolio results are generally consistent with misvaluation, but not as

strong as our findings using EW portfolios. Overall, the VW SEO portfolios in the

lowest firm-specific error quartile have the highest abnormal returns (which are positive

though insignificantly different from zero), while the SEO portfolios in the highest firm-

22
specific error quartile have significantly negative abnormal returns (with the exception of

the 5-year portfolio using Carhart four-factor model.) We also note that the average

abnormal returns do not decrease monotonically for the 5-year VW portfolio14

Panel B of Table 6 reports post-issue returns across quartiles of total error (which

equals firm-specific error plus time-series sector error.) As mentioned earlier, because

time-series sector error contains forward-looking information it does not allow for as

clean a test of the behavioral explanation of low post-issue returns. However, time-series

sector error may reflect inside information held by managers. Thus, total error is a more

complete measure of misvaluation in that it captures mispricing due to both behavioral

biases and asymmetric information. Consistent with this, Panel B shows qualitatively

similar, but more pronounced, results as compared to the breakdown based on firm-

specific error alone. These results support the notion that managers try to time the market

to issue equity when they believe the stock and the industry is overvalued, and that

managers have more information about true value of the stock than outside investors.

Panel C of Table 6 presents average abnormal returns for long-run value-to-book

quartile portfolios. We have shown in Tables 4 and 5 that issuing firms in the highest

long-run value-to-book quartile invest more aggressively in R&D and capital

expenditures after issuance than firms in the lowest quartile, but here we see no evidence

that issuing firms in the highest quartile have lower post-issue returns than firms in the

lowest quartile. In fact, in many cases, the average post-issue return to firms in the

highest long-run book-to-value quartile is higher than that of firms in the lowest quartile.

14
Loughran and Ritter (1999), Brav, Geczy and Gompers (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. Here our goal is to investigate whether valuation errors influence the issuance decision and future
stock returns, not to quantify wealth impact on firms after issuance. Therefore, we believe equal-weighting
may be more appropriate.

23
This evidence does support explanations of post-issue stock price performance put

forward by Zhang (2005) and Carlson, Fisher and Giammarino (2005).

We recognize several caveats with respect to the interpretation of the findings in

this section. First, evidence that firms in the high long-run value-to-book quartile invest

aggressively post-issue in R&D suggests that in addition to converting growth options to

assets in place, issuing firms may also contemporaneously be adding growth options.

Thus, R&D investment may mitigate post-issue risk-reduction of the type suggested by

Carlson, Fisher and Giammarino (2006); this may explain why we do not observe lower

post-issue returns for the high long-run value-to-book issuers. 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 firms in the lowest CRSP/Compustat firm-specific error quartile

(Panel A), which might be considered to be “undervalued” do not have significant

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 reflect

decreased firm leverage ratios and increased stock liquidity after issuance as suggested in

Eckbo, Masulis and Norli (2000). Thus, while we find evidence that misvaluation prior

to issuance contributes to the long-term underperformance of SEO stocks, we cannot

exclude the possibility that other factors also play a role. Finally, we recognize the

possibility that our measure of firm-specific error may be correlated with risk factors that

are not captured by the Fama and French and Carhart models. In that case, our study

might help shed light on these factors.

24
5. Summary

This paper provides evidence on behavioral and rational explanations of stock price

performance around seasoned equity offerings. Using the Rhodes-Kropf, Robinson and

Viswanathan (2005) methodology to decompose market-to-book ratios (M/B) into

misvaluation and growth option components, we find that issuing firms have both greater

mispricing and greater long-run growth opportunities relative to a comparison sample of

non-issuing firms. Issuing firms that are identified as more overvalued tend to decrease

long-term debt, increase cash holdings and earn lower post-issue abnormal returns. In

contrast, firms with greater growth opportunities invest more aggressively in R&D and

capital expenditures and do not experience more negative post-issue stock price

performance. These results are more consistent with the behavioral explanations for SEO

underperformance, and show that managers have more information about true firm value

than outside investors and act to maximize current shareholder’s wealth. The results do

not support theories that link post-issue performance with investment activities.

25
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27
Table 1
Number of seasoned equity offerings

This table reports the number of SEOs by year. All SEO information is from the SDC database for the years
1970 to 2004. To be included in the final sample, a SEO firm must have enough Compustat and CRSP data
to decompose its market-to-book ratio as described in Section 3.2. We exclude firms 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 firm issues primary shares more than once
within a three-year period, then only the first 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 4325 100

28
Table 2
Time-series average conditional regression multiples

This table reports the time-series average multiples from regression Eq. (4) in Section 3.4. 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 net income is negative (I(<0) ) and leverage (LEV). The regression is estimated cross-sectionally at the industry-year level for each of the Fama and French 12
industries from fiscal year 1969 to 2003. The subscripts i, j and t refer to firm, industry and year, respectively. E t (ˆ k ) is the time-series average regression
multiple for the kth accounting variable. We also report the Fama-Macbeth standard errors below the average estimated multiples. The reported R 2 is the average
adjusted-R2 for each industry.

Fama and French industry classification

Parameter 1 2 3 4 5 6 7 8 9 10 11 12
mit   0 jt  1 jt bit   2 jt ln( NI )   3 jt I ( 0 ) ln( NI )   4 jt LEVit   it

it

it

Et (ˆ 0 ) 2.26 2.43 2.06 2.10 2.52 2.32 2.59 2.32 2.18 2.51 1.99 2.22
0.07 0.11 0.07 0.08 0.06 0.06 0.15 0.14 0.06 0.05 0.05 0.06
E t (ˆ 1 ) 0.62 0.58 0.66 0.68 0.59 0.61 0.62 0.79 0.66 0.60 0.58 0.62
0.01 0.02 0.01 0.02 0.03 0.02 0.02 0.03 0.01 0.02 0.01 0.01
Et (ˆ 2 ) 0.31 0.30 0.28 0.25 0.36 0.34 0.29 0.18 0.29 0.34 0.39 0.31
0.01 0.02 0.01 0.01 0.02 0.01 0.02 0.03 0.01 0.02 0.01 0.01
E t (ˆ 3 ) 0.00 -0.02 -0.04 -0.04 -0.01 -0.07 0.04 -0.15 -0.06 -0.10 -0.23 -0.06
0.02 0.02 0.01 0.03 0.03 0.01 0.10 0.11 0.01 0.02 0.02 0.01
Et (ˆ 4 ) -2.66 -2.53 -2.30 -2.25 -3.00 -2.64 -2.38 -2.68 -2.28 -2.68 -1.12 -2.05
0.08 0.11 0.09 0.13 0.10 0.10 0.18 0.24 0.06 0.09 0.04 0.07
R2 0.85 0.83 0.87 0.87 0.86 0.85 0.87 0.92 0.87 0.88 0.85 0.85

29
Table 3
Firm-level decomposition of market-to-book ratios

Panel A reports the decomposition of market-to-book ratios at the firm-level for our sample of SEO firms
and for a comparison sample of all non-SEO CRSP/Compustat firms over the period 1970 to 2004. The
column t(diff) reports the t-statistic for the test that SEO firms have the same average market-to-book ratio
(or component) as the non-SEO CRSP/Compustat comparison firms. Panel B shows the distribution of the
SEO sample across firm-specific error and long-run value-to-book quartiles. We report the percentage of
SEO firms that belong to each quartile. The quartile breakpoints for firm-specific error and long-run value
to book are generated from the universe of all (SEO plus non-SEO) CRSP/Compustat firms for each fiscal
year. Panel C shows the distribution of the SEO sample across total error and long-run value-to-book
quartiles.

Panel A: Decomposing market-to-book at the firm-level

Non-SEO firms SEO firms
Valuation component Mean N Mean N t(diff)
mit  bit 0.42 159,927 0.95 4,325 -32.35

mit  v ( it ;  jt ) Firm-specific -0.01 159,475 0.27 4,325 -24.89

v ( it ;  jt )  v ( it ;  j )Sector 0.02 159,475 0.06 4,325 -10.06

Long run
v ( it ;  j )  bit value-to-book 0.41 159,475 0.62 4,325 -18.18

Panel B: Distribution of SEO sample across firm-specific error and value-to-book quartiles
Long-run value-to-book
Firm-specific error Low Quartile 2 Quartile 3 High Total
Low 2% 2% 4% 7% 14%
Quartile 2 3% 4% 6% 8% 21%
Quartile 3 5% 7% 7% 8% 27%
High 10% 7% 8% 13% 39%
Total 19% 20% 25% 36% 100%

Panel C. Distribution of SEO sample across total error and value-to-book quartiles
Long-run value-to-book
Total error Low Quartile 2 Quartile 3 High Total
Low 2% 2% 4% 6% 14%
Quartile 2 3% 4% 6% 8% 20%
Quartile 3 5% 7% 7% 9% 27%
High 10% 7% 9% 13% 39%
Total 19% 20% 25% 36% 100%

30
Table 4
Average post-issue increases in assets and expenditures by M/B components

Panels A, B and C of this table report average post-issue increases in assets and expenditures by firm-
specific error, total error and long-run value-to-book quartiles, respectively. Increases in expenditures
4
(R&D, capital expenditure, long-term debt reduction and acquisition) are calculated as V
i 1
i / Asset 0 .
4
Increases in assets (cash, inventory and total assets) are calculated as  (V  V ) / Asset
i 1
i 0 0 , where V is

the variable being measured, year 0 is the fiscal year-end just prior to the SEO issuance day, and year i is
number of years after year 0. The columns Diff and t(diff) report the difference and statistical significance,
respectively in mean expenditure between quartiles 4 and 1. The means reported here are winsorized at
0.5% for each tail to remove influential outliers.

Panel A: Firm-specific error

Firm-specific error quartiles

V i 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

31
4 1.51 2.02 1.86 2.41 0.90 3.85

32
Panel B: Total error (=firm-specific error plus time-series sector error)
Total error quartiles

V i Low 2 3 High Diff (4-1) t(diff)

∑R&D 1 0.19 0.16 0.12 0.13 -0.06 -2.85
2 0.44 0.39 0.28 0.33 -0.11 -2.66
3 0.72 0.64 0.47 0.55 -0.18 -2.18
4 1.06 0.92 0.71 0.81 -0.25 -1.92
∑CAPEX 1 0.13 0.12 0.13 0.16 0.03 1.82
2 0.30 0.29 0.33 0.40 0.11 2.36
3 0.50 0.49 0.53 0.65 0.16 0.87
4 0.69 0.71 0.76 0.92 0.23 1.38
∑LT Debt 1 0.07 0.13 0.14 0.18 0.10 7.57
Reduction 2 0.18 0.25 0.27 0.36 0.18 4.57
3 0.33 0.44 0.47 0.55 0.22 1.29
4 0.54 0.68 0.65 0.84 0.30 1.56
∑Acquisition 1 0.05 0.07 0.07 0.09 0.04 3.52
2 0.11 0.17 0.15 0.19 0.08 3.80
3 0.16 0.29 0.24 0.29 0.13 3.39
4 0.22 0.42 0.34 0.39 0.17 3.62
∆Cash 1 0.18 0.26 0.23 0.37 0.19 5.33
2 0.21 0.28 0.24 0.37 0.16 3.44
3 0.32 0.30 0.27 0.36 0.05 1.35
4 0.37 0.35 0.34 0.46 0.10 1.80
∆Inventory 1 0.04 0.06 0.05 0.06 0.02 2.33
2 0.09 0.12 0.11 0.12 0.03 2.90
3 0.12 0.20 0.17 0.17 0.04 1.80
4 0.17 0.26 0.22 0.22 0.05 2.23
∆Total Assets 1 0.51 0.61 0.60 0.86 0.36 5.92
2 0.89 1.05 1.05 1.44 0.55 3.56
3 1.36 1.56 1.44 1.84 0.48 3.15
4 1.67 1.96 1.82 2.42 0.75 3.33

33
Panel C: Long-run value-to-book
Long-run value-to-book quartiles

V i Low 2 3 High Diff (4-1) t(diff)

∑R&D 1 0.03 0.05 0.08 0.23 0.21 17.09
2 0.07 0.10 0.18 0.56 0.50 17.56
3 0.11 0.17 0.32 0.94 0.83 13.30
4 0.17 0.27 0.47 1.37 1.20 12.61
∑CAPEX 1 0.09 0.12 0.15 0.17 0.08 8.65
2 0.20 0.27 0.37 0.44 0.24 8.60
3 0.33 0.43 0.58 0.73 0.39 7.60
4 0.49 0.62 0.82 1.01 0.52 6.30
∑LT Debt 1 0.17 0.19 0.15 0.10 -0.07 -1.65
Reduction 2 0.35 0.37 0.31 0.22 -0.13 -2.00
3 0.54 0.57 0.52 0.37 -0.17 -0.94
4 0.76 0.85 0.80 0.57 -0.19 -0.69
∑Acquisition 1 0.05 0.08 0.08 0.08 0.03 4.54
2 0.11 0.16 0.15 0.20 0.10 5.20
3 0.16 0.24 0.23 0.35 0.19 5.39
4 0.22 0.32 0.34 0.46 0.24 3.59
∆Cash 1 0.03 0.06 0.16 0.63 0.60 17.40
2 0.04 0.07 0.17 0.69 0.65 12.21
3 0.06 0.07 0.19 0.71 0.65 11.30
4 0.07 0.09 0.25 0.84 0.77 9.45
∆Inventory 1 0.03 0.04 0.06 0.07 0.04 5.90
2 0.06 0.08 0.12 0.15 0.09 6.57
3 0.08 0.13 0.19 0.22 0.14 5.52
4 0.12 0.16 0.24 0.29 0.18 5.90
∆Total Assets 1 0.23 0.37 0.56 1.25 1.02 18.69
2 0.47 0.70 1.00 2.02 1.55 8.16
3 0.65 1.04 1.40 2.65 2.00 10.98
4 0.86 1.30 1.88 3.33 2.46 8.62

34
Table 5
The effect of M/B components on post-issue increases in assets and expenditures

Panel A presents the regression results showing how each of the three components of M/B (firm-specific error, sector
error and long-run value-to-book) affects post-issue increases in assets and expenditures. The dependent variable is
 t 
Yt  ln (Vi / TotalAsset 0 )  1 for V= R&D, capital expenditure, LT debt reduction and acquisition, and
 i 1 
Yt  ln ((Vt  V0 ) / TotalAsset 0 )  1 for V=cash, inventory and total assets. Panel B reports regression results
when M/B is decomposed into two components: total error (=firm-specific error plus sector error) and long-run value-
to-book. Bold letters indicate statistical significance at 5% level.

Panel A:
 Pr imaryCap    OtherCapt  
Yt  1 FirmSpec   2 LongRun   3 Sector   4 ln    1   5 ln 
 
  1   6 ln(TotalAsset

 TotalAsset 0    TotalAsset 0  
Firm- Long run Primary Other Total p-value
specific VtB Sector Cap Cap Asset %
V t β1 β2 β3 β4 β5 β6 β1= β2 Adj.R2 n
∑R&D 1 (0.01) 0.05 (0.06) 0.14 0.06 0.00 0.00 0.48 1,962
2 (0.01) 0.09 (0.10) 0.29 0.10 0.01 0.00 0.57 1,812
3 (0.01) 0.12 (0.12) 0.40 0.15 0.02 0.00 0.59 1,630
4 (0.01) 0.15 (0.16) 0.47 0.17 0.02 0.00 0.61 1,450
∑CAPEX 1 (0.00) 0.02 0.03 0.06 0.12 (0.00) 0.00 0.29 3,269
2 0.01 0.04 0.06 0.17 0.18 0.00 0.00 0.38 3,081
3 0.01 0.06 0.04 0.22 0.24 0.01 0.00 0.41 2,766
4 0.01 0.07 0.02 0.25 0.25 0.01 0.00 0.41 2,489
∑LT Debt 1 0.01 (0.04) (0.01) (0.08) 0.27 (0.02) 0.00 0.33 3,180
Reduction 2 0.03 (0.06) 0.02 (0.16) 0.31 (0.02) 0.00 0.37 3,093
3 0.03 (0.08) 0.02 (0.22) 0.38 (0.03) 0.00 0.40 2,726
4 0.04 (0.11) 0.08 (0.22) 0.43 (0.03) 0.00 0.43 2,427
∑Acquisition 1 (0.00) (0.01) 0.03 0.03 0.13 (0.00) 91.29 0.16 3,128
2 0.01 (0.01) 0.03 0.04 0.17 (0.00) 31.57 0.19 2,836
3 0.01 (0.01) 0.03 0.08 0.19 (0.00) 27.01 0.20 2,472
4 0.02 (0.01) 0.06 0.10 0.20 0.00 11.64 0.21 2,227
∆Cash 1 0.01 (0.00) (0.01) 0.87 0.24 0.02 11.07 0.72 3,307
2 0.03 0.00 (0.03) 0.71 0.25 0.03 4.98 0.51 3,143
3 0.02 0.02 (0.05) 0.56 0.25 0.02 63.06 0.41 2,856
4 0.03 0.03 (0.11) 0.52 0.25 0.02 80.26 0.37 2,588
∆Inventory 1 (0.00) (0.00) 0.01 0.05 0.04 (0.00) 63.40 0.12 3,239
2 (0.01) 0.00 0.00 0.10 0.08 (0.01) 31.63 0.19 3,074
3 (0.01) 0.00 (0.02) 0.10 0.11 (0.01) 20.14 0.21 2,789
4 (0.01) 0.00 (0.03) 0.12 0.12 (0.01) 41.42 0.22 2,523
∆Total 1 0.00 0.04 0.11 0.94 0.50 0.02 0.01 0.74 3,308
Assets 2 0.04 0.06 0.15 0.82 0.58 0.02 21.63 0.58 3,148
3 0.03 0.08 0.10 0.62 0.64 0.01 2.49 0.53 2,859
4 0.03 0.09 (0.01) 0.52 0.63 0.01 2.49 0.46 2,589

35
Panel B:
 Pr imaryCap    OtherCapt  
Yt  1TotalError   2 LongRun   3 ln    1   4 ln    1   5 ln(TotalAsset 0 ) 
 TotalAsset 0    TotalAsset 0   i

Total Long Primary Other Total %

error run VtB Cap Cap Asset p-value
V i β1 β2 β3 β4 β5 β 1= β 2 Adj.R2 n
∑R&D 1 (0.01) 0.05 0.14 0.06 0.01 0.00 0.48 1,962
2 (0.02) 0.08 0.30 0.11 0.01 0.00 0.57 1,812
3 (0.01) 0.12 0.40 0.15 0.02 0.00 0.59 1,630
4 (0.02) 0.15 0.47 0.17 0.03 0.00 0.61 1,450

∑CAPEX 1 0.00 0.02 0.06 0.11 (0.00) 0.00 0.29 3,269

2 0.01 0.04 0.17 0.18 0.00 0.00 0.38 3,081
3 0.01 0.06 0.22 0.24 0.01 0.00 0.41 2,766
4 0.02 0.07 0.25 0.25 0.01 0.00 0.41 2,489
∑LT Debt 1 0.01 (0.04) 0.08) 0.27 (0.02) 0.00 0.33 3,180
Reduction 2 0.03 (0.06) (0.16) 0.31 (0.02) 0.00 0.37 3,093
3 0.03 (0.08) (0.21) 0.38 (0.03) 0.00 0.40 2,726
4 0.04 (0.11) (0.22) 0.43 (0.03) 0.00 0.43 2,427

∑Acquisition 1 (0.00) (0.00) 0.02 0.13 (0.00) 75.00 0.15 3,128

2 0.01 (0.00) 0.04 0.17 (0.00) 27.32 0.19 2,836
3 0.01 (0.01) 0.08 0.19 (0.00) 24.29 0.20 2,472
4 0.02 (0.01) 0.10 0.20 0.00 10.01 0.21 2,227

∆Cash 1 0.01 (0.00) 0.87 0.24 0.02 13.61 0.71 3,307

2 0.02 (0.00) 0.71 0.25 0.03 7.52 0.51 3,143
3 0.02 0.02 0.56 0.25 0.02 77.76 0.41 2,856
4 0.02 0.03 0.52 0.25 0.02 58.07 0.37 2,588

∆Inventory 1 (0.00) 0.00 0.05 0.04 (0.00) 68.58 0.12 3,239

2 (0.01) 0.00 0.10 0.08 (0.01) 33.57 0.19 3,074
3 (0.01) 0.00 0.10 0.11 (0.01) 19.21 0.21 2,789
4 (0.01) (0.00) 0.12 0.12 (0.01) 37.50 0.22 2,523

∆Total 1 0.01 0.04 0.93 0.50 0.02 0.03 0.74 3,308

Assets 2 0.04 0.06 0.82 0.58 0.02 33.17 0.58 3,148
3 0.03 0.08 0.62 0.64 0.01 3.36 0.53 2,859
4 0.03 0.09 0.52 0.63 0.01 2.10 0.46 2,589
Table 6
Calendar-time factor regressions for firms with SEOs in the prior three years (five years)

This table reports calendar-time factor regression results of portfolios consisting of firms that issue equity in the prior three (five) years and belong to each firm-
specific error (long-run value to book) quartile as defined in Panel B of Table 3. Quartile breakpoints are formed using all CRSP/Compustat firms, such that
different quartiles have different numbers of SEO firms (quartile 1 has least number of SEO firms and quartile 4 has most SEO firms). Every month from
January 1975 to December 2003, we form equal-weighted (EW) and value-weighted (VW) portfolios of firms that issued seasoned equity in the past 3 years (or 5
years) and belong to that specific quartile. The dependent variable is the excess return of the quartile portfolio over one-month T-bill rate. We use the Fama and
French (1993) three-factor model and Carhart (1997) four-factor model as our factor models, and measure portfolio underperformance as the intercept (α) from
the factor regressions. *, and ** indicate significance at 5% and 1% level respectively.

Panel A: Calendar-time factor regressions for SEO firms by firm-specific error quartile
Firm-specific error FF 3 Factor Model CARHART 4 Factor Model
Adj. Adj.
Quartile Portfolio α (%) MKT SMB HML 2 α (%) MKT SMB HML UMD
R R2
Low EW 3 yr -0.11 1.32 0.96 -0.08 0.79 0.09 1.29 0.96 -0.13 -0.19 0.79
2 3 yr -0.17 1.18 0.97 0.01 0.84 -0.04 1.16 0.97 -0.02 -0.12 0.84
3 3 yr -0.31* 1.17 0.89 0.09 0.89 -0.15 1.15 0.89 0.05 -0.15 0.89
High 3 yr -0.54** 1.28 0.82 -0.07 0.90 -0.27* 1.25 0.82 -0.13 -0.25 0.92

Low EW 5 yr -0.11 1.27 0.99 0.03 0.83 0.04 1.25 1.00 -0.01 -0.15 0.83
2 5 yr -0.18 1.17 1.00 0.04 0.88 -0.09 1.16 1.01 0.02 -0.10 0.88
3 5 yr -0.19 1.20 0.82 0.13 0.91 -0.07 1.19 0.83 0.10 -0.12 0.92
High 5 yr -0.43** 1.27 0.83 0.06 0.91 -0.20 1.24 0.85 0.00 -0.23 0.93

Low VW 3 yr 0.05 1.30 0.76 -0.53 0.72 0.08 1.30 0.76 -0.54 -0.03 0.72
2 3 yr -0.26 1.22 0.75 -0.05 0.78 -0.22 1.21 0.75 -0.06 -0.04 0.78
3 3 yr -0.32* 1.14 0.30 -0.15 0.84 -0.31* 1.14 0.30 -0.15 -0.01 0.84
High 3 yr -0.32** 1.12 0.02 -0.24 0.87 -0.32** 1.12 0.02 -0.24 0.00 0.87

Low VW 5 yr 0.02 1.24 0.87 -0.49 0.78 0.05 1.24 0.87 -0.50 -0.03 0.78
2 5 yr -0.21 1.19 0.66 -0.17 0.84 -0.20 1.19 0.66 -0.17 -0.01 0.84
3 5 yr -0.19 1.16 0.24 -0.08 0.89 -0.21 1.16 0.24 -0.08 0.02 0.89
High 5 yr -0.21* 1.08 0.05 -0.15 0.89 -0.17 1.08 0.06 -0.16 -0.04 0.89

37
Panel B: Calendar-time factor regressions for SEO firms by total error quartile
Total error (Firm+Sector) FF 3 FACTOR CARHART 4 FACTOR
Adj. Adj.
Quartile Portfolio α (%) MKT SMB HML α (%) MKT SMB HML UMD
R2 R2
Low EW 3 yr 0.02 1.30 1.02 -0.04 0.79 0.25 1.26 1.02 -0.10 -0.21 0.80
2 3 yr -0.12 1.18 0.99 0.09 0.85 0.05 1.16 0.99 0.05 -0.17 0.86
3 3 yr -0.25* 1.17 0.88 -0.02 0.91 -0.16 1.16 0.88 -0.04 -0.09 0.91
High 3 yr -0.64** 1.30 0.81 -0.05 0.89 -0.34** 1.26 0.81 -0.12 -0.29 0.91

Low EW 5 yr 0.01 1.24 1.06 0.06 0.83 0.18 1.22 1.08 0.01 -0.18 0.83
2 5 yr -0.04 1.14 0.94 0.04 0.89 0.08 1.13 0.95 0.01 -0.12 0.90
3 5 yr -0.21 1.21 0.85 0.11 0.92 -0.12 1.20 0.86 0.08 -0.09 0.92
High 5 yr -0.53** 1.28 0.81 0.06 0.90 -0.29** 1.25 0.84 0.00 -0.25 0.92

Low VW 3 yr -0.07 1.27 0.86 -0.27 0.72 -0.10 1.28 0.86 -0.27 0.03 0.72
2 3 yr -0.25 1.20 0.60 -0.05 0.75 -0.20 1.19 0.60 -0.06 -0.05 0.75
3 3 yr -0.12 1.10 0.36 -0.33 0.83 -0.25 1.12 0.36 -0.29 0.13 0.83
High 3 yr -0.33** 1.12 0.03 -0.25 0.87 -0.30* 1.12 0.03 -0.26 -0.03 0.87

Low VW 5 yr 0.06 1.22 0.94 -0.22 0.79 0.02 1.23 0.94 -0.21 0.04 0.79
2 5 yr -0.15 1.13 0.57 -0.11 0.83 -0.17 1.14 0.56 -0.11 0.02 0.83
3 5 yr -0.03 1.16 0.34 -0.17 0.87 -0.10 1.17 0.33 -0.15 0.08 0.87
High 5 yr -0.28** 1.08 0.05 -0.17 0.89 -0.22* 1.08 0.06 -0.19 -0.06 0.89

38
Panel C: Calendar- time factor regressions for SEO firms by long- run value-to-book quartile
Long run value-to-book FF 3 FACTOR CARHART 4 FACTOR
Adj.
Quartile Portfolio α (%) MKT SMB HML Adj. R 2 α (%) MKT SMB HML UMD
R2
Low EW 3 yr -0.40 1.21 0.94 0.59 0.69 -0.11 1.17 0.94 0.52 -0.27 0.71
2 3 yr -0.41** 1.16 0.60 0.35 0.80 -0.20 1.13 0.60 0.30 -0.19 0.82
3 3 yr -0.31* 1.22 0.75 -0.13 0.89 -0.16 1.20 0.76 -0.17 -0.14 0.89
High 3 yr -0.30 1.26 1.13 -0.39 0.90 -0.05 1.23 1.13 -0.44 -0.23 0.91

Low EW 5 yr -0.35* 1.26 0.83 0.65 0.82 -0.16 1.24 0.85 0.61 -0.20 0.83
2 5 yr -0.38** 1.20 0.56 0.47 0.87 -0.24* 1.18 0.58 0.44 -0.15 0.88
3 5 yr -0.34** 1.19 0.81 0.01 0.90 -0.21 1.18 0.83 -0.02 -0.14 0.90
High 5 yr -0.18 1.25 1.14 -0.34 0.90 0.03 1.23 1.16 -0.39 -0.22 0.91

Low VW 3 yr -0.43 1.15 0.39 0.45 0.60 -0.33 1.14 0.39 0.42 -0.10 0.60
2 3 yr -0.41* 1.11 0.07 0.25 0.71 -0.19 1.08 0.08 0.20 -0.20 0.73
3 3 yr -0.10 1.16 0.11 -0.41 0.80 -0.18 1.17 0.11 -0.40 0.07 0.80
High 3 yr -0.14 1.09 0.38 -0.81 0.86 -0.21 1.10 0.38 -0.80 0.07 0.86

Low VW 5 yr -0.35* 1.17 0.19 0.34 0.75 -0.30 1.17 0.19 0.33 -0.05 0.75
2 5 yr -0.30* 1.13 -0.01 0.31 0.78 -0.16 1.11 0.01 0.28 -0.14 0.79
3 5 yr -0.18 1.10 0.17 -0.35 0.85 -0.18 1.10 0.17 -0.36 -0.01 0.85
High 5 yr -0.03 1.08 0.39 -0.74 0.88 -0.02 1.08 0.39 -0.75 -0.01 0.88

39