Beware IPO Earnings Management

It’s logical to believe that corporate managers have a preference for issuing equity at times when they perceive that their company’s stock price is overvalued, or high relative to some benchmark (such as price-to-earnings ratio or book-to-market ratio). What’s more, the academic research on the subject supports this hypothesis—seasoned equity offerings (SEOs) tend to be preceded by unusually high stock returns.

The literature also shows that there are incentives (such as concerns about current-period performance-based compensation, prospects for promotion, future employment, post-retirement benefits such as directorships, the potential for termination, and the hope that subsequent positive events will allow them to “bury” the negative news) that can lead to a tendency among corporate managers to hoard bad news. They withhold and accumulate bad news for an extended period of time, keeping stock prices temporarily higher (think of WorldCom and Enron).

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