Search

We propose reduced investment as a potential explanation for why firms with internal control weakness (ICW) exhibit lower valuation relative to non-ICW firms. We show that ICW firms significantly reduce investment around ICW disclosure and also have poor stock performance. Additional evidence shows that many of the investment reductions have been announced during the year before ICW disclosure. A possible explanation for investment reductions is the higher costs of financial friction associated with ICW. Consistent with this explanation, we show that ICW firms with credit ratings do not reduce their investment as much and have much better stock performance than ICW firms without credit ratings.

We find that firms reporting internal control material weakness (ICW) under Section 404 of Sarbanes–Oxley Act (SOX) have 13% lower valuation than non-ICW firms based on Tobin's q. This valuation difference is mainly driven by stock underperformance of more than 13% during the year before ICW disclosure. The ICW firms that remedy the internal control weakness in the subsequent year have much better stock performance compared to those firms that fail to remedy existing ICW problems. We further show a better stock performance in the year before disclosure if a SOX 404 ICW firm has prior SOX 302 ICW disclosure more than one year earlier. All these results are consistent with the hypothesis that the equity market has incorporated the negative information associated with SOX 404 ICW reports before the actual disclosures are made.

We fi nd that IPO underpricing is positively related to post-IPO growth in sales and EBITDA, but is not signifi cantly related to growth in earnings. Our evidence suggests that accrual reversals or earnings management may cause this inconsistency. We interpret the growth rates of sales and EBITDA as measures of fi rm quality, and conclude that our evidence supports the notion that IPO fi rms with greater underpricing are of better quality. Our tests on analysts’ earnings forecast errors show that analysts are less positively biased in their earnings forecasts for IPO fi rms that have greater underpricing. In this paper we examine the relation between initial public offering (IPO) underpricing and postIPO growth rates of accounting performance variables. Previous research on IPOs suggests that IPO underpricing is related to the quality of the IPO fi rms (Allen and Faulhaber, 1989, Welch, 1989, Grinblatt and Hwang, 1989, and Rock, 1986). If we use growth rates of accounting performance variables (such as earnings) as measures of fi rm quality, then this suggestion implies a positive relation between IPO underpricing and growth rates. Our hypothesis is that IPO fi rms with greater underpricing should have higher post-IPO growth rates of accounting performance variables. However, rather than just concentrate on growth in earnings, we also include growth in EBITDA and growth in sales. Relative to earnings, these latter variables are more diffi cult for managers to manipulate. Thus, to reduce the possible contamination of our analysis by earnings management strategies, we consider the growth rates of earnings, EBITDA, and sales, and how they relate to IPO underpricing. Consistent with our hypothesis, we fi nd that underpricing is positively related to growth in sales and EBITDA in the fi ve years following an IPO. These results suggest that the IPOs with greater underpricing have higher quality. We also fi nd that IPO growth rates in earnings are much lower than the growth rates in sales and EBITDA. Further tests show that this inconsistency is likely caused by earnings management at the time of the IPO, which infl ates earnings initially and thus reduces earnings growth rates in subsequent years. This result suggests that earnings growth rates may not be accurate measures of IPO fi rm quality compared to sales and EBITDA growth rates. We fi nd that the fi rms with greater underpricing experience larger decreases in accruals after the fi rst year. This fi nding implies that earnings management may also reduce the correlation between IPO underpricing and earnings growth rates. We examine the accuracy of analysts’ earnings forecasts to determine how analysts react to the relation between IPO growth rates and IPO underpricing. If analysts are misled by earnings We thank Mark Huson, participants at the 2005 Northern Finance Association Conference, and, in particular, Bill Christie (the Editor) and an anonymous referee for helpful comments and suggestions. The authors gratefully acknowledge the contribution of Thompson Financial for providing earnings forecast data, available through I/B/E/S (Institutional Brokers Estimate System).

I examine the relation between initial public offering (IPO) long-run stock performance and the amount of cash raised by the firm in the offering. I find that IPOs raising more cash have poorer long-run performance. The result is robust to different measurement methods. The evidence suggests that the market underreacts to free cash flow related agency problems in IPOs. Consistent with this interpretation, I find that IPO long-run performance is more sensitive to the new cash raised in the offering if an IPO firm has lower capital expenditure or higher opening bid-ask spread.