Do risk factors matter in the IPO valuation?
| Published date | 27 February 2007 |
| DOI | https://doi.org/10.1108/13581980710726796 |
| Date | 27 February 2007 |
| Pages | 63-89 |
| Author | Khaled Abdou,Mehmet F. Dicle |
| Subject Matter | Accounting & finance |
Do risk factors matter in the
IPO valuation?
Khaled Abdou
Penn State University, Reading, Pennsylvania, USA, and
Mehmet F. Dicle
College of Business, University of New Orleans, New Orleans, Louisiana, USA
Abstract
Purpose – The purpose of this paper is to investigate whether all of the risk factors were priced
during the internet bubble period.
Design/methodology/approach – A unique hand collected dataset was used from public
prospectuses for companies that issued an initial public offering during the internet bubble period.
Three hypotheses were proposed: the risk factors mentioned in the prospectus are important for
IPO trading and therefore affect IPO underpricing; risk factors affect the IPO deal attributes; and the
number of risk factors cited by the issuing firm is affected by direct participants such as venture
capitalists and investment bankers.
Findings – It was found that hi-tech dummy played a significant role during the bubble period.
Moreover, not all risk factors are regarded important, some of them are not significant at all as
predicted by first hypothesis. The most striking observation is the negative economic significance of
the risk factor no prior market for the traded stock. This reveals that, traders are selective in valuing
risks and may value some factors as opportunities and not as risk factors. In addition, the results
reveal that risk factors do affect the deal attributes as predicted by our second hypothesis. Also, the
pricing of these risk factors are not different between retail and hi-tech companies. Regarding the
participants, it was found that venture capitalists and investment bankers have a significant statistical
and economic effect on the number of risk factors reported in the prospectus.
Originality/value – The paper contributes to the literature by investigating the IPO underpricing
phenomenon in the internet bubble period.
Keywords Internet, Financial risk, Risk analysis,Pricing
Paper type Research paper
The period of the internet bubble between 1996 and 2000 still attracts a lot of
attention. One of the puzzles of that period is the huge underpricing of IPOs. In such
period, the primary market experienced many examples. One example is etoys who
experienced a 145 percent change in its stock price in only two weeks of going public.
MarketWatch.com Inc. is another example of the huge underpricing. The percentage
change of its stock price approached the 474 percent in the first day of going public.
Also, the IPO underpricing exists in other international markets. Georgen et al. (2003)
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1358-1988.htm
The authors thank Dr Oonagh McDonald, the Editor of Journal of Financial Regulation and
Compliance, and an anonymous referee for the helpful comments and suggestions, Edgar online
for providing a database for the previous filings of all firms and Jay Ritter for providing the
ranking of the investment bankers freely available on his web site. They also thank Michael
Morris for the helpful comments. Of course, all errors are theirs. The idea of this paper is based
on a very preliminary research paper previously conducted by Khaled Abdou, Yunus
Kathawala, and Arne Kassner entitled “Risk factors in the new global economy.”
Do risk factors
matter in the IPO
valuation?
63
Journal of Financial Regulation and
Compliance
Vol. 15 No. 1, 2007
pp. 63-89
qEmerald Group Publishing Limited
1358-1988
DOI 10.1108/13581980710726796
showed the short-run IPO underpricing across the European New Markets from the
first date of trading in those markets till the end of 2000.
The outstanding profits triggered the idea of IPO underpricing, especially for the
high-tech companies. Although a significant amount of research has been conducted to
explain this phenomenon, still there is no clear-cut conclusion. This issue motivates us
to investigate whether the prospectus plays a role in the underpricing. We ask, whether
the risk factors that are included in the prospectus play a role in the underpricing
during the internet bubble period. Are these risk factors priced? So that prices of
securities will be lower in order to compensate investors for bearing such risks.
The motivation of the paper was strengthened by the questions; since prospectus is
required by the regulatory agencies domestically and internationally, is it that
important? Does it include information that affect the stock price after issuance? If so,
what type of information? Are investors widely affected by all of the information in the
prospectus, especially the risk factors cited?
One recent incident that confirms that the prospectus is seen as an important
investment guide, is the fine imposed on an investment banker for failure of sending the
prospectus to potential investors. Although the prospectus is thought of “a standard”
document, Davis (2004) reported that some brokerage firms failed to send these
(prospectuses) documents to their customers, and hence they may face millions of dollars
in liabilities to their customers because of these invalid sales. This tough move was done
by the NYSE (New York Stock Exchange). In a recent incident, NYSE has fined Morgan
Stanley $19 million, which was considered a very high amount. This fine was imposed
because of the failure of sending the prospectus as well as other operational and
supervisory deficiencies. Davis describes the incident as “The issue could hit some Wall
Street wallets hard.” The question here is that since it was thought of as a standard form,
why Morgan Stanley failed to send such document? Another question, did the failure of
sending the prospectus result in a material[1] decision-making changes for investors?
Based on the above incident, we expect that the prospectus is a major document that
includes a lot of information that should be considered by investors as well as financial
analysts. When we did our preliminary investigation, we found out that some
companies mention many risk factors while others mention few of the risk factors.
Because of these observations, we argue that risk factors portion of the prospectus is
not a standard part and hence the inclusion/exclusion of some factors affects the
amount of the discount to an IPO.
We divide the risk factors into several categories; management issues, international
trade issues, technological issues, operational issues, financial issues and finally,
market, economic and regulatory issues. In each of the above categories, the different
risk factors are discussed. All of the risk factors that are cited by companies and are
related to management issues are tested. For example, the management issues category
include anti-takeover provisions, control mechanisms by directors, control by existing
shareholders, control by principal shareholders, dependence on key personnel, dilution
to shareholdings, limited liability of directors, limited experience and limited human
resources risk. We include comprehensive definitions of each risk factor in Appendix 2.
Each company was tested based on the above categories to conclude whether or not
any of those risk factors were cited by the company in its prospectus. For example,
etoys cited nine risk factors. Those risk factors are: dependence on key personnel,
assets comprise of intellectual property and intangible assets, Y2K risk, managing
JFRC
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