Industry Peer Firms' Earnings Quality and IPO Underpricing

• Date: 01 January 2019
• DOI: http://doi.org/10.1002/jcaf.22366
• Published date: 01 January 2019

Industry Peer Firms’Earnings

Quality and IPO Underpricing

Ji Yu, Ling Tuo and Da Wu

INTRODUCTION

Proper pricing of

an initial public offer-

ing (IPO) has been a

challenge as many

IPOs tend to be

underpriced world-

wide. We examine the

association between

peer firms’earnings

quality and IPO

underpricing. Gener-

ally, IPOs tend to

have a large positive

first-day initial return,

whichisreferredtoas

the IPO underpricing

phenomenon.

1

IPOs

can be underpriced

for a variety of rea-

sons including con-

cerns regarding the

liquidity and predict-

ability of demand for

the IPO, managerial

incentivized under-

pricing to compe nsate for

liquidity and predictability risks,

investor push to participate in

the IPO process, the possibility

of information asymmetry, and

corporate governance effective-

ness (Beatty & Ritter, 1986;

Chen, Liao, & Lu, 2012; Leone,

Rock, & Willenborg, 2007;

Ljungqvist, 2007). Prior

research (Leone et al., 2007;

Teoh, Welch, & Wong, 1998;

Willenborg & McKeown, 2001)

often focuses on investigating

the effect of firms’

own characteristics

(earnings) on IPO

underpricing. Our

study extends this

line of research by:

(a) investigating the

link between peer

firms’earnings

quality and IPO

underpricing; and

(b) examining the

effect of the Sarbanes-

Oxley Act of 2002

(hereafter SOX) on

IPO underpricing.

2

Our analysis of

the relation between

IPO underpricing and

peer firms’earnings

quality is motivated

by three streams of

research. The first

stream investigates

the determinants and

mechanisms behind

the IPO underpricing

(e.g., Allen & Faulhaber, 1989;

Boulton, Smart, & Zutter,

2011; Leone et al., 2007;

Ljungqvist, 2007; Willenborg &

McKeown, 2001). The second

stream of research examines

the peer firms’effect in the

We investigate the relation between peer firms’

earnings quality and initial public offering (IPO)

underpricing. By examining 3,711 IPOs from

1976 to 2013, we find that peer firms’earnings

quality is negatively associated with IPO under-

pricing after controlling for IPO firm earnings

quality and other attributes. This study also finds

that comparable peer firms (with a similar mar-

ket capitalization in the same industry) play a

more important role in impacting IPO under-

pricing than influential peer firms (with the

highest market capitalization in the same indus-

try). We further provide evidence that the peer

firms’earnings quality effect is attenuated after

the Sarbanes-Oxley Act of 2002. Our results sug-

gest that information from peer firms in the

same industry is beneficial for investors to

assess new IPO firms and is associated with less

information asymmetr y than newer IPOs. These

results provide policy , practical, and resear ch

implications. © 2019 Wiley Pe riodicals, Inc.

JEL Classification: G24, M41, M48

© 2019 Wiley Periodicals, Inc.

Published online in Wiley Online Library (wileyonlinelibrary.com).

DOI 10.1002/jcaf.22366

36

Refereed (Double-Blind

Peer Reviewed)

capital market (e.g., Kim &

Ritter, 1999; Ma, 2013; Mac-

Kay & Phillips, 2005), showing

that the specificfirm’sfinancing

decision in large part is a

response to the financing deci-

sion of peer firms. Finally, the

third stream investigates the

impact of SOX on financial

reporting quality by lowering

discretionary accruals (Lobo &

Zhou, 2006), reducing accrual

earnings management

(Ashbaugh-Skaife, Collins,

Kinney, & Lafond, 2008; Chen

et al., 2012; Cohen, Dey, &

Lys, 2008), stimulating non-

profit organizations to adopt

governance measures similar to

SOX (Iyer & Watkins, 2008),

and reducing IPO underpricing

(Johnston & Madura, 2009).

Our study complements yet dif-

fers from these three studies by

investigating the link between

peer firms’earnings quality and

IPO underpricing.

The theoretical intuition

for our hypothesized link

between peer firms’earnings

quality and IPO underpricing is

based on the “information

asymmetry”theory of pricing

following Ljungqvist’s (2007)

theoretical framework. Per-

ceived IPO information asym-

metry can be addressed by

examining peer firms’institu-

tional environment, production

technology, and product mar-

ket characteristics along with

their possible association with

the IPO firm (Leary & Roberts,

2014). Following the informa-

tion asymmetry theory and

peer firms’effect postulate, we

posit that peer firms’earnings

quality is associated with IPO

underpricing. We argue that

there are two mechanisms,

which can explain the link

between peer firms’informa-

tion and new IPO under-

pricing. One of those

mechanisms is the internality

channel through which earn-

ings quality information from

peer firms impacts investors’

assessed variance of the specific

firm’s cash flows and covari-

ance (Lambert, Leuz, &

Verrecchia, 2007). With

reduced variance and covari-

ance of the IPO firm’s cash

flow, investors can better esti-

mate the future cash flows of

IPOs based on more credible

information from peer firms

(Admati & Pfleiderer, 2000;

Dye, 1990; Ma, 2013). The

reduced internal variance and

covariance factors connected

with information asymmetry

will together provide a signifi-

cant effect on the IPO’s under-

pricing. The second mechanism

is the externality channel

through which information dis-

closure from a specificfirm has

influence on investors’belief

and perception of other firms’

market value and cash flows in

the same industry (Brown,

Tian, & Tucker, 2014; Dye,

1990 and Foster, 1981). Inves-

tors’perception of the new firm’s

financial condition may highly

depend on the information of

firms within the same industry.

Using a sample of 3,711

IPOs during the period from

January 1976 to December

2013, we test the effect of

peer firms’earnings quality on

IPO underpricing.

3

Following

earnings quality literature

(e.g., Dechow, Sloan, &

Sweeney, 1995; Jones, 1991;

Kothari, Leone, & Wasley,

2005), we construct three

individual earnings quality

measurements and an aggre-

gate average value of the three

individual earnings quality

measurements. We classify

industries based on SIC-2 digit

codes classification, which

leads to 64 industries in our

sample.

4

Based on the three

individual measurements of

firm-specific earnings quality

measures, we develop six mea-

surements of equally weighted

or market-share weighted (rev-

enue) peer firms’earnings qual-

ity measurements. We also

establish an aggregate measure-

ment of peer firms’earnings

quality measurement based on

the average of the six peer

firms’earnings quality mea-

surements. In total, we estab-

lish seven peer firms’earnings

quality measurements as

explained in detail in earnings

quality measurements section.

We find that high peer

firms’earnings quality in gen-

eral is associated with lower

IPO underpricing after control-

ling for the IPO firm earnings

quality and other firm’s charac-

teristics documented in the lit-

erature. Our results are robust

after controlling for IPO firms’

earnings quality, suggesting

that peer firms’earnings qual-

ity can impact IPO under-

pricing beyond IPO firms’

earnings attributes. We argue

that the peer firms’effect in the

IPO setting might be due to

investors’awareness of man-

agement’s manipulation behav-

ior before IPOs. Prior research

shows that firms change their

reporting practices in the years

leading up to an IPO

(e.g., Aharony, Lee, & Wong,

2000; DuCharme, Malatesta, &

Sefcik, 2002; Teoh & Wong,

2002). IPO investors are aware

of this potential manipulation

behavior and expect the firms

to revert back to “normal”

reporting practices after the

offering. Thus, in the IPO set-

ting, investors might be skepti-

cal about IPOs’financial

information while relying on

information conveyed by other

firms within the same industry.

The Journal of Corporate Accounting & Finance / January 2019 37

© 2019 Wiley Periodicals, Inc. DOI 10.1002/jcaf