Industry Peer Firms' Earnings Quality and IPO Underpricing

Date01 January 2019
Published date01 January 2019
Industry Peer FirmsEarnings
Quality and IPO Underpricing
Ji Yu, Ling Tuo and Da Wu
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 rmsearnings
quality and IPO
underpricing. Gener-
ally, IPOs tend to
have a large positive
rst-day initial return,
the IPO underpricing
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 rms
own characteristics
(earnings) on IPO
underpricing. Our
study extends this
line of research by:
(a) investigating the
link between peer
quality and IPO
underpricing; and
(b) examining the
effect of the Sarbanes-
Oxley Act of 2002
(hereafter SOX) on
IPO underpricing.
Our analysis of
the relation between
IPO underpricing and
peer rmsearnings
quality is motivated
by three streams of
research. The rst
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 rmseffect in the
We investigate the relation between peer rms
earnings quality and initial public offering (IPO)
underpricing. By examining 3,711 IPOs from
1976 to 2013, we nd that peer rmsearnings
quality is negatively associated with IPO under-
pricing after controlling for IPO rm earnings
quality and other attributes. This study also nds
that comparable peer rms (with a similar mar-
ket capitalization in the same industry) play a
more important role in impacting IPO under-
pricing than inuential peer rms (with the
highest market capitalization in the same indus-
try). We further provide evidence that the peer
rmsearnings quality effect is attenuated after
the Sarbanes-Oxley Act of 2002. Our results sug-
gest that information from peer rms in the
same industry is benecial for investors to
assess new IPO rms 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 Classication: G24, M41, M48
© 2019 Wiley Periodicals, Inc.
Published online in Wiley Online Library (
DOI 10.1002/jcaf.22366
Refereed (Double-Blind
Peer Reviewed)
capital market (e.g., Kim &
Ritter, 1999; Ma, 2013; Mac-
Kay & Phillips, 2005), showing
that the specicrmsnancing
decision in large part is a
response to the nancing deci-
sion of peer rms. Finally, the
third stream investigates the
impact of SOX on nancial
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-
prot 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 rmsearnings quality and
IPO underpricing.
The theoretical intuition
for our hypothesized link
between peer rmsearnings
quality and IPO underpricing is
based on the information
asymmetrytheory of pricing
following Ljungqvists (2007)
theoretical framework. Per-
ceived IPO information asym-
metry can be addressed by
examining peer rmsinstitu-
tional environment, production
technology, and product mar-
ket characteristics along with
their possible association with
the IPO rm (Leary & Roberts,
2014). Following the informa-
tion asymmetry theory and
peer rmseffect postulate, we
posit that peer rmsearnings
quality is associated with IPO
underpricing. We argue that
there are two mechanisms,
which can explain the link
between peer rmsinforma-
tion and new IPO under-
pricing. One of those
mechanisms is the internality
channel through which earn-
ings quality information from
peer rms impacts investors
assessed variance of the specic
rms cash ows and covari-
ance (Lambert, Leuz, &
Verrecchia, 2007). With
reduced variance and covari-
ance of the IPO rms cash
ow, investors can better esti-
mate the future cash ows of
IPOs based on more credible
information from peer rms
(Admati & Peiderer, 2000;
Dye, 1990; Ma, 2013). The
reduced internal variance and
covariance factors connected
with information asymmetry
will together provide a signi-
cant effect on the IPOs under-
pricing. The second mechanism
is the externality channel
through which information dis-
closure from a specicrm has
inuence on investorsbelief
and perception of other rms
market value and cash ows in
the same industry (Brown,
Tian, & Tucker, 2014; Dye,
1990 and Foster, 1981). Inves-
torsperception of the new rms
nancial condition may highly
depend on the information of
rms 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 rmsearnings quality on
IPO underpricing.
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 classication, which
leads to 64 industries in our
Based on the three
individual measurements of
rm-specic earnings quality
measures, we develop six mea-
surements of equally weighted
or market-share weighted (rev-
enue) peer rmsearnings qual-
ity measurements. We also
establish an aggregate measure-
ment of peer rmsearnings
quality measurement based on
the average of the six peer
rmsearnings quality mea-
surements. In total, we estab-
lish seven peer rmsearnings
quality measurements as
explained in detail in earnings
quality measurements section.
We nd that high peer
rmsearnings quality in gen-
eral is associated with lower
IPO underpricing after control-
ling for the IPO rm earnings
quality and other rms charac-
teristics documented in the lit-
erature. Our results are robust
after controlling for IPO rms
earnings quality, suggesting
that peer rmsearnings qual-
ity can impact IPO under-
pricing beyond IPO rms
earnings attributes. We argue
that the peer rmseffect in the
IPO setting might be due to
investorsawareness of man-
agements manipulation behav-
ior before IPOs. Prior research
shows that rms 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 rms
to revert back to normal
reporting practices after the
offering. Thus, in the IPO set-
ting, investors might be skepti-
cal about IPOsnancial
information while relying on
information conveyed by other
rms within the same industry.
The Journal of Corporate Accounting & Finance / January 2019 37
© 2019 Wiley Periodicals, Inc. DOI 10.1002/jcaf

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