New Flexible Paradigms in Equity Valuation: Knowledge Based Enterprises

Abstract

The relationship between flexibility and market valuations has recently started attracting attention. Information Technology (IT) industry, by definition, is one of the most flexible industries. The primary assets for this industry are re-deployable human capital and embedded knowledge. IT Industry participants are unhampered by large fixed investments in physical assets and rigid processes. The incremental value placed by the stock market investors on this flexibility is measured using Initial Public Offering returns. The results indicate that investors in information technology industry IPOs earn significant excess positive returns. These excess returns occur across the board and are robust to market capitalization and exchange listing choices

Keywords: excess returns, flexibility, information technology, initial public offerings

Introduction

This paper empirically examines the degree of premium placed by investors on enhanced flexibility. Initial public offerings (IPO) of corporate stock provide an interesting opportunity to observe the pattern of demand for the portfolio of assets being offered to the investors at large. Existing research appears to attribute any IPO price run up to a deliberate under pricing on the part of the issuers and/or underwriters. The role of interaction between supply and demand for the stock being issued seems to have been ignored. The current research focuses on the relative attractiveness of the asset portfolio being offered to the investors and the value placed by investors on this portfolio. Since the supply of stock is fixed and introduced instantaneously, unmet demand from willing buyers should result in a higher price being offered to the initial stockholders. This higher price should, in turn, generate secondary selling by buyers till a new market clearing price and volume of trading is reached. It follows that as the demand for an asset increases, its value and, therefore, the premium offered by interested buyers should also increase. Under these conditions, enhanced value should result from an increase in flexibility of the enterprise. This suggests that if some stocks offer a higher degree of flexibility to investors and if the investors value such higher flexibility, such stocks should exhibit significantly higher IPO returns as compared to other stocks.

During the recent stock market boom, market capitalization of information technology (IT) sector firms quickly surpassed conventional manufacturing industry firms. Standard & Poor's index of 100 largest firms today includes thirty firms that did not even exist ten years ago. Conventional equity valuation models that rely on balance sheet and income statement data fail to justify the lofty valuations assigned to companies bent on burning cash rather than making money. These valuations have been variously attributed to a wave of euphoria, irrational herd behaviour, or plain inability of conventional valuation models to deal with the high degree of uncertainty involved in a rapidly evolving industry. It has been suggested that the appropriate model for IT industry stock valuations is equity options rather than traditional discounted cash flow methods as the options valuation methods incorporate the inherent flexibility of enterprises.

Meteoric rise and spectacular crash of dot COM enterprises has also attracted a lot of investor and media attention. It has been suggested that IT firms can realign their resources efficiently in the short run, as they are not hampered by large capital investments in fixed assets and rigid processes. Assets specificity can exist in tangible as well as intangible assets. Prime asset in IT sector may be the embedded knowledge created in the firm. Anecdotal evidence suggests that IT firms organized in flexible teams that readily disseminate this knowledge (e.g. CISCO) have fared consistently better than firms where this embedded knowledge has been tightly controlled by a small group within the firm (e.g. Yahoo!). In spite of the dot com flameout IT firms have turned in a better performance than the market at large as measured by the NASDAQ composite index.

The Information Technology industry comprises of a number of subgroups. The recognized subgroups included in the NASDAQ index and their performance during the twelve months ending March 2001 are listed in Table 1.

It is interesting to see that the survivors in the recent stock market crash are the firms providing tools rather than single applications products in the IT marketplace. The returns have varied in the direct order of flexibility enjoyed by the firms.

A business firm can be defined as a portfolio of contracts, capabilities and assets. The composition of this portfolio determines the firm's degree of flexibility in operational, financial, technological and strategic decision- making. The relationship between flexibility and market valuations has recently started attracting attention. Tang and Tikoo (1999) explore the relationship between firms' stock returns and accounting earnings for different levels of operational flexibility. They define operational flexibility as a firm's ability to respond profitably to environmental fluctuations by shifting factors of production within a multinational network of subsidiaries. They find a significant positive impact on stock returns and accounting earnings for multinational firms that operate in many countries and limit their concentration in any one country. Anand and Singh (1997) analyze firms from a resource-base perspective and suggest that firms are bundles of assets, some of which are fungible in nature. They propose that firms should be able to re-deploy these fungible assets to enter new markets when their existing businesses decline. This ability to enter new businesses is a valuable asset and contributes to firm performance. Busby and Pitts (1995) suggest that investment decisions can be analyzed as options to adapt the operations of the firm to environmental changes. They propose that projects with flexibility are more appealing and that this flexibility is a valuable asset in itself. Gronhaug and Nordhaug (1992) propose that a firm's capacity to retain, develop, organize, and utilize its competencies determines its future success. They also suggest that the firms' competencies create valuable flexibility if these competencies can be extended to alternate business applications, and hence facilitate strategic change. An alternative explanation for the role of flexibility in enhancing value by increasing the demand for a risky but flexible asset has been offered by Gollier et al. (1997). They propose that willingness to accept risk rises as the flexibility of an investor's portfolio increases. Aivazian and Berkowitz (1998) show that production flexibility increases potential tax shields from debt and lowers expected bankruptcy costs. The results suggest that in industries where assets are easily re-deployable, the impact of taxes on both investment and financial leverage will be positive and increasing with the size of capacity adjustment.

A sample of initial public offerings (IPOs) made from 1989 to 1998 was analyzed for realized excess returns. Factors influencing initial IPO pricing were identified and the impact of the IT industry's flexibility on investor returns was analyzed. Returns on IPOs have been studied extensively in finance literature. Excess IPO returns have been observed, measured, and attributed to information signaling, lawsuit avoidance, underwriter reputation, competition, and price stabilization behaviour. Prior research has concentrated on explaining the observed positive event day excess returns as a systematic pattern of underpricing in IPOs. Carter and Manaster (1990) suggest that uninformed investors require IPO returns as compensation for the risk of trading against superior information. Their results indicate that prestigious underwriters are likely to be associated with lower risk offerings requiring lower returns. Chishty et al. (1996) provide evidence that actual or potential competition among underwriters provides at least as much explanatory power as the more standard reputation variable in determining the price run-ups in the post issue trading.

Drake and Vetsuypens (1993) present empirical evidence on the lawsuit avoidance hypothesis. According to this hypothesis, large positive initial public offering (IPO) returns reduce the probability of a lawsuit, the conditional probability of an adverse judgment if a lawsuit is filed, and the amount of damages in the event of an adverse judgment. Evidence presented by Ruud (1993) substantiates the hypothesis that underwriter price supports play a role in explaining high average initial IPO returns. Jagadeesh et al. (1993) suggest that deliberate IPO under pricing is used by issuers to convey their private information about the value of their projects and prepare the market for subsequent issues of seasoned equity.

In a general supply and demand driven price framework, we should expect to observe the following relationships.

* Higher supply of tradable stock should result in lower IPO returns.

* Larger trading volume should result in higher IPO returns.

* Higher flexibility of the enterprise should result in higher IPO returns.

Data and Methodology

The sample consists of all common stock initial offerings during the period 1989-1998 for which data were available from the CRSP-NASDAQ tapes. Following prior studies, some categories of offerings were excluded, as shown in Table 2.

The final sample size is 7012 IPO offerings. The sample IPO offerings are divided into three categories based on the industry characteristics.

In order to evaluate market performance of the IPOs, raw returns and excess returns are computed for the day of the offering (day 0) and for two days following the offering (days 0,2). Appendix I shows the degree of abnormal appreciation from the offering price over the first day of trading and two trading days following the offering for the entire sample and classified by our groups of industries. The results indicate that if an investor had purchased each IPO at the offering date and price and held the investments for one day, the rate of return earned would be 2.316% or 1.120% higher than that of similarly timed investments in the composite index. The excess returns are positive and statistically significant. These results also show that virtually all price adjustment takes place during the first trading day. This suggests that the aftermarket for IPOs is quite efficient. Both of these results are consistent with the results of prior research.

There is substantial variation in the degree of abnormal returns over the industry groups. The mean IPO day returns for IT firms at 4.30% are significantly higher than those for manufacturing (2.79%) and other services (0.76%). Appendix II presents the ANOVA results for differences in IPO returns for the classification groups supporting the continued existence of these differences. Again, the tendency for full price adjustment to occur in the first trading day is apparent.

Further analysis is carried out to establish the existence of supply and demand effects of the size of the offering, and the trading volume of the securities, on the IPO day returns.

The proposed regression model is

X^sub 1^ = B^sub 0^+B^sub 1^ ADJSHR^sub t^+B^sub 2^*ADJVOL^sub t^

Where Xt is the abnormal IPO return, and

ADJSHR^sub t^ = CRSP adjusted shares outstanding for the stock for time period t

ADJVOL^sub t^ = CRSP adjusted volume for the stock for time period t

The results of the regression are presented in Appendix III. These results show that the effects are as hypothesized and statistically significant (F = 14.85, P>F=0.0000). The coefficient of trading volume, representing demand is positive and significant, while the coefficient of outstanding shares, or supply, is negative and significant. Analysis of variance is also performed for the effect of these variables while using industry classification grouping as class variables. The results show that the differences in IPO returns are significant for the three groups (F = 8.842, P>F = 0.0000). These results are presented in Appendix IV.

Cross-Sectional Analysis

The previous analysis was performed on the aggregate sample and time series of IPOs and may, therefore, be masking important cross-sectional variations. In particular, prior literature suggests that stocks with smaller market capitalization tend to out perform larger stocks, and that NASDAQ market tends to host smaller stocks. Therefore, it may be that the IPOs conforming to these classifications or the patterns are driving the results and that the reported results are not descriptive of the IPO market as a whole. Instead, the observed higher returns for IT firms may be a function of the presence of the smaller, riskier issues with little following among investors and investment banks.

To examine this possibility, the regression analysis for IPO returns is rerun with added variables representing the market capitalization and exchange listing. The results show that while the returns are influenced by the trading volume, number of shares outstanding, and the industry classification, variables representing market capitalization and choice of exchange listing do not add explanatory power to the model (F=6.069, P>F=0.0000). Further analysis shows that there is no significant difference in market capitalization (F=0.739, P>F= 0.4775) between the industry groups formed for the analysis. The results indicating significant differences between IPO returns for the industry groups appear to be robust to the firm capital size. These results are presented in Appendix V.

To summarize, the results of this analysis show that in aggregate, the investment returns behaviour of IPOs is supportive of IT industry premium. It has also been demonstrated that these results were not driven by a subset of smaller, more speculative, issues. Instead, the superior performance of IT industry IPOs is a robust "across the board" phenomenon in the IPO market, appearing in aggregate, over time, and across capitalization size categories.

Concluding Remarks

The results suggest that the possibility that underwriters do not systematically price IPOs below their intrinsic values should be explored. The presence of statistically significant excess returns that can be explained by the number of the shares offered, the IPO day trading volume and industry groupings indicates that the IPO returns may be driven by the balance of supply and demand in the market place, and that IT industry stocks may command premiums in view of the considerably higher flexibility enjoyed by the industry.

References

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Anand J. and Singh H. (1997) Asset Redeployment, Acquisitions and Corporate Strategy in Declining Industries, Strategic Management Journal,, 18(Special Issue Supplement), 99-118.

Busby J.S. and Pitts C.G.C. (1995) Investment and Unpredictability: Why Yardsticks Mislead us, Management Accounting London, 73(8), 38-40.

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Ruud J.S. (1993) Underwriter Price Support and the IPO Under pricing Puzzle, Journal of Financial Economics, 34(2), 135-151.

Tang C. Y. and Tikoo S. (1999) Operational Flexibility and Market Valuation of Earnings, Strategic Management Journal, 20(8), 749-761

Ashok B. Abbott

Associate Professor of Finance

College of Business and Economics

West Virginia University

Morgantown, WV, 26506-6025

Copyright Global Institute of Flexible Systems Management (GIFT) Jan-Mar 2001
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