The latest edition of the Federal Reserve Bank of New York’s Current Issues in Economics and Finance is available: Pre-IPO Financial Performance and Aftermarket Survival.
Analyzing two decades of data on the financial condition of firms undertaking initial public offerings (IPOs), economists Stavros Peristiani and Gijoon Hong confirm that profitability prior to a public offering is a reliable indicator of a firm’s aftermarket success. The authors point to evidence for the 1980-2000 period that shows, other factors being equal, that firms with negative pre-IPO earnings were three times more likely to be dropped from an exchange than were profitable issuing companies.
The data also show a marked deterioration over those two decades in the pre-IPO financial condition of issuers, leading to a significant rise in the aftermarket failure rate that culminated in the collapse of tech IPO stocks in 2001-03. Peristiani and Hong primarily use two factors to evaluate financial soundness: return on assets, defined as net income after taxes divided by total assets; and capitalization, or net worth, defined as total assets minus total liabilities.
The authors note that pre-IPO earnings for nontech firms declined from a healthy $1.29 a share in 1980-84 to a loss of 45 cents a share in the 1995-2000 period. Pre-IPO earnings for tech firms in the 1980-84 period declined from 77 cents a share to a loss of $1.17 a share in the 1995-2000 period.
In the 1980-84 period, the IPO firms—tech and nontech—that were delisted accounted for 0.3 percent of all publicly traded firms on an annual basis; by contrast, the comparable failure rate for 1995-2000 hit 2 percent. In 2001, an unprecedented 600 IPO firms—accounting for 3.8 percent of all publicly traded firms—were dropped by the major stock exchanges.
Company age also serves as a reliable measure of financial riskiness. Until the 1990s, the mean age of new listed companies was around seven years. With the dot-com explosion of the late 1990s, however, the average age of an issuing firm was four years.
The average profit level of IPO firms has improved, with the mean return-on-assets ratio for issuers rising from -42 percent in 2000 to -6 percent in 2001-02. In the first three quarters of 2003, IPO firms achieved a positive 3.9 percent return on assets, suggesting that market participants have begun to underwrite and invest in financially stronger companies.
Stavros Peristiani is a research officer in the Banking Studies Function of the Research and Market Analysis Group; Gijoon Hong is an assistant economist in the Capital Markets Function.
Pre-IPO Financial Performance and Aftermarket Survival »