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Managerial Finance
Vol. 33 No. 6, 2007
pp. 352-367
#Emerald Group Publishing Limited
0307-4358
DOI 10.1108/03074350710748722
Over-optimism when pricing IPOs
Stefano Paleari and Silvio Vismara
Department of Management and Information Technology,
University of Bergamo, Bergamo, Italy
Abstract
Purpose The purpose of this paper is to contribute to the literature on the valuation of initial
public offerings (IPOs). In particular, it tests the presence of over-optimism when pricing IPOs on the
Italian Nuovo Mercato.
Design/methodology/approach The paper investigates whether the analysts make systematic
errors when forecasting the performance of the firm undergoing the IPO by comparing analysts ex-
ante expectations to actual ex-post figures. Using a sample of pre-IPO analysts reports, the paper
performs a regression analysis using the forecast errors (FE) of post-issue sales as dependent variable
in order to find out the determinants of mis-valuation.
Findings It is found that the Nuovo Mercato has been essentiallya market for projects inwhichyoung
enterprises endowed with a few tangible assets sold their business plans to the market exploiting
high-growth opportunities. In the aftermarket, stock and operating performances are found to be
declining, falling short of initial expectations. The extent of the actual post-issue growth was lower than
the ex-ante estimations by financial analysts, whose valuations were systematically upwardly biased.
Affiliated analysts are found not to be more over-optimistic than the unaffiliated. FEappear to be primarily
driven by the extent of forecasted growth, by market sentiment and (inversely) by the size of the firm.
Originality/value Fromthe perspective of investors, this study contributes to the understanding of the
helpfulness and limits of the analysts forecasts in investment decisions and, more generally, of the
determinants of over-optimism. This study addresses the issue of over-optimism and provides empirical
evidence of it. This paper also contributes to the literature on the rise and fall of the new European stock
markets.
Keywords Stock markets, Financial reporting, Italy
Paper type Research paper
1. Introduction
Firms may time their initial public offering (IPO) in order to take advantage of
windows of opportunity (Loughran and Ritter, 1995). These are periods of market
buoyancy during which companies have an incentive to issue new shares on the base of
an over-valuation of other companies in their industry. Besides, firms may decide to go
public when they are able to display positive growth opportunities, and thus to induce
optimistic valuations. To do this, managers may window-dress their accounting
numbers to make the firms look better before public offering (Teoh et al., 1998). If the
market does not understand that earnings growth tends to mean revert, IPO will be
over-valued.
Today, most IPOs are priced using the book building procedure (Sherman, 2002).
Under this framework, underwriters determine the final offer price in two steps. First,
they determine an initial price range primarily using the discounted cash flow (DCF)
method or the comparable multiples method. Second, they collect indications of interest
from institutional investors.
Valuation is therefore a pivotal issue in the analysis of IPOs. Nevertheless, a
few studies addressed this issue. Kim and Ritter (1999), Cassia et al. (2004), and
Purnanandam and Swaminathan (2004) examine the valuation of IPOs using multiples.
Although this method can reduce the probability of misvaluing a firm relative to
others, it provides no safeguard against an entire sector being under- or over-valued.
The peer comparables approach may therefore cause over-optimistic valuations to be
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self-justified. Whether or not IPO pricing reflects the IPOs fundamental valuations is
an open question. Although it is difficult to come up with accurate valuation measures
for IPOs, this literature is promising. The next step may involve the use of earnings
forecasts with more detailed corporate information (Ritter and Welch, 2002).
The present paper contributes to the literature in this direction by valuing the
accuracy of pre-IPO analysts forecasts. This is the first paper comparing the analysts
forecasts with the actual post-IPO performance for companies listed on the Nuovo
Mercato. Four other papers investigated the pre-IPO forecasts using samples of IPOs
on the German Neuer Markt (Leuz, 2003) and on the French Nouveau Marche (Schatt
and Roy, 2002; Gerard et al., 2003; Chahine, 2004). In particular, Chahine (2004) finds
that the forecasts of analysts were systematically biased upwardly compared to actual
figures, for one and two years after the IPO. Our study on the Nuovo Mercato confirms
these findings and investigates the determinants of such over-optimism.
The rise and fall of new European markets offer favorable conditions to analyze
IPOs over-valuation. This study tests the hypothesis of over-optimistic valuations of
firms going public on the Nuovo Mercato, the third new European market in terms of
capitalization. This market, launched by the Italian Exchange in 1999, is particularly
suitable for such test for three reasons.
(1) The Nuovo Mercato is a dedicated market for companies with high growth
potential that have much of their value represented by intangibles and
growth options, rather than assets in place. Their valuation is therefore an
outstandingly difficult task. In particular, high-tech companies are often valued
through the peer comparables approach. This methodology builds-in errors that
the market might be making in valuing comparable firms and, consequently, it
may generate a run-up effect in the IPO market. The rise in prices of a firm that
listed first makes it convenient for follower companies in the same sector (who
list subsequently) to go public on that market (Cassia et al., 2004).
(2) As the other new markets, the Nuovo Mercato aims to meet the needs of
companies with high growth potential. Its listing pre-requisites are indeed less
binding than those of traditional stock markets in terms of pre-issue
profitability, allowing young but not yet profitable firms to be listed and issue
new capital. The nature of firms listing on the new markets is therefore different
from those on the traditional markets. Since age (young firms), size (small) and
industry (high-tech) are among the determinants of long-run underperformance
(Loughran and Ritter, 1995; Brav and Gompers, 1997; Hansen and Sarin, 1998),
the new markets IPOs constitute an ideal sample for testing if these variables,
among others, are also determinants of over-optimism.
(3) During periods when investors are optimistic about the growth potential of
companies going public, the large volumes of IPOs may represent a response by
entrepreneurs timing the IPO to exploit the over-valuation of their companies
by the market. The windows of opportunity hypothesis predicts indeed that
firms going public in a particular period and sector are more likely to be over-
valued than other IPOs. Then, if the market gradually recognizes the over-
valuation, a long-run underperformance will result as an effect of stock price
revaluation (Ritter, 1991). This could be the case of the Nuovo Mercato, which
saw a hot issue period with 30 IPOs in 2000 (the Italian stock exchange very
rarely reached such numbers throughout its history) then just four IPOs in
2001, and no more afterward.
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In order to test for over-optimism, we investigate whether analysts growth forecasts
are overly optimistic at the time of equity offerings. We find that actual post-issue
growth in sales is much lower than the ex-ante estimations by financial analysts. Using
a sample of 64 pre-IPO analysts reports, we compare forecasts on CAGRs with the
actual post-issue CAGRs. The results points to analysts optimistic expectations for the
post-issue. Both affiliated and unaffiliated analysts did not fully accomplish to their
role in reducing the information asymmetry between the issuer and the public and in
promoting market efficiency by providing accurate valuations. On the contrary, IPOs
were priced on the base of overconfident prospects of future growth. We perform a
regression analysis to identify the determinants of the over-optimism. Upward bias in
analysts forecasts appears to be related to: (1) high growth forecasts, (2) market
momentum, (3) time passed from the publication of the first analysts report on the
Nuovo Mercato, (4) high-tech industry specificity and (5) size (negatively related).
On the wave of this over-optimism, the listing on the Nuovo Mercato often offered
pre-IPO shareholders with the opportunity to fund the companies and at the same time
to found their capital at favorable conditions. We argue that the Nuovo Mercato has
been essentially a market for projects in which young enterprises endowed with a few
tangible assets sold their business plans to the market.
The paper is organized as follows. The next section discusses the literature on the
topic; section 3 explains the hypotheses and the methodology. Section 4 characterizes
the IPOs on the Nuovo Mercato, while section 5 describes the empirical findings. We
present our conclusions in section 6.
2. Literature survey
The value of analystsactivity is widely debated in the academic literature. On one side,
analysts activity reduces agency costs associated with the separation of ownership
and control ( Jensen and Meckling, 1976): analysts play the role of monitoring the
manager. On the other hand, there is some criticism that analysts provide biased
information. Prior research has indeed typically indicated that analysts tend to be
over-optimistic and that their forecasts systematically exceed the actual figures (Butler
and Lang, 1991; Brous and Kini, 1993; Francis and Philbrick, 1993; Dreman and Berry,
1995; Brown, 1996; Rajan and Servaes, 1997; Brav and Lehavy, 2003). Over-optimism
may result from a selection bias; analysts do not pick randomly the firms they follow,
but typically start following stocks they are optimistic about (McNichols and OBrien,
1997). Moreover, over-optimism may also result from analysts incentives to issue buy
recommendations or optimistic forecasts to make the deal look more attractive to the
market. This may happen because some analysts work for investment banks that have
a relationship with the firm being analyzed (Dugar and Nathan, 1995; Lin and
McNichols, 1998). Furthermore, analysts rely on the firms management, which may
not be neutral, as an important source of information (Lim, 2001).
A growing literature has focused on analyst objectivity valuing the effect of
affiliation on analysts forecasts. It is argued that affiliated analysts issue more
optimistic forecasts and more favorable recommendations (Dugar and Nathan, 1995;
Dechow et al., 2000) and that IPO firms recommended by affiliated underwriters
perform worse than firms recommended by unaffiliated underwriters (Michaely and
Womack, 1999; Lin et al., 2003). However, conflicting evidence exists on this issue since
some research finds no difference between the forecasts of affiliated and unaffiliated
analysts (Branson et al., 1998; Lin and McNichols, 1998; Bradley et al., 2003). On one
Over-optimism
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355
hand, the affiliated can access to superior information, and on the other they have a
higher incentive to boost their predictions.
Nevertheless, analysts activity is important for the market since it promotes
market efficiency by helping investors to value companies more accurately ( Jegadeesh
et al., 2004). Several studies document indeed that favorable (unfavorable) analysts
recommendations are accompanied by positive (negative) returns at the time of
announcement (Stickel, 1995; Womack, 1996; Brav and Lehavy, 2003). A profitable
trading strategy is found to be associated with purchasing (selling short) stocks with
most (least) favorable consensus (Barber et al., 2001). Analyst coverage is also an
important factor in the success of an IPO. It is argued that it is one of the most sought
services by IPO firms (Krigmam et al., 1999). Bradley et al. (2003) find that US firms
who have coverage initiated after the quiet period experience a significantly positive
market-adjusted return. These findings are consistent with the theory that analysts
play a role in reducing the information asymmetry between the issuer and the public
(DMello and Ferris, 2000).
Our contribution is to quantify over-optimism of the analysts on the Nuovo Mercato
and to identify its determinants. To the best of our knowledge, this is the first paper
that specifically addresses this issue on the Nuovo Mercato. Previously, four papers
investigated pre-IPO forecast on other European new markets. In particular, Chahine
(2004) investigates the forecast errors for a sample of 168 IPOs on the Second Marche
and on the Nouveau Marche. He finds an upward bias in analysts forecast for one and
two years after the IPO. The perspective of the other three papers is instead quite
different. Leuz (2003) uses the dispersion of analysts forecasts as a proxy for
information asymmetry to investigate the effect of the adoption of different accounting
standards (IAS vs US GAAP) by companies listed on the Neuer Markt. Two other
recent papers investigate the quality of the information provided in the IPO
prospectuses issued by companies going public on the Second Marche and on the
Nouveau Marche. By comparing VC and non-VC IPOs prospectus profit forecast
errors, Gerard et al. (2003) find evidence that VCs have a positive impact on the
information disclosed. Schatt and Roy (2002) investigate the forecast errors for the
fiscal year of the IPO and find no statistical differences between actual (year 0) and
forecasts reported in the prospectus.
3. Hypotheses and methodology
Previous research indicates that analysts tend to be overly optimistic in their forecasts
of firms prospects. We investigate if the analysts make systematic errors when
forecasting the performance of the firm undergoing the IPO by comparing analysts
ex-ante expectations to actual ex-post figures. Forecast errors (FE) are therefore
defined as the difference between expected sales (marked with E) and actual sales,
scaled by actual sales[1]:
FEy
i. j

SalesyE
i. j
Salesy
i. j
Salesy
i. j
1
where y is the year of the IPO (e.g. 1 refers to the year following the IPO) for the firm j,
analyzed by the report i.
We would expect that if analysts forecasts are unbiased, then the forecasting error
should be equal to zero, such that the expected sales should not significantly differ
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from actual sales. On the contrary, biases in analysts forecasts would shift the
distribution of FE in either direction.
Forecasts by analysts affiliated with the lead investment bank underwriting the
offering should be more accurate as they can access to better information about the
firm being valued. On the other hand, affiliated have stronger incentive to make overly
optimistic forecasts to lowering the offering firms cost of capital. Being our reports by
both affiliated and unaffiliated analysts, we are able to evaluate the effect of affiliation
on analysts forecasts by splitting the sample of report on the base of analysts
affiliation (Dechow et al., 2000).
We perform a regression analysis using the FE of post-issue sales as dependent
variable in order to find out the determinants of misvaluation. When identifying the
explanatory variables, we focused on variables that prior studies found to have some
predictive power when predicting initial over-valuation and subsequent long-run
underperformance. Among these, age (young firms), size (small) and industry (high-tech)
are characteristics intrinsic to the nature of the firms going public on the new markets.
4. IPOs on the Nuovo Mercato
A firm wishing to go public in Italy may choose to raise equity on the main board
(Mercato Telematico Azionario, MTA) or on the Nuovo Mercato. While companies on
the MTA come from all sectors of business, the Nuovo Mercato targets high-tech small
and medium-sized enterprises. Companies going public on this market are indeed
younger and smaller than those on the MTA (Table I). The capital raised at the listing
has also a different level of importance among the two markets. The Nuovo Mercato
attracted firms whose operations depend on the capital raised on floatation and,
therefore, whose initial value almost exclusively incorporates future expectations.
Indeed, firms on the Nuovo Mercato undergo a real equity foundation in going public.
The amount of issued capital is significant if compared to the book value of equity after
the listing; on average, 81.55 per cent of the post-listing book equity comes from newly
issued shares (IPOBOOKEQUITY). We argue that the Nuovo Mercato has been
Nuovo Mercato MTA Test on the difference
Average Median Average Median Mean Median
Nuovo Mercato vs main board (MTA)
AGE at the IPO (years) 10 8 40 33 6.088* 5.768*
Pre-IPO SALES (mE) 64.9 22.4 738.4 152.9 1.333 5.364*
Pre-IPO BOOKEQUITY (mE) 10.8 8.1 547.6 34.6 1.468 6.045*
SIZE (no. of employees) 131 46 3,156 560 1.412 6.066*
IPOBOOKEQUITY (%) 81.55 84.18 42.58 44.73 7.469* 5.985*
IPOMARKETEQUITY (%) 24.04 22.22 17.38 17.03 2.614* 2.218**
No of observations 39 40
Notes: The Nuovo Mercatos IPOs are compared to the IPOs by operating companies on the
Italian main board during the period 1999-2001. Data refers to the most recent information
reported in the offering prospectuses. NEWEQUITY is the proportion of the post-listing book
equity that comes from the raising of capital contextual to the listing; PRIMARYISSUE are the
newly issued shares as a percentage of shares in issue following the offer. *indicates two-sided
statistical significance at 1 per cent; **indicates two-sided statistical significance at 5 per cent.
The significance level for the median is based on the Wilcoxon test (MannWhitney), and for the
mean it is based on t-statistics
Table I.
Descriptive statistics on
the Italian IPO markets
Over-optimism
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357
essentially a market for projects in which young enterprises endowed with a few
tangible assets sold their business plans to the market. The proportion of newly issued
shares over total shares in issue following the offer (IPOMARKETEQUITY) is around
20 per cent for both markets. Therefore, new shareholders contribute to the firms
capitalization more than the share of capital they receive, in particular on the Nuovo
Mercato. With such figures, it can be inferred that IPOs on the Nuovo Mercato have
primarily been an opportunity to fund the companies and to found their capital.
Even though the capital gathered during the offer represents more than 80 per cent
of the post-IPO book equity value (IPOBOOKEQUITY), this capital contributes far less
(only 22 per cent) to the market value of equity (IPOMARKETEQUITY). The cause of
this misalignment could be associated to a high goodwill contribution demanded to
investors for the participation in the capital of high potential firms. In this view, the
offer is a necessary funding for the implementation of the entrepreneurial idea. The
analysis of the evolution of the market capitalization after the offer compared to the
market capitalization at the moment of the IPO provides insights on the reliability of
the projects financed by the stock market. Figure 1 graphs the trend of the market
capitalization with reference to the median values of the IPOs of the Nuovo Mercato.
This ratio evidences a decline starting from six months after the listing, until three
years after the IPO, when it approaches the post-IPO book value (expressed in
per cent over the offering capitalization). If the vertical distance between these two
is interpreted as the present net value of the firms projects, it follows that the real
profitability of the business projects turns out to be lower than the markets
expectations at the moment of the offering. The median market capitalization three
years after the issue is indeed not higher than the median book value at the IPO[2].
Furthermore, three years after the offer, the first quartile of the market capitalization is
Figure 1.
Calling to the earth
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not only lower than the median of the equity book value, but also lower than the
median of the capital underwritten. Therefore, at that time after the IPO, the
capitalization of at least a fourth of the firms listed on the Nuovo Mercato turns out to
be lower than the capital underwritten.
Even though the high levels of price-to-book values at the IPO for the Nuovo
Mercato are not completely unjustified due to the intrinsic nature of the typology of
firms listed, the subsequent evolution of financial trends sounds like a calling to the
Earth. Therefore, it seems appropriate to claim that the listings on the Nuovo Mercato
happened in a climate of over-optimism upon the future potential of the firms value
creation after entering the stock market. Subsequently, the market realized that firms
were not able to sustain the forecasted high growth rates and both valuations and
stock markets collapsed. It is not comforting to note that the number of failed
companies is low on the Nuovo Mercato (only two companies failed up to August 2004).
Indeed, three years after the IPO, the market value of the companies is often lower than
the capital underwritten at the IPO (24 firms out of 39). This evidence points to
over-optimism when pricing IPOs on the Nuovo Mercato and induces to investigate
whether the pre-IPO expectations were overconfident.
The difference between the proportion of equity capital coming from IPO investors
in terms of book (IPOBOOKEQUITY) and market values (IPOMARKETEQUITY) is a
direct consequence of the premium paid by the investor on the Nuovo Mercato. This
means that a large part of the IPO share prices relies on intangible assets and on
expectations of growth opportunities. In order to roughly estimate the extent of such
expectations, we apply a sort of reverse DCF process to IPO firms. We hypothesize
that the time horizon T identifies two time-regions where free cash flows have different
(but stable) growth rates. While the first period measures the fraction of the value of
the firm that is due to the extra-growth opportunities (i.e. free cash flow to the firm
(FCFF) growing each by an extra-growth rate, g
1
), during the second period future
expected cash flows grow forever at a stable rate ( g
2
).
Obviously, there are many firm-specific factors to consider when attempting to
forecast growth rates of the cash flows. However, this simple model allows to estimate
the short-run growth rates implied in the offer price of each IPO. In other words, we
start from the value of the firms to deduct the implicit assumption on growth rates:
EV P
OFFER
N
SHARES
NFP

X
T
t1
FCFF 1 g
1

t
1 WACC
t

X
1
tT1
FCFF 1 g
1

T
1 g
2

tT
1 WACC
t
FCFF
X
T
t1
1 g
1
1 WACC

t

1 g
1
1 WACC

T
X
1
t1
1 g
2
1 WACC

t
" #
2
where:
the enterprise value (EV) is the sum of the net financial position (NFP) prior to
the IPO and the capital raised from the company (offer price times number of
newly issued shares);
FCFF is the free cash flow to the firm for the year prior to the IPO;
g
1
(unknown factor) is the implicit short-run growth rate from the IPO through
period T;
Over-optimism
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359
g
2
is the long-run constant growth rate after year T (assumed equal to 2.5 per
cent, almost equal to the median value of the Italian annual GDP growth rate in
the last 20 years);
T is assumed equal to six years after reading the prospectuses; and
WACC is estimated using the capital asset pricing model with a real risk free
rate equal to 2.5 per cent, inflation rate 2 per cent, gross cost of debt 8 per cent,
tax rate 36 per cent, market premium 8 per cent and betas at 250 days estimated
for each company.
Figure 2 shows the estimation of short-run growth rates for the IPO on the Nuovo
Mercato, and compares the results to those for the companies that went public on the
Italian main board during the same period (1999-2001). We find that implicit growth
rates are higher for the firms going public on the Nuovo Mercato than for those on the
main board. Sixty per cent of MTAs IPOs are valued with a growth rate lower than 25
per cent and no IPO exceeds 75 per cent. On the contrary, growth rates of the majority
of the IPOs on the Nuovo Mercato are in the second quartile (25-59 per cent), and almost
20 per cent imply a short-run growth rate higher than 75 per cent.
The extent of such growth rates is certainly sensitive to the questionable hypothesis
assumed for the implementation of the DCF model; however, the results may be viewed as
a symptom of overconfidence on the Nuovo Mercato. To assess such over-optimism, in the
following section we compare ex-ante analysts expectations with ex-post actual figures.
5. Results
In this study, we use a sample of 64 pre-IPO analysts reports on the firms going public
on the Nuovo Mercato and test if their forecasts are upwardly biased. We find that
analysts do not err when forecasting sales for the fiscal year of the IPO. On the
contrary, they are over-optimistic referring to one and two years after the issue. Even if
IPO firms do grow faster in the post-issue than in the pre-issue (Figure 3), the growth is
Figure 2.
Growth rates implicit
in the IPO prices
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lower than expected. Post-issue CAGRs appear indeed to be positive (around 30
per cent), but statistically lower than expectations (around 50 per cent).
Further, we would expect that if forecasts are unbiased, then the expected
forecasting error should be statistically equal to zero. Nevertheless, the percentage of
cases with positive FE is more than half (Table II). As for Chanine (2004), we find that
the median FE is statistically positive for year +1 and +2, and that the latter (+2) is
higher than the former (+1). Hence, over-optimism grows in time. This may be related
to two distinct effects. First, forecasts are more difficult on longer horizons. Second,
the analysts reputation is less affected by a FE at a two-year horizon than for the end
of the first year following the IPO (Degeorge and Derrien, 2001).
We find that affiliated analysts forecasts perform slightly better than unaffiliated,
but the difference is not statistically significant. Affiliated analysts are therefore at
least as optimistic as unaffiliated, but affiliation does not have a clear impact on the
level of over-optimism. Affiliated analysts possibility to access to superior information
is not exploited in improved forecasts; neither a higher level of incentives to make
overly optimistic forecasts is found for affiliated analysts.
However, whichever sample (affiliated or unaffiliated) we use, analysts were over-
optimistic when valuing firms going public on the Nuovo Mercato. We conclude that
they did not fully accomplish to their role in reducing the information asymmetry
between the issuer and the public and in promoting market efficiency by providing
accurate valuations.
To identify the determinants of such over-optimism, we perform regressions using
the FE of post-issue sales as dependent variable. When identifying the explanatory
variables, we focused on variables that prior studies show have some predictive power
and checked for absence of correlation. The final model considers five independent
variables referring to the expected sales-growth rates (GROWTH(y)E), to the price
Figure 3.
Pre- and post-issue
operating performance
Over-optimism
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market momentum (MM6), to the Running Bubble Time from the first analysts
report (RBT), to the high-tech specificity of the industry measured in terms of
extra-return (HTSECTOR) and to the size of the firms (SIZE). Table III describes the
explanatory variables and provides a theoretical and bibliographical background.
The regression model is as follow:
FEy
i. j
c u GROWTHyE
i. j
MM6
i
` RBT
i

j HTSECTOR
i. j
SIZE
i. j

3
where y is the number of years after the IPO, i is the report for the firm and j the firm
itself.
Consistently with the literature (La Porta, 1996; Dechow and Sloan, 1997; Rajan and
Servaes, 1997), we find that firms receiving higher growth forecasts also have larger
forecast errors (Table IV). FE are indeed positively related to the level of forecasted
growth and the level of correlation increases in the second year after the IPO. Moreover,
GROWTH( y)E is the variable with the highest partial explanatory power. Thus, we
deduce that the upward bias in analysts forecasts appears to be driven primarily by
the high growth forecasts.
Errors are related to the market momentum (MM6, measured as the performance of
the Datastream European Telecom, Media and IT index during the six months before
the release of the report). This variable gives account of the level of the bubble in
Europe. We argue that analysts valuations are affected by market sentiment.
Table II.
Actual vs expected: FE
All reports Affiliated
Post-issue sales: median values, CAGR and FE
Year relative to the IPO 0 +1 +2 0 +1 +2
Actual sales (mE) 37.21 43.40 50.57 39.82 52.04 55.85
Expected sales (mE) 37.84 63.32 80.14 37.20 58.88 81.94
z-stat (MannWhitney) 0.062 1.267 2.189* 0.231 0.802 1.824**
CAGR actual (%) 38.78 27.16 29.30 36.16 28.57 29.30
CAGR expected (%) 38.39 62.23 54.11 42.00 57.88 52.75
z-stat (MannWhitney) 0.056 2.185** 2.439** 0.516 1.694** 2.002*
FE (%) 4.39 24.36 50.30 2.55 27.51 46.05
z-stat (MannWhitney) 1.571 2.514* 3.283** 1.096 1.973* 2.523*
No of positive FE (%) 63.2 71.1 78.1 60.9 69.6 76.2
Affiliation effect (MannWhitney) 0.335 0.157 0.655
No of observations 38 38 32 23 23 21
Notes: The table reports the median values of post-issue sales as reported by the financial
statements (actual) and as estimated by analysts (expected). The average of the forecasts issued
by the analysts following the firm was taken for every firm and for every forecast period. The
all reports column refers to the sample of 64 reports, while the affiliated column considers only
reports by affiliated analysts. FE stands for the analysts forecast error, measured as the
difference between expected sales and actual sales, scaled by actual sales. The affiliation effect is
estimated through a MannWhitney test on the difference between affiliated and unaffiliated
analysts forecast errors. The z-statistic refers to the non-parametric Wilcoxon signed rank test
(MannWhitney) of difference in medians. *Significance at the 5 per cent level; **Significance at
the 10 per cent level; ***Significance at the 1 per cent level
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Table III.
Description of the
predictive variables
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Over-optimism
when pricing
IPOs
363
From a different perspective, Jegadeesh et al. (2004) suggest that analysts create their
own price momentum by virtue of their stature as opinion makers. As we find that the
over-optimism increased during the bubble (RBTs coefficients are significantly
positive), we hypothesize that there was a sort of contagion effect among analysts, with
forecast errors increasing in time from the first report on a firm going public on the
Nuovo Mercato.
No industry requirements are requested for going public on the Nuovo Mercato.
Hence, part of the samples firms is listed on the Nuovo Mercato because of their
innovative approach to products, processes and distribution in traditional sectors.
HTSECTOR takes into account this specificity. We find that sectors extra-returns have
an upward effect on forecast errors. We argue that analysts valuations may be affected
by the high-tech specificity of an industry as far as high-tech industries have a higher
degree of uncertainty and information asymmetry. This interpretation is suggested by
Loughran and Ritters (1995) findings that IPOs bunch because particular industries
tend to be over-valued at specific times[3].
Finally, our model includes a control for firm size (SIZE). We find that it is
negatively related to forecasts errors in the first year after the IPO. Over-optimism
is therefore higher for smaller companies. This evidence may be due to an
underestimation of the difficulties that these firms meet in their growth. On the other
hand, it may be argued that information asymmetries are lower for bigger firms,
leading to easier estimations (and lower forecast errors) for these firms.
6. Conclusions
The Italian Nuovo Mercato was launched in mid-1999 and two years later 40 firms
were listed on it. Afterwards, no other company decided to go public on this market.
Table IV.
Regression analysis on
the forecasting errors
FE(1) FE(2)
Coeff. Part R
2
(%) Coeff. Part R
2
(%)
OLS regression model
Intercept 0.701 0.88 1.388 2.82
GROWTH( y)E 0.171* 13.75 0.835* 49.75
MM6 5.731* 15.00 7.85* 21.84
RBT 1.347** 5.22 2.579*** 13.25
HTSECTOR 8.813* 18.15 8.596* 14.64
SIZE 0.854* 14.24 0.242 1.15
F-value 6.64* 11.01*
Adj. R
2
(%) 38.07 55.02
Mean (FE(y)) 1.12 1.77
Var (FE(y)) 4.97 6.10
No of observations 60 51
Notes: FE(y)
i, j
=c u [GROWTH(y)E
i, j
] [MM6
i
]+` [RBT
i
]j [HTSECTOR
i, j
] [SIZE
i,j
].
In the by-firm sample the average of the forecasts issued by the analysts following the firm was
taken for every firm and every forecast period. Observations are identified as outliers when their
distance D
i
is higher or equal to 4: D
i
(x
i
x)/o
x
4, where x and o
x
are, respectively, the mean
and the standard deviation of FE. One company (Freedomland) was identified as outlier and deleted.
*Significance at the 1 per cent level using a two-tailed t-test; **Significance at the 10 per cent
level using a two-tailed t-test; ***Significance at the 5 per cent level using a two-tailed t-test
MF
33,6
364
This picture calls to mind the windows of opportunity hypothesis that interprets
cycles in IPO volume as a possible signal of issuers taking advantage of an
overconfident market. This paper addresses the overconfidence issue by analyzing
the analysts forecasts.
The Nuovo Mercato is a market for small and young companies endowed with a
few tangible assets. Since much of their value is constituted by growth opportunities,
firms going public on the Nuovo Mercato were priced on the base of high growth
expectations. As a consequence, even though these firms went public with few tangible
assets, their initial market valuations were considerable. It seems that the Nuovo
Mercato is looked upon as a market for projects, where entrepreneurs sell ambitious
business plans to the public, and IPO firms are almost entirely financed by the market
on the basis of expectations of future growth. To our mind, the extent of such prospects
(almost twice those on the traditional main board) may be viewed as a warning sign of
over-valuation. We recognize, however, that it is (at least partly) traceable to the high-
tech nature of the firms targeted by the Nuovo Mercato. Nevertheless, firms were not
able to sustain in the aftermarket the pre-IPO extraordinary expectations. Analysts
estimations were indeed over-optimistic and systematically upwardly biased with
respect to actual (ex-post) performances. Furthermore, analysts affiliation (and the
consequent access to better information) did not lead to minor forecast errors. As a
result, since the market realized after the IPO that the expectations were dismissed, the
stock prices fell. Three years after the IPO the market capitalization was often lower
than the capital raised by the companies at the IPO.
We expect this research to be of interest for both financial academics and
practitioners. From an academic perspective, this study addresses the issue of
over-optimism and provides empirical evidence of it. This paper also contributes to
the literature on the rise and fall of the new European stock markets, which are
largely under-research markets. From the perspective of investors, this study aims
to contribute to the understanding of the helpfulness and limits of the analysts
forecasts in investment decisions and, more generally, of the determinants of
over-optimism.
Post-issue decline in stock prices and over-optimism in analysts forecast insist on
the need to make explicit the valuation metrics used for valuing firms going public.
This remark is particularly urgent in markets targeting high growth companies. The
difficulties implicit in valuing high-tech firms with no history, no comparables and no
earnings leave indeed a great responsibility to investment bankers and to the other
architects of the IPOs. However, if the number of firms going public on a market each
year is small, or if the financial analysts industry is not well-developed, reputation-
based incentives[4] for these architects may be imperfect. Incentive to build a
reputation in valuing IPOs apply as far as underwriters deal repeatedly in the IPO
market, otherwise they might not be sufficient to reduce the information asymmetry
between the firm going public and the investors. To this extent, it could be helpful for
stock markets to clearly distinguish between financing the growth of companies and
financing promising business plans.
Notes
1. We focus on sales since earnings are not always forecasted by analysts for Nuovo
Mercatos firms and since actual EBITs are negative in the post-issue for the majority of
the firms (giving little significance to EBITs FE).
Over-optimism
when pricing
IPOs
365
2. The median book to market ratio at the IPO (28.05 per cent) is not significantly different
from the median ratio between the market value three years after the IPO and the
listing capitalization (29.52 per cent). Indeed, using a Wilcoxon matched-pairs signed-
ranks test, we cannot reject the null hypothesis of equality in medians (the p-value
is 0.124).
3. We test the regression model also on the sample of affiliated reports and found similar
results, but with lower explanatory power. For this sub-sample, MM6 and HTSECTOR
appear not to be statistically significant. It may be argued that since affiliated analysts
access to superior information than unaffiliated, their valuations are less biased by the
influence of the industry and of the market momentum.
4. We believe that if the firm is undervalued, its existing shareholders do not appreciate
to leave money on the table; if the firm is over-valued, the investors will be
displeased and cautious in subscribing to future IPOs underwritten by the same
investment banks.
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