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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 firmstech and nontechthat 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 firmsaccounting for 3.8 percent of all publicly traded firmswere 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.