Stock Prices and IPO Waves (.pdf)

Capital Ideas is now Chicago Booth Review but unfortunately original articles are no longer available. If you click through you will be taken to the Internet Archive site to find an archived copy.

Pastor and Veronsi explain IPO waves by creating a model of “optimal IPO timing.” Their model predicts that firms will be more willing to issue shares when the required returns are lower, when the firm’s expected cash flows are higher (which could be interpreted at there being more positive investment opportunities-and therefore likely a greater need for cash), and “when the uncertainty surrounding those [cash] flows is high.” What sets this paper aside from others of the same genre is this not only models the IPO timing, but it also empirically tests the model. And guess what? It passes! Using data from 1960-2002, the model is supported. What really makes the paper valuable however is that the model can be used to explain some of the troubling findings that have been pointed out by others in the field. For example, the finding that market-to-book values for IPO firms drop over time has been suggested to show that investors are irrational in the pricing of IPOs. However, P&V’s model accurately predicts this decline and explain it not as irrationality but rather that it is due to less uncertainty (options lose value) and mean reversion. (highly recommended article!) [ Annotation]

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