This paper looks at the negative relation between external financing activities and future stock returns.
We show that financial-statement information about corporate financing activities (e.g., equity issuance, equity repurchase or debt issuance) often telegraphs news of future stock returns.
We also show that external correlates both with negative future earnings performance and with overly optimistic analysts’ forecasts. In addition, analyst overoptimism is related to the type of security being issued.
We find that debt sales tend to precede overly optimistic short-term earnings forecasts, while equity sales tend to precede overly optimistic long-term earnings forecasts, stock price targets and recommendations. This evidence indicates that analysts play a central role in the overpricing of security issuances.
We provide evidence that external financing is negatively related to future earnings performance, though the reason for this is not clear.
One potential explanation is that managers could opportunistically raise new capital when they realize that profitability is about to deteriorate. This explanation is most consistent with the views expressed in the finance literature.
Another potential option is that managers could invest the proceeds from their external financing activities less profitably. This explanation is consistent with the anecdotes concerning investor and manager hubris during ‘hot issue’ markets.
A third potential option: managers could simply inflate corporate earnings when they are raising funds.