IPO valuation and insider manipulation of R&D

Abstract

Purpose

The purpose of this paper is to examine the effects of R&D manipulation on stock valuation for periods around IPOs. Insider manipulation is the difference in actual R&D change minus predicted R&D change where a negative difference indicates R&D underinvestment.

Design/methodology/approach

This study is designed to build on prior IPO research that has found reduced R&D expenditures when insiders lower their ownership. The paper derives an R&D manipulation variable that measures underinvestment in R&D. This variable is used in a regression methodology to test its influence on: IPO stock valuation at various points in time and post‐IPO price changes relative to the offer price.

Findings

The paper discovers that greater underinvestment in R&D is associated with greater values during the IPO stock valuation process. This association is reversed when the paper looks at short‐term valuation based on market prices. Only for bubble period IPOs do the paper finds poorer valuations for the long‐term. Larger insider ownership decreases lead to poorer valuations regardless of the period of occurrence. Greater R&D underinvestment and insider ownership decreases both lead to less underpricing.

Research limitations/implications

Like prior research, the paper assumes that knowledge about the change in R&D is known at the time of the offering. Interpretations for long‐run results can be tenuous due to unexpected changes that occur over time.

Practical implications

Investors should note that managers are able to set higher offer prices when they inflate earnings by underinvesting in R&D. Buying at an inflated offer price with R&D manipulation leads to losses in the aftermarket with these losses associated with IPOs that occur during a bubble period.

Social implications

Misrepresentation during the IPO valuation process affects those who buy shares at inflated prices. This raises ethical questions about the behavior of those involved in the issuance process.

Originality/value

This study is unique in testing how R&D manipulation and changes in insider ownership proportions impact the: IPO valuation process, post‐IPO valuation, and changes in the stock price over time relative to the offer price.

Citation

Hull, R., Walker, R. and Kwak, S. (2013), "IPO valuation and insider manipulation of R&D", Managerial Finance, Vol. 39 No. 10, pp. 888-914. https://doi.org/10.1108/MF-05-2012-0125