Why Follow-Ons Are a Red Flag
News of a follow-on equity offering is almost never received well by shareholders, and stocks typically fall on the day of the announcement. But studies also show that the negative effects of a secondary offering can actually last for years.
Companies issuing additional shares have historically underperformed nonissuing companies by 3.4% in the five years following the offering, according to Jay Ritter, professor of finance at the University of Florida.
That's potentially bad news for Activision (ATVI) -- which sold new shares Wednesday -- and for the 267 other U.S. companies that have conducted follow-on offerings so far this year.
Although the rationale behind a stock sale varies depending on the firm, in almost all cases companies issue more shares because they are unable to generate the necessary cash from current operations to fund or grow their business.Ritter notes that stocks fall 3% on average on the day a follow-on announcement is made because investors realize that additional stock can dilute existing ownership and earnings. Secondary offerings often go hand in hand with insider selling, which can also indicate that the company is in trouble, he said. In addition, equity issuance is interpreted by some investors as a sign that shares are overvalued. Companies that conduct a follow-on, or seasoned equity offering, as it is also known, typically do so when valuations are rich. Activision, for example, has surged almost 48% over the past year while Accenture (ACN), which sold an additional $1.8 billion worth of stock last month in one of the largest follow-on offerings so far this year, is up almost 30% from its initial public offering last year. Ritter said stocks typically show an average return of 72% in the year prior to the offering. Tim Loughran, associate professor of finance at the University of Notre Dame, who co-authored a study on this subject with Ritter, also noted that profit margins are usually "very good" before a stock sale.
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