Simultaneous Signaling in IPOs via Management Earnings Forecasts and Retained Ownership: An Empirical Analysis of the Substitution Effect

Abstract

This study empirically tests the substitution effect outlined in theoretical bivariate signaling models using a Canadian IPO setting. We first show that retained ownership and the provision of management earnings forecasts are credible (value-relevant) signals for our sample of IPOs, and that they jointly affect IPO valuation. We then use simultaneous equations to investigate what factors affect managers' choices of these two signals and whether the two signals act as complements or substitutes. Our analysis indicates that managers' choices of the earnings forecast and retained ownership signals are jointly determined after controlling for other factors that affect each decision independently, and that a substitution effect exists between managers' choices of the two signals. These findings are consistent with Hughes's (1986) bivariate signaling model.

Management earnings forecasts and IPO performance: evidence of a regime change

“…For instance, Hughes (1986) and Guo (2005) highlight the importance of the information asymmetry between investors and the issuer of an IPO. 7 Li and McConomy (2004) show that retained ownership and management earnings forecasts are credible, value-relevant signals. However, in contrast to the Greek IPO market, forecasts in Canada never became compulsory.…”

“…Prior literature documents a mandatory disclosure environment for earnings forecasts in Singapore, Malaysia, and New Zealand, and a voluntary one in other Commonwealth countries (Firth and Smith 1992;Firth et al 1995;Hartnett and Romcke 2000;Chen et al 2001;Li and McConomy 2004;Jelic 2011). The results on earnings forecasts reveal low levels of error in countries with voluntary disclosure (Australia: 34.49 %, Hong Kong: 12.79 %, UK: 11 %) compared with countries with mandatory earnings forecasts (Malaysia: 54.1 % and New Zealand: 111 %).…”

“…The literature indicates that a high (low) percentage of retained (given) ownership signals high firm quality (e.g., Li and McConomy 2004). 14 Managements of such IPO firms believe in the strength and potential of their companies and have strong motivation to provide accurate earnings forecasts.…”

“…Basic questions that this paper addresses include: Does a flexible disclosure status brought about by regulatory change (mandatory to voluntary) contribute to increased forecast accuracy? Can earnings forecasts provided in IPO prospectuses constitute an 1 International evidence covering management earnings forecasts around IPOs includes Lee et al (1993) and Hartnett and Romcke (2000) for Australia; Li and McConomy (2004) for Canada; Chen and Firth (1999), Firth et al (2008), Tan et al (2015) for China; Cormier and Martinez (2006) for France; Gounopoulos et al (2015) for Greece; Jaggi (1997), Cheng and Firth (2000), and Chen et al (2001) for Hong Kong; Jelic et al (2001) for Malaysia; Firth and Smith (1992) for New Zealand; Firth et al (1995) for Singapore; Jaggi (2006) for Taiwan; Firth and Lonkani (2005) for Thailand; Jelic (2011) for the UK; and Drobetz et al (2015) for the maritime industry. important determinant of future market performance?…”

Better Together? Signaling Interactions in New Venture Pursuit of Initial External Capital

“…Firms can send simultaneous signals (Li & McConomy, 2004) that work together with third party affiliation to improve the firms' likelihood of being selected by external investors.…”