The Effects of Share Prices Relative to 'Fundamental'' Value on Stock Issuances and Repurchases

The Effects of Share Prices Relative to ‘Fundamental’ Value on Stock Issuances and
Repurchases
William M. Gentry
Graduate School of Business, Columbia University
and NBER
Christopher J. Mayer
The Wharton School, University of Pennsylvania
April 9, 2003
We thank John Core, Joe Gyourko, Charles Jones, Todd Sinai, and seminar participants at the
ASSA Meetings, Columbia Business School, and Wharton for helpful comments. We are
especially grateful to Jon Fosheim and Green Street Advisors for providing crucial data and to
Dou-Yan Yang for excellent research assistance. The Paul Milstein Center for Real Estate at
Columbia Business School and the Zell-Lurie Real Estate Center at the Wharton School
provided financial support.
William M. Gentry; Graduate School of Business, Columbia University, 602 Uris Hall, 3022
Broadway, New York, NY 10027; (212) 854-5092, (212) 316-9219 (fax); wmg6@columbia.edu.
Christopher J. Mayer, The Wharton School, University of Pennsylvania, 314 Lauder-Fischer
Hall, 256 South 37th Street, Philadelphia, PA 19104; (215) 573-5009, (215) 573-2220 (fax);
mayerc@wharton.upenn.edu.

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The Effects of Share Prices Relative to ‘Fundamental’ Value on Stock Issuances and
Repurchases
William M. Gentry
Graduate School of Business, Columbia University
and NBER
Christopher J. Mayer
The Wharton School, University of Pennsylvania
April 9, 2003
Abstract
Recent papers have shown that managers time their equity offerings based on the value of
share prices relative to the book value of the firm or recent share price changes. We utilize
special attributes of real estate investment trusts (REITs) to show that deviations in the relative
value of share prices impact managers’ decisions to issue equity and repurchase shares. First, we
show that the ratio of price to net asset value (NAV) strongly predicts whether managers issue or
repurchase shares. This relationship is non-linear. Managers rarely issue equity when price-to-
NAV is below one and rarely repurchase shares when price-to-NAV exceeds unity. Second, we
demonstrate that available information is an important factor in determining the stock market
response to changes in outstanding shares. Stock prices respond more strongly to
announcements of share issuances and repurchases when NAV is unavailable. For REITs with
NAV estimates, the announcement effect depends on the price-to-NAV ratio. When price-to-
NAV equals one, we cannot reject that the announcement effect equals zero for both repurchases
and offerings. Taken together, our results suggest that investors are aware of managers’ attempts
to time the equity market and respond accordingly.

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I.
Introduction
Equity prices are tied to active changes in a firm’s shares outstanding. For example, a
firm’s stock price usually falls when it issues new (seasoned) equity, while its share price rises
when the firm announces a plan to repurchase its shares.1 A typical new equity offering can
result in a decline in the value of existing shares of as much as 30 percent of the value of the
stock raised in a seasoned equity offering (Asquith and Mullins, 1986).2 Most research attributes
these findings to the fact that shareholders realize that managers have superior information about
the firm’s current value and future prospects and penalize a firm that adjusts its capital structure
in ways that may take advantage of future buyers (or sellers) of their securities (Myers and
Majluf, 1984).
Below, we examine the factors that drive firms to adjust their shares outstanding and how
investors respond to these capital structure adjustments. In doing so, we take advantage of a
special type of firm, real estate investment trusts (REITs), which have characteristics that allow
us to expand upon the results from previous research. Analysts typically evaluate REITs by
appraising their properties, which provides a more accurate estimate of a REIT’s net asset value
(NAV) than is available for industrial firms, where researchers have typically used the book
value of assets to proxy for the extent to which a firm is over- or under-valued.3 One such set of
appraisal-based NAV estimates, from Green Street Advisors (the best known REIT analyst),
provides the key variable for our empirical analysis.
1For evidence on seasoned equity issuances, see Asquith and Mullins (1986), Masulis and Korwar (1986),
Mikkelson and Partch (1986),
2 For example, if announcing an offering that is 10 percent of shares outstanding results in a 3 percent
decline in the stock price, then the announcement effect is roughly 30 percent of the proceeds of the
equity raised.
3 One paper that uses appraisals--Aboody, Barth, and Kasznik 1999–shows that revaluations of fixed
assets can help predict future firm performance in UK companies.

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In addition to access to high-quality estimates of the market value of the assets inside the
firm, REITs are a useful vehicle to study equity issuance and repurchase decisions for three other
reasons. First, special tax rules for REITs reduce the role of taxes in explaining capital structure
choice. REITs receive a deduction for dividends paid, which mostly eliminates the tax
arguments for taking on debt instead of equity and the incentive to repurchase shares instead of
paying dividends.4 Second, as part of the special tax rules, REITs must pay out the bulk of their
taxable income as dividends. Thus, REITs must distribute more than one-half of their cash flow,
giving them less discretion to fund new investment with retained cash. In addition, they must
go to the capital markets to finance new investment of any significant scale, so all REITs can be
considered “equity dependent firms.” Thus, REIT equity issuances arguably face a smaller
asymmetric information problem than equity issuances of industrial firms that have more
discretion to raise capital with internally-generated cash flow because potential investors
understand that REITs may often need to issue equity. Third, most REITs tend to have relatively
low debt levels and stable cash flows, so bankruptcy seems less likely than for other public
companies.
We are interested in two questions. First, do estimates of the under- or overvaluation of a
firm’s shares (relative to the value of its assets) affect managerial decisions about when to
repurchase shares or issue equity? Second, conditional on observing share repurchases or equity
offerings, are these estimates of under- or overvaluation relevant for how the market responds to
the “news” embodied in the announcement?
4 Once a REIT has distributed all of its income as dividends, additional distributions will be characterized
as a return of capital, which does not face dividend taxation but does lower the shareholder’s tax basis.
By lowering the tax basis, the return of capital is taxed as a capital gain, which is normally the tax-
motivation for repurchasing shares rather than paying dividends.
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For the first question, we estimate whether the ratio of price-to-NAV predicts repurchase
and equity offering decisions.5 For repurchases, our estimates imply that a REIT with a price-to-
NAV ratio of 0.9 has a roughly 19 to 22 percent chance of announcing a repurchase plan in the
year, compared to a 14 percent chance of announcing a repurchase if the price-to-NAV stays at
1.0. This effect is non-linear, so that repurchase plans are rarely announced or executed at times
when price-to-NAV exceeds unity, but the likelihood of announcing rises rapidly when price-to-
NAV falls below unity. For equity issuances, we find that a high price-to-NAV ratio predicts
that a REIT is more likely to issue new shares. As with repurchases, this effect is non-linear
with the effect of the price-to-NAV ratio much stronger when the ratio is above one. Essentially,
when the price-to-NAV ratio is below one, REITs rarely issue new shares. These results are
consistent with managers attempting to time the equity market in making decisions about share
repurchases and equity issuances.
Given the apparent attempts by managers to time their equity issuances and repurchases,
we are interested in whether the stock market reaction to firms’ activities in the equity market
are related to perceived under- or overvaluation of the shares. How does analyst information
affect the market reaction to announcements? The estimates of under- or overvaluation from
Green Street are only contemporaneously available to some investors. Therefore, these
estimates are not broadly known by market participants; however, the trades of the informed
investors or further research around announcements could impact share prices.
5 In addition, as we discuss below, firms covered by Green Street are more likely to both repurchase
shares and issue shares than are firms that are not covered by Green Street, which suggests that either
Green Street’s coverage decision is non-random or that analyst coverage makes it easier to undertake
these activities.
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For this question, we exploit two types of variation. First, we examine whether news of
an announcement has a different effect on firms that are not covered by Green Street than on
firms that are covered by Green Street. We finding striking evidence that the non-covered firms
have much more pronounced stock market reactions to announcements than do the covered
firms. For example, we find that REITs that are not covered by Green Street who issue seasoned
equity have abnormal returns of about -0.60 percent over a three-day event window compared to
only -0.33 percent for the covered firms.6 For repurchases, this pattern is even more pronounced
in absolute value for repurchase announcements, with share prices of covered firms rising only
one-sixth as much (0.7 percent) as the stock prices of non-covered firms (4.3 percent) over the
same 3-day event window. This evidence suggests that analyst coverage might drastically
reduce the asymmetric information problem, resulting in smaller (absolute) changes in share
prices associated with active changes in equity outstanding, possibly leading to a greater
likelihood of managers making active adjustments to the amount of equity.
Second, we explore whether the announcement effects are related to analysts’ perceptions
for REITs that are covered by Green Street. When we interact the price-to-NAV ratio with the
three-day event window, we find that share prices increase less for repurchase announcements by
firms with relatively high price-to-NAV ratios and fall less when firms with relatively low price-
to-NAV ratios announce a seasoned equity offering. In fact, the estimates show that most of the
announcement effect is due to the fact that they typical REIT that issues seasoned equity has a
price-to-NAV ratio above one, while REITs that repurchase shares have a price-to-NAV ratio
6 Even the non-covered REITs have a smaller response than the negative excess returns associated with
seasoned equity offerings for the utilities in Asquith and Mullins’ (1986) study, which is consistent with
REITs having less severe asymmetric information problems than other firms.
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below one. For REITs with a price-to-NAV equal to one, we cannot reject that there is a zero
announcement effect both for announcements of repurchases and seasoned equity offerings.
Together, these facts suggest that the market uses information about the relative value of the firm
in determining its response to changes in capital structure. REITs that announce repurchases
when the relative valuation of their shares is low get very big benefits, while REITs that issue
equity when the relative valuation of their shares is high incur a greater price penalty. Thus,
announcements effects appear strongest when the manager’s “signal” is consistent with the
analysts’ perception.
Section II briefly summarizes the literature, while Section III provides a background on
REITs. Section IV describes the data, including the NAV estimates from Green Street Advisors.
Section V examines the propensity of firms to repurchase or issue new shares. Section VI
considers the stock market reaction to the announcement of a seasoned equity offering or a
repurchase plan. Section VII concludes with brief comments on future research directions.
II. Previous Literature
Given the negative excess returns associated with new equity issuances, researchers have
examined the factors that drive firms to issue seasoned equity. For example, a firm is much
more likely to issue equity after a pronounced run-up in the price of its shares or when its book-
to-market value is high (Taggert, 1977, Marsh, 1979, Asquith and Mullins, 1986, Korajczyk,
Lucas, and MacDonald, 1991, Jung, Kim, and Stulz, 1994, and Hovakimian, Opler, and Titman,
2001). At the aggregate market level, firms are more likely to issue shares relative to debt prior
to periods of low market returns (Baker and Wurgler, 2000). Managers respond in surveys that
they issue shares based on the relative value of their shares (Graham and Harvey, 2001).
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Moreover, the negative impact of a new equity issuance on share prices is not limited to the
period around the announcement date. Subsequent to issuing seasoned equity, firms also earn
lower returns than their peers (Spiess and Affleck-Graves, 1995 and Loughran and Ritter, 1995).
Conversely, when companies want to return capital to shareholders in the form of share
repurchases, shareholders appear to view this as a positive signal.7 Conditional on announcing a
repurchase plan, a company’s share prices tend to rise immediately, but also exhibit excess
returns on a longer-term basis, as well (Ikenberry, Lakonishok, and Vermaelen, 1995). Firms
may also repurchase shares in an attempt to manage earnings per share (Bens, et. al., 2002).
An implication of this research is that managers take advantage of their superior
knowledge of both the firm’s and the market’s prospects to adjust capital structure in ways that
benefit current shareholders and that the market is sometimes slow to respond. Nonetheless,
other alternative explanations for this evidence have been raised, including differences in risk
(Eckbo, Masulis, and Norli, 2000), the desire to re-optimize overall capital structure, and tax
avoidance.
An alternative approach to examining managers’ intentions is to directly examine the role
of information in the negative announcement effect for seasoned equity offerings by comparing
differences in announcement returns across various types of firms or over time. For example,
Asquith and Mullins (1986) show that the negative returns associated with announcing new
equity offerings are much smaller for utility companies compared to industrial firms, possibly
due to greater predictability of new capital needs or the relative homogeneity of utility
7 The literature has also examined differences in the choice between repurchases and dividends. The
findings suggest that managers will typically choose dividends to distribute “permanent”increases in cash
flows, while they use repurchases to distribute cash flow that is more transient in nature (Jagannathan,
Stephens, and Weisbach 2000 and Guay and Harford 2000).
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companies. Korajczyk, Lucas, and MacDonald (1991) find that the price drop at the
announcement of an equity offering is smaller if the announcement is closer to an information
release (such as an earnings report), when the authors argue that asymmetric information should
be less of a problem. Finally, Bayless and Chaplinsky (1996) show that the price reaction to the
announcement of an equity issuance is smaller during “HOT” periods when many other firms are
issuing equity relative to “COLD” periods when fewer firms are issuing new equity, which they
interpret as evidence that firms are more likely to use equity finance at times when asymmetric
information is less of a problem.
III. Background on REITs
With certain key tax-related exceptions, REITs are similar to other corporations. Like
other corporations, REITs often initiate operations by raising capital from external markets and
investing the capital in operating assets. To qualify as a REIT, among other things, a firm must
meet certain asset and income tests that set minimum levels of real estate activity to prevent
REITs from using their tax-advantaged status to move into other business areas. REITs must
earn at least 75 percent of their income from real estate related investments and 95 percent of
their income from these sources as well as dividends, interest and gains from securities sales. In
addition, at least 75 percent of their assets must be invested in real estate, mortgages, REIT
shares, government securities, or cash. While older REITs were often passive investors, several
changes in tax rules in the late 1980s allowed REITs to actively manage their assets during the
1990s. Although some REITs invest in real estate mortgages, we restrict our focus to equity
REITs, which primarily invest in rental properties.
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In addition to the asset and income tests, tax law requires REITs to pay out a minimum
percentage of their taxable income as dividends each year. For most of our sample period, this
percentage was 95 percent; however, tax changes in 2000 reduced the minimum percentage to 90
percent. This distribution requirement is based on taxable income rather than financial reporting
income. Despite this requirement, REITs have some discretionary cash flow because operating
cash flow typically exceeds taxable income, especially since depreciation allowances reduce
taxable income but not cash flow. In general, however, the distribution requirement limits
REITs’ ability to finance investment with internally generated funds, so they uniformly rely
more heavily on secondary equity issues than do regular corporations.
The benefit of qualifying as a REIT is avoiding the double taxation of equity-financed
investment. Unlike regular corporations, REITs receive an annual tax deduction for dividends
paid out to shareholders. REITs often distribute all of their taxable income to shareholders each
year, which eliminates the corporate tax altogether.
IV. Data Description
Our sample period begins in 1994 , the first year for which we can obtain announcement
data on repurchases and seasoned equity offerings from SDC, and ends in 2001. The number of
equity REITs shrunk modestly from 175 in 1994 to 151 in 2001, but the average size of a REIT
grew several fold, with the industry equity market capitalization growing from $39 billion in
1994 to $147 billion in 2001, resulting in a strong gain in liquidity and trading volume.8
8 Industry statistics are from the National Association of Real Estate Investment Trusts’ website at
www.nareit.org.
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