Quantity, Quantity, Quantity

Based on research Alexander Butler, Gustavo Grullon, James P. Weston and Jess Cornaggia

• Most companies tend to underperform after they raise capital.
• Some scholars argue that the composition of equity compared to debt determines whether stock prices fall after an infusion of capital.
• But recent research shows that net financing matters more than the composition of financing.

You could call it the opposite of dieting: When corporations get a hearty helping of funding, their stock prices often drop. But until three professors at the business school compared the roles of net financing and financing composition, scholars were unclear on why. What the Rice researchers found could influence managers' choices in how to fund their firms.

Companies usually raise money in two ways. In equity financing, an investor writes a check in exchange for a certain amount of control and input on major decisions. The investor gets part ownership of the company and a portion of profits. Alternatively, companies can simply take out a loan.

While a loan doesn't require ceding control to investors, it's not without risk. Too much debt stifles growth. It can also spook potential investors, who may find a firm too risky, leading to cash flow problems. As a result, most companies prefer to split the difference, taking on a mix of financing that includes both debt and equity.

Until recently, some scholars have argued that it’s the particular mixture of these two funding sources that determines if stock prices fall after a capital infusion. Then Alexander W. Butler, Gustavo Grullon and James P. Weston, professors at the business school, along with their colleague Jess Cornaggia, now at Georgetown University, examined the role of financing composition on a company’s future performance. Their discovery: The quantity — not the qualities — of a financing plan matters most in future stock returns.

Before Butler, Grullon, Weston and Cornaggia's study, scholars explained the stock price phenomenon in two different ways. One idea, called market timing theory, proposes that managers issue securities as a way to exploit overpricing. Market timing theory suggests that when managers think equity is overvalued, they issue more equity and borrow less. Naturally, according to this belief, lower stock prices follow, since managers issued the securities at a time when stocks were overpriced.

An alternative theory argues that market prices respond efficiently to the risks involved in raising external capital. Returns are low after a security issuance because managers are converting growth options into real assets or responding to changes in the cost of capital.

Looking at data from companies over a 38 year period, Butler, Grullon, Weston and Cornaggia came to a very different conclusion. Ample evidence shows that when considered separately, both the composition and the level of net financing can affect capital flows. For example, some studies do find that firms tend to underperform after raising equity capital. When the sources of capital were mixed together, though, investment composition did not matter as much as investment levels in determining future stock prices.

If managers can successfully time the market through their financing decisions, then their choice of debt or equity should predict future stock returns. Since firms that raise a large amount of capital can be expected to underperform for a variety of reasons, underperforming after an infusion of external capital is not necessarily evidence of poor market timing. The more telling test: whether the composition of capital, raised or distributed, affects future returns. The Rice team found that it does not.

Although firms tend to raise capital when stock market prices are high and seem to reflect better investment opportunities, the research suggests managers shouldn't try to toggle between debt and equity in an effort to strengthen future returns. Ultimately, it's calories in that makes the difference: regardless of composition, the quantity of money raised is the key in a company’s performance.

Alexander W. Butler a professor of finance

Gustavo Grullon is a Jesse H. Jones Professor of Finance

James P. Weston is the Harmon Whittington Professor of Finance at the Jones Graduate School of Business at Rice University

To learn more, please see: Butler, A. W., Cornaggia, J., Grullon, G., & Weston, J. P. (2011). Corporate financing decisions, managerial market timing and real investment. Journal of Financial Economics, 101(3), 666–683.