What Might Explain Why the Market Would React Negatively to the Issuance of Common Stock by a Firm?

by Slav Fedorov

The issuance of new common stock by a company is called a secondary offering. The market often reacts negatively to a secondary, sending the stock price down. A negative reaction can be caused by several factors.

Dilution

Many investors value stocks on the basis of the price-to-earnings (P/E) ratio. A P/E is the current stock price divided by current earnings per share (EPS). The lower a P/E, the cheaper a stock is considered to be. EPS are a company's net earnings divided by the total number of shares outstanding. When a company issues more shares, its earnings per share drop because the same amount of net earnings must be divided by more shares outstanding. Lower EPS translate into a higher P/E. Investors feel that their shares have become more expensive or are worth less. Some may sell them, others may decide against buying an instantly more expensive stock. Selling or even just lack of buying may send a stock price down.

Topping Stock Price

Companies want to raise as much money as possible at the lowest cost. The higher a stock price, the fewer shares a company needs to sell to raise the same amount. Investors reason that a company would do a secondary when it believes its stock is as high as it can get, and start taking profits, sending the stock price down.

Manipulation

Instead of waiting for a stock price to go up to do a secondary, a company might "put up" the stock price by skillful manipulation. At other times, a company may delay the release of negative news that could depress the stock price until after a secondary is done. Once a secondary is done, the stock price collapses.

Secondary Pricing

Companies usually place secondaries with large institutional investors to make sure the entire issue is sold. Retail investors might not be offered any shares. If a secondary is priced significantly below the current stock price, the retail shareholders who bought shares at higher prices prior to the secondary feel betrayed by the company management and may sell their shares in disgust, swearing never to return.

Secondary Purpose

A company is supposed to sustain itself by generating enough cash from operations. A secondary might suggest a company needs cash -- that it is losing money because of sagging sales, soaring costs or mismanagement. A company may need to raise cash for an acquisition, but investors prefer organic growth because an acquisition could be a sign of slowing growth, may be ill-conceived or poorly executed, or the company might overpay for it. All these factors are strong reasons to sell the stock.

References

  • "PassTrak Series 7: General Securities Representative License Exam"; Dearborn Financial Services; 2003
  • "The Wall Street Journal Guide to Understanding Money & Investing", Kenneth M. Morris, 2004

About the Author

Based in San Diego, Slav Fedorov started writing for online publications in 2007, specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker. Now working as a professional trader, Fedorov is also the founder of a stock-picking company.