Box 5 Activity in the euro area initial public offering market

Initial public offering (IPO) activity in the euro area, measured either by total transacted amounts or by the number of transactions, surged after the mid-1990s (see Chart A below). The market was particularly active in 1999 and reached a peak in the first quarter of 2000. Since then activity has fallen off markedly and by the third quarter of 2002 it reached levels as low as those seen in the mid-1990s. While several factors may have played a role in these swings, this box focuses on the link between IPO activity and its cost, as proxied by the cost of equity.

Chart A: Initial public offering activity (four-quarter moving average, quarterly data)

IPO amounts transacted, EUR billions (left-hand scale) number (right-hand scale) 20 100 18 90 16 80 14 70 12 60 10 50 8 40 6 30 4 20 2 10 0 0 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 1988 1990 1991 1992 1993 1995 1996 1997 1998 2000 2001 2002

Source: Bondware.

A commonly accepted definition of the cost faced by firms in raising equity capital is the return demanded by investors to bear the risk of an equity investment. It can be broken down into a risk-free interest rate, usually the return that investors would obtain from investing in a government bond, plus an equity risk premium, the additional return demanded by the investor to bear the specific risk attached to equity. From a conceptual

34 ECB • Monthly Bulletin • December 2002 viewpoint the definition of the cost of equity is straightforward; in practice, however, its measurement is rather cumbersome, notably because it is difficult to measure the size of the equity risk premium.

Stock prices reflect the discounted value of future dividends. The discount rate that equates the current stock price with the net present value of future dividends is the return demanded by shareholders for holding stocks. If the return demanded by shareholders rises, this will, assuming dividends cannot be raised and all else being equal, bring about a decline in stock prices and a rise in the dividend yield, i.e. the anticipated annual dividend as a percentage of the share price. Such a rise in the dividend yield then implies a higher cost of equity capital.

Chart B: Initial public offering activity and the price/dividend ratio (four-quarter moving average, quarterly data)

IPO amounts transacted, EUR billions (left-hand scale) price dividend ratio 1) (right-hand scale) 20 65 18 60 16 14 55 12 50 10 8 45 6 40 4 2 35 Q2 Q2 Q2 Q2 Q2 Q2 Q2 1996 1997 1998 1999 2000 2001 2002 Source: Bondware and Datastream. 1) Share price as a percentage of the anticipated annual dividend.

Chart B shows the amounts transacted in IPOs in the euro area since 1995 together with the price/dividend ratio (i.e. the inverse of the dividend yield) of the euro area Datastream stock index. The two series show a very high correlation. The IPO market was more active when the price/dividend ratio was high or, in other words, when the cost of equity was low. In the period since 1995, the price/dividend ratio has been driven mainly by stock price developments. Hence it would seem that there is a close link between IPO activity and stock price developments, which impact on the cost of equity. This result sheds light on one of the transmission mechanisms between asset prices and the real economy, namely the cost-of-capital channel. It illustrates how the decline in stock prices over the past two years has made access to equity financing more difficult.

ECB • Monthly Bulletin • December 2002 35