Abstract
Extant literature has documented positive stock price reactions to announcements of stock breakups (including tracking stock offerings, equity carve-outs, and corporate spin-offs). At the same time, most firms experience no improvement in operating performance subsequent to stock breakups. These findings puzzle practitioners and researchers as to the source of value increase. This paper offers a resolution to the puzzle. We argue that stock breakups, by dividing consolidated firms into pure-play units, reduce the complexity of the businesses and enable outsiders to detect firms' values at lower costs. In such a setting, high-value firms, which are undervalued by the market, find it optimal to use stock breakups to attract more information production from outsiders and reveal their true values, while low-value firms have a lower incentive to do so since more information production will expose their true quality to the market. Therefore, a stock breakup signals firm quality to the market but does not change the firm's investment decisions and implies no subsequent improvement in operating performance. The model can also explain the following stylized facts: (1) the number and quality of analysts covering the firm increase and the degree of information asymmetry decreases after stock breakups; (2) focus-increasing stock breakups (where the two divisions of the firm operate in different industries) are associated with higher announcement returns compared with non-focus-increasing ones; (3) a positive relation exists between the announcement return and the degree of information asymmetry of the firm prior to a stock breakup. The model also provides some novel empirical implications; e.g., it predicts that there is an inverted U-shaped relation between the ratio of subsidiary to total firm value and the announcement return.
Published Version
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