M PRA Munich Personal RePEc Archive Stock market misvaluation and corporate investment Ming Dong and David Hirshleifer and Siew Hong Teoh Merage School of Business, University of California, Irvine 5. May 2007 Online at http://mpra.de/3109/ MPRA Paper No. May 2007 May 5, 2007 Stock Market Misvaluation and Corporate Investment Ming Donga David Hirshleiferb Siew Hong Teohc Abstract: This paper explores whether and why misvaluation affects corporate investment by com- paring tangible and intangible investments; and by using a price-based misvaluation proxy that filters out scale and earnings growth prospects. Capital, and especially R&D expenditures increase with overpricing; but only among overvalued firms.
Misvaluation affects investment both directly (catering) and through equity issuance. The sensitivity of capital expenditures to misvaluation is stronger among financially constrained firms; for R&D this differential is strong and in the opposite direction. We identify several other factors that influence the strength of misvaluation effects on investment. Generally the equity channel reinforces direct catering, suggesting that the two are complementary.
Overall, our evidence supports several implications of the misvaluation hypothesis for the tangible and intangible components of investment. a Schulich School of Business, York University, Canada; mdong@ssb. b Merage School of Business, University of California, Irvine; david. c Merage School of Business, University of California, Irvine; steoh@uci.
We thank seminar participants at the University of Notre Dame for very helpful com- ments. Stock Market Misvaluation and Corporate Investment This paper explores whether and why misvaluation affects corporate investment by com- paring tangible and intangible investments; and by using a price-based misvaluation proxy that filters out scale and earnings growth prospects. Capital, and especially R&D expenditures increase with overpricing; but only among overvalued firms. Misvaluation affects investment both directly (catering) and through equity issuance.
The sensitivity of capital expenditures to misvaluation is stronger among financially constrained firms; for R&D this differential is strong and in the opposite direction. We identify several other factors that influence the strength of misvaluation effects on investment. Generally the equity channel reinforces direct catering, suggesting that the two are complementary. Overall, our evidence supports several implications of the misvaluation hypothesis for the tangible and intangible components of investment.
1 Introduction Both efficient and inefficient market theories imply that higher stock prices should be associated with higher corporate investment. Under the q theory of investment (Tobin (1969)), markets are efficient, so that a high stock price reflects strong growth opportu- nities. It follows that a high-priced firm should invest more. Under what we call the misvaluation hypothesis, firms respond to overvaluation by investing more.
Equity overvaluation can stimulate investment by encouraging the firm to raise more equity capital (Stein (1996), Baker, Stein, and Wurgler (2003), Gilchrist, Himmelberg, and Huberman (2005)), thereby exploiting new shareholders for the benefit of existing shareholders.1 If the market overvalues the firm’s new investment opportu- nities, the firm may commit to additional investment in order to obtain a high price for newly issued equity. However, the misvaluation hypothesis does not require equity issuance. If a manager likes having a high short run stock price even at the expense of long-term value, he may invest heavily in order to stimulate or cater to optimistic market expectations (Stein (1996), Polk and Sapienza (2006), Jensen (2005)). In this paper we test the misvaluation hypothesis using an approach designed to distinguish rational from misvaluation effects, and to probe into the sources of misvalu- ation effects.
This approach is to test the relationship between investment and a single overall measure of misvaluation. A distinctive feature of how we identify misvaluation as a predictor of investment is that we examine the deviation of market price from a forward-looking measure of fundamental value.2 Doing so filters from our misvaluation proxy the contaminating effects of prospects for future profit growth. Removing such contamination is crucial, since, as the q theory of investment implies, current investment should increase with the quality of investment opportunities; and because firms with bet- ter management teams optimally should invest more. In this respect our misvaluation 1 Several authors provide evidence suggesting that firms time new equity issues to exploit market misvaluation, or manage earnings to induce such misvaluation—see, e.
There is also evidence that overvaluation is associated with greater use of equity as a means of payment in takeover (Dong et al. 2 In this respect our approach differs from that of Chirinko and Schaller (2001, 2006), who develop structural models of stock prices under efficient markets, in order to measure market misvaluation and its effect on corporate investment in Japan and the U. 1 measure minimizes the confounding of growth prospects and misvaluation effects that is present in many past studies of the stock market and investment. To do so, we apply the residual income model of Ohlson (1995) to obtain a measure of fundamental value, sometimes called ‘intrinsic value’ (V ), and measure misvaluation by V /P , the deviation of market price from this value.3 Intrinsic value reflects not just current book value, but a discounted value of analyst forecasts of future earnings.
Since intrinsic value reflects growth prospects and opportunities, normalizing market price by intrinsic value filters out the extraneous effects of firm growth to provide a purified measure of misvaluation. In contrast, misvaluation measures such as Tobin’s q or equity market-to-book rely for their fundamental benchmarks on a backward looking value measure, book value. Such valuation ratios therefore reflect information about the ability of the firm to gen- erate high returns on its assets. Indeed, many studies have viewed Tobin’s q or related variables as proxies for earnings growth prospects, investment opportunities, or man- agerial effectiveness.
So it is hard to distinguish misvaluation from other rational effects based solely on q or market-to-book as misvaluation measures.4 Furthermore, Tobin’s q is a measure of total firm misvaluation (setting aside the confounding with growth prospects). However, a better measure of the firm’s access to underpriced equity capital is its equity misvaluation. Training a purer measure of misvaluation upon the misvaluation/investment rela- tionship is only one of the two main purposes of this paper. The other main purpose here is to probe the economic sources of these effects.
We do so in three ways. First, we test the distinctive predictions of the misvaluation hypothesis for tangible versus intan- gible investments. Second, we revisit in greater depth the issue of whether the effect of misvaluation on investment operates through equity issuance. Third, we examine how investment sensitivities to misvaluation vary across size, financial constraint, turnover, and valuation subsamples.
With regard to the first issue, we identify a sharp contrast between the effect of mis- valuation on the creation of intangible assets through R&D investment and the effect 3 This measure of misvaluation has been applied in a number of studies to the prediction of subsequent returns (Frankel and Lee (1998), and Lee, Myers, and Swaminathan (1999)), repurchases (D’Mello and Shroff (2000)), and takeover-related behaviors (Dong et al. 4 To the extent that our purification is imperfect, variation in our purified measure would still reflect firm growth rather than misvaluation. If this problem were severe we would expect our measure to have a high absolute correlation with q. In our sample, the correlation with q is not especially strong (−0.
Nevertheless, as a further precaution, we additionally control for growth prospects as proxied by book-to-market in our tests. 2 on the creation of tangible assets through capital expenditures.5 This is an important topic, since R&D is a source of business innovation, and quantitatively is a major com- ponent of corporate investment. Indeed, in our sample, beginning in the mid-1990’s R&D constitutes a larger fraction of corporate investment than capital expenditures. Under the misvaluation hypothesis, measured misvaluation should be most strongly related to the form of investment that investors are most prone to misvaluing.
Intangible investments such as R&D presumably have relatively uncertain payoff, and therefore should tend to be relatively hard to value compared to ordinary capital expenditures.6 Intangible investment projects will tend to present managers with greater opportunities for funding with overvalued equity, and for catering to project misvaluation. Thus, the misvaluation hypothesis predicts a stronger relation between misvaluation and R&D expenditures than between misvaluation and capital expenditures. An integrated examination of equity issuance and investment offers insight into whether the effect of misvaluation on investment occurs because managers inherently seek to boost the stock price (a catering theory, as in Polk and Sapienza (2006)), or whether overvaluation encourages managers to issue equity (using such funds to invest more) in order to profit at the expense of new shareholders. Polk and Sapienza (2006) test between these possibilities by regressing capital expenditures on their misvaluation test variable, discretionary accruals, and including equity issuance as one of their con- trols.
The effect of discretionary accruals survives the inclusion of equity issuance, so they conclude that there is a catering effect of misvaluation on capital expenditures. However, if high market valuations cause the firm to issue more equity to finance investment, then equity issuance is an endogenous variable that is influenced by misvalu- ation. Thus, under the misvaluation hypothesis simple regressions tests for misvaluation effects that control for equity issuance are biased. It is therefore important to revisit the question of whether misvaluation affects investment through the equity channel versus 5 The primary dependent variable in previous literature on misvaluation is the level of capital expen- ditures.
Polk and Sapienza (2006) use the firm characteristic of high versus low R&D as a conditioning variable in some of their tests of the relation between misvaluation and capital expenditures. Baker, Stein, and Wurgler (2003) examine several measures of investment, one of which is the sum of capital expenditures and R&D, but do not examine whether misvaluation affects capital expenditures and R&D differently. 6 Psychological evidence suggests that biases such as overconfidence will be more severe in activi- ties (such as long-term research and product development) for which feedback is deferred and highly uncertain; see, e. In the investment model of Panageas (2005), investment is most affected by market valuations when the disagreement about the marginal product of capital is greatest.
Furthermore, there is evidence that greater valuation uncertainty is associated with stronger behavioral biases in the trades of individual investors (Kumar (2006)). We do so using a 2-Stage Least Squares procedure. We apply such a procedure each year and pool the estimates across time as in Fama and MacBeth (1973). Empirically, we find that more positive mispricing is associated with greater capital expenditures and, very strongly, greater R&D.
These findings remain after controlling for several other possible determinants of investment, including growth opportunities (proxied by q or equity book-to-market)7 , cash flow, leverage, and return volatility. In regression tests, the sensitivity of R&D to misvaluation is about 4-5 times greater than the sensitivity of capital expenditures. When we employ simple OLS regressions within our Fama-MacBeth tests, controlling for equity issuance makes little difference for the relation between misvaluation and capital expenditures, and between misvaluation and R&D. This might seem to imply that the misvaluation effect on investment does not operate through equity issuance.
However, when we address the endogeneity of equity issuance using 2-stage least squares, the conclusion is quite different; about half of the effect of misvaluation on investment occurs through equity issuance. Thus, our evidence is consistent with the hypothesis that overvaluation induces firms to raise cheap equity capital to finance investment, consistent with the models of Stein (1996) and Baker, Stein, and Wurgler (2003). At the same time, consistent with the theory of Jensen (2005) and the model of Polk and Sapienza (2006), misvaluation effects do not operate solely through the equity channel. In other words, our evidence is consis- tent with misvaluation affecting investment for other reasons as well, such as a catering incentive to boost the short-term stock price.
With regard to the third issue, we probe further into the sources of the misvaluation effect by considering different subsamples which, under different hypotheses, should affect the strength of the misvaluation/investment relation.