Ex ante and ex post overvalued equities: The roles of corporate governance and product market competition

Abstract

Abstract This paper examines equity overvaluation and the effects of corporate governance and product market competition on market valuation of potentially overvalued equities in an economy with high earnings management and weak investor protection (Taiwan). We follow Beneish and Nicholas (2009) to mimic Altman Z-Score and Beneish M-Score to compose an ex ante O-Score to measure overvaluation. We show that our ex ante overvaluation measure (O-Score) can effectively identify those that are likely to be overvalued by manipulation. Portfolios of longing stocks with high current O-Score and shorting stocks with low current O-Score earn abnormal returns. Portfolios of longing stocks with high one-year-ahead O-Score and shorting stocks with low one-year-ahead O-Score suffer losses. We also show that corporate governance reduces but product market competition raises managers’ incentive to manipulate market overvaluation. Moreover, product market competition reduces market valuation on currently overvalued equities. Corporate governance effectively reduces but product market competition reinforces the reverse effect of one-year-ahead overvaluation on current market valuation.