Abstract
About 40% of the S&P 500 firms reported negative tangible equity (NTE) in 2019, a significant increase from the 10% level two decades ago. We find that debt-fueled NTE firms are associated with larger market caps with more stock buybacks and acquisitions of intangibles. NTE firms’ higher credit ratings and lower bond yields in the latest decade suggest that they are viewed as less risky by debtholders than previously. We also find that their stock prices increase (decrease) immediately after the Federal Reserve’s monetary policy action decreased (increased) interest rates. In addition, NTE firms’ stock returns outperform by 3.77% and 3.65% in the first and the second year after portfolio formation in 2011–2019, but such outperformance is not accompanied by higher earnings expectations. Our results contradict Graham and Dodd’s (1940) advice to avoid NTE firms but raise questions about their valuations, should interest rates rise in the future.
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