Equity Overvaluation Research Articles

Is Shareholder Litigation an Effective External Monitoring Device? Evidence from M&As

We examine the effect of shareholder litigation rights on managers’ acquisition decisions. Our experimental design exploits a U.S. Ninth Circuit Court of Appeals ruling on July 2, 1999 that resulted in a reduction in shareholder class actions. We find that, since the ruling, firms in Ninth Circuit states acquire larger targets. Furthermore, acquirers’ returns are lower in these states, especially for those with weaker corporate governance. Further analysis shows that value destruction is the result of managers’ freedom to conduct empire-building acquisitions using overvalued equity. Overall, our findings indicate the importance of shareholder litigation as an external governance mechanism.

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

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.

The High Agency Costs of Overvalued Equity in an Emerging Market: Evidence from the Growth Enterprise Market (GEM) in China

Restriction on the access to the public equity market and non-market based selection of public listing create overvaluation and distort managerial incentives in the public listed companies in the Chinese stock market. Using the sample of newly listed firms in the Growth Enterprise Market (GEM), this paper documents evidence on the high agency costs of overvalued equity. We show that newly listed firms experience exodus of top executives shortly after public listing, and the executives time their resignations in order to “cash out” their stock holdings. Firms with greater overvaluation and lower profitability are more likely to experience executive resignation. Consistent with Jensen (2005), we find that managerial actions resulting from systemic equity overvaluation can be destructive: market reactions to executive resignation are negative and firms that experience executive exodus perform poorly. The results suggest that high valuation of public companies resulting from tight control of public equity market entry helps to create wealth for the corporate insiders rather than to create successful enterprises.

The Role of Cash Holdings in Corporate Misconduct

We test the role of cash holdings in corporate misconduct. Consistent with the agency costs of equity overvaluation, before misconduct, investors overvalue firms’ cash holdings, and firms that commit misconduct accumulate excess cash holdings. Furthermore, consistent with the free cash flow hypothesis, the accumulated excess cash holdings at the beginning of misconduct positively predict firms’ simultaneous misconduct actions, including overinvestment decisions, the delay of bad news disclosures, and insider selling. The association of excess cash holdings with the degree of withholding bad news and insider trading occurs mainly in firms with higher managerial equity-based incentives or firms with internal control weakness. The results suggest that cash holdings are one important mechanism by which equity overvaluation leads to corporate misconduct and emphasize the importance of internal control over financial reporting in safeguarding corporate resources.

Agency Costs of Overvalued Equity and Earnings Management in Companies Listed on WSE

Agency Costs of Overvalued Equity and Earnings Management in Companies Listed on WSE

Business Strategy, Overvalued Equities, and Stock Price Crash Risk

This paper examines empirically the effect of firm-level business strategies on future stock price crash risk and the extent to which equity overvaluation moderates this relation. By exploring the extent to which firms following particular business strategies are more or less likely to experience crash risk, we provide evidence that increases our understanding of the underlying determinants of crash risk. Using a composite strategy score developed by Bentley, Omer and Sharp (2013) and applying two variants of crash risk, we document that firms following innovative business strategies (prospectors) are more prone to future crash risk than defenders. We extend our analysis by examining the moderating role of equity overvaluation and find that prospectors are more prone to equity overvaluation which increases future crash risk.

Why Do Firms Disagree with Short Sellers? Managerial Self-Interest Versus Private Information

Though short sellers are generally adept at identifying overvalued equity, firms are more likely to repurchase stock when short interest increases. We investigate the causes and consequences of firms disagreeing with short sellers by repurchasing company stock. On average, managers do not disagree to defend overvalued stock; instead, these repurchases appear motivated by private information that dominates the information of short sellers. Information channels include future earnings, changes in risk, and acquisition activity. We observe one exception: Managers are more likely to defend overvalued stock if an activist investor previously identified the management team as inefficient. Our results suggest that short sellers and other investors can glean information from publicly available repurchase disclosures: An implementable trading strategy based on our findings yields annual abnormal returns of approximately 7%.

Business strategy, overvalued equities, and stock price crash risk

This paper examines empirically the effect of firm-level business strategies on future stock price crash risk, and the extent to which equity overvaluation moderates this relation. By exploring the extent to which firms following particular business strategies are more or less likely to experience crash risk, we provide evidence that increases our understanding of the underlying determinants of crash risk. Using a composite strategy score developed by Bentley, Omer and Sharp (2013) and applying two variants of crash risk, we document that firms following innovative business strategies (prospectors) are more prone to future crash risk than defenders. We also find that prospectors are more prone to equity overvaluation which, in turn, increases future crash risk.

Equity Investor Sentiment and Bond Market Reaction: Test of Overinvestment and Capital Flow Hypotheses

This paper examines the effect of equity investor sentiment on the bond market. While empirical evidence suggests that high investor sentiment leads to equity overvaluation, there is limited evidence of its effect on the bond market. Sentiment can have a negative impact on bond returns via two channels. First, in times of high investor sentiment, overvalued equity can lead to firm overinvestment, resulting in a negative impact on bond pricing due to an increase in default risk. Second, overvalued equity attracts capital flow to the equity market from the bond market which can create a downward pressure on bond pricing. Consistent with these channels, I find that equity investor sentiment exhibits a significant negative relation with contemporaneous bond returns; this effect is stronger for the sample of firms with overinvestment. In distinguishing the effects of the two channels, I find a positive relation between sentiment and subsequent bond returns, consistent with a return reversal predicted by the capital flow channel (due to the backflow of capital); however, there is no return reversal observed for the overinvestment sample, indicating that overinvestment has a more lasting impact. Additionally, I find a negative (but delayed) impact of equity investor sentiment on bond ratings for the overinvestment sample consistent with an increase in default risk of these firms. Overall, my study highlights that behavioral biases in the equity market do not automatically get transmitted to the bond market. In fact, the bond market reacts negatively to sentiment-induced overinvestment in a rational way, consistent with bond investors' payoff function. In addition, the results indicate a potential role of investor sentiment in explaining the decoupling relation between the stock and bond markets.

Financial disclosure on the internet and overvalued equity: the case of Iran

Due to the advantages of high stock price, managers usually take actions to explain watered stock. Therefore, at least, they disclose less information about financial aspects of the corporation. The objective of this study is to provide evidence on the relationship between overvalued equity and the disclosure of financial information via the internet in the Tehran Stock Exchange (TSE). To this end, using 83 companies' data, it was tried to examine the relationship between the variables. According to correlation analysis (Pearson and partial), regression analysis (annual and biennial) and t-test, a negative significant relationship between overvalued equity and internet disclosure of financial information in the Iranian companies is determined. That is to say, when companies experience overvaluation, Iranian managers disclose less information through the company's website too. Also, the results reveal the existence of significant and positive relationship between previous internet disclosure of financial information and internet disclosure of financial information.

The Effect of Overvalued Equity on the Relationship between Audit Quality and Earning Quality (Evidence from Iran)

The purpose of this article is to investigate the effect of overvalued equity on the relationship between audit quality and earning quality. In this article audit firm size, auditor industry specialization and auditor tenure were used as audit quality variable. The sample population consists of 189 companies listed in Tehran stock Exchange during the period 2008 to 2012. To test the hypotheses, OLS in Eviews has been used and investigation method of data is panel. The results show a reverse relationship between all audit quality variables and absolute discretionary accruals indicating that high audit quality causes higher earning quality. But the existence of overvalued equity cause decreasing or reversing of these relationships, in other words, when a firm is highly valued the accruals’ decreasing effect of high quality auditors is reduced.

Market Timing and Merger Waves

Merger activity tends to peak at times of high stock prices. I examine the allocation of equity issue proceeds conditional on the level of merger activity to shed light on the source of this empirical regularity. I find that firms do not allocate more of the equity proceeds raised in high merger times to increase debt repayment or to increase equity payouts. This lack of substitution of old for new (presumably cheaper) financing runs against the idea that equity overvaluation drives both merger activity and equity issuance. Instead, firms tend to permanently allocate more of the equity proceeds raised in high merger times to hoard cash. This is especially true in a sub-sample of financially constrained firms. This finding is consistent with the notion that times of high merger activity are also times of less adverse selection in the stock market. I also show that firms use significantly more of the equity proceeds raised in high merger times to increase investment. This increased allocation towards investment is associated with a gradual increase in debt issuance. These findings suggest that times of high merger activity are also times at which firms exercise growth options and prefer a conservative leverage ratio. This pattern is consistent with the existence of irreversibility and uncertain time-to-build in investment decisions. Overall, the evidence suggests that investment and financial frictions are important elements to explain the time series behavior of M&A activity.

CEO Pay Slice and Earnings Manipulation in Overvalued Companies

Both the magnitude and signs of discretionary accrual (DACC) should be considered when examining its impact on firm-specific risk. In this study, we show that only overvalued firms that have positive DACC exhibit low firm-specific information and high price crash risk. We also investigate whether corporate governance affects the earnings management decisions of overvalued firms. Among all the variables we examine, CEO pay slice (CPS) has the strongest power in predicting overvalued firms’ earnings management choice, followed by monitoring intensity and information asymmetry measures. We also find that the passage of SOX plays a positive role in controlling the “value-destroying forces” set in motion by equity overvaluation and firms are more likely to use DACC for informational purpose after the passage of SOX.

Do equity mispricing and management compensation incentives drive bank mergers?

Purpose – The purpose of this paper is to test whether bank mergers are driven by equity overvaluation and management compensation incentives. Design/methodology/approach – To test whether equity mispricing drive bank mergers, the authors employ two alternative price-to-residual income valuation (P/V) measures for bidders and targets while the authors control for their growth prospects with the price-to-book (P/B) (two years before) ratio. The intrinsic value (V) is estimated using the three-period forecast horizon residual income model of Ohlson (1995) and perpetual residual income model that does not rely on analysts’ forecasts of future earnings prospects. The latter measure allows the authors to estimate V for a much larger sample of banks. The empirical analysis is supplemented with a standard event analysis and assessment of the long-term performance of bank mergers subsequent to the announcement date. Findings – The evidence shows that bidders are overvalued relative to their targets, especially in equity offer deals. The authors also find that highly valued bidders: are more likely to use stock than cash; are willing to pay more relative to the target market price; are more likely to acquire private than public targets; earn lower announcement-period returns; fail to create synergy gains; experience long-term underperformance; and reward their top managers of with large compensation increases subsequent to mergers. Originality/value – This study provides results consistent with the view that behavioral and managerial incentives play an important role in motivating bank mergers.

Do Equity Mispricing and Management Compensation Incentives Drive Bank Mergers?

This study tests whether bank mergers are associated with valuation gains and examines how equity overvaluation and management compensation incentives influence any valuation effects. Our evidence shows that bidders are overvalued relative to their targets, especially in equity offer deals. We also find that highly valued bidders are (i) more likely to use stock than cash, (ii) are willing to pay more relative to the target market price, (iii) are more likely to acquire private than public targets, (iv) earn lower announcement-period returns, (v) fail to create synergy gains, (vi) experience long-term underperformance, and (vii) reward their top managers of with large compensation increases subsequent to mergers.

Housing and behavioural factors

The field of behavioural finance is well established. Studies of housing bubbles are less common than studies of equity overvaluation and studies of the behavioural aspects of real-estate pricing are rare. This article examines the housing market from 1987 to the present with particular attention to the 2003 to 2007 bubble. Both behavioural and traditional variables are considered. Models with behavioural variables are seen to provide a better fit during the housing bubble. A state-space model shows that the coefficients on those behavioural variables vary in ways consistent with the emergence and dissipation of the recent housing bubble.

Overvalued equities and audit fees: a research note

Purpose – The purpose of this research note is to examine the association between overvalued equities and audit fees in the USA.Design/methodology/approach – The paper employs a standard audit fee regression model incorporating proxies for overvalued equities and controls for other known determinants of audit fees. Three proxies for overvaluation are used in this paper. These are: a lagged price‐earnings‐based overvaluation measure; a lagged price‐to‐book‐based overvaluation measure; and finally, a lagged abnormal‐return‐based overvaluation proxy measure.Findings – Findings show that auditors charge higher audit fees for clients posing increased audit risks because of equity overvaluation, that this relationship did not change during and after the global financial crisis period, and is more pronounced for firms prone to aggressive earnings management.Practical implications – This finding should assure investors about audit quality, since the positive finding potentially implies that auditors exert extra a...

Do cash stockpiles fuel cash acquisitions?

U.S. firms currently hold a $2trillion cash stockpile. We examine if cash stockpiles fuel cash acquisitions by studying the method of payment decision for cash-rich firms. Surprisingly, cash-rich firms are 23% less likely to make cash bids than stock bids, relative to firms that are not cash rich. We examine several potential explanations related to omitted variable bias and endogeneity and the result remains. More specifically, the results are robust to explanations related to agency, financial constraints, tax-related explanations, equity overvaluation, and capital structure. Our evidence implies that the link between cash stockpiles and cash acquisitions is not obvious.

Do Overvaluation-Driven Stock Acquisitions Really Benefit Acquirer Shareholders?

AbstractI study the effects of overvalued equity on acquisition activity and shareholder wealth, using managers’ insider trades to measure overvaluation. I find that overvalued equity drives managers to make stock acquisitions, and such acquisitions destroy value for acquirer shareholders. Overvalued stock acquirers earn negative and lower returns in the short run and substantially underperform similarly overvalued nonacquirer firms in the long run. My results do not support the idea that managers can benefit shareholders by converting overvalued equity into real assets through stock acquisitions.

Are Corporate Share Repurchases Used to Support Overvalued Equity?

Prior research shows that companies repurchase stock during quarters with low returns, presumably because the stock is undervalued. We focus on repurchase increases and investigate another motive: Are repurchases increased to provide price support for a stock that, despite recent low returns, remains overvalued? Using an increase in short selling to indicate overvaluation, we regress quarterly changes in share repurchases on quarterly changes in short interest. Consistent with price support, the association is positive and statistically significant each year from 2003 to 2014. We find the price support quarter is followed by a sharp multi-quarter decline in ROA (return on assets), but the corresponding decline in EPS (earnings per share) is modest due to the reduction in outstanding shares. Abnormal returns after the price support quarter are positive, indicating that price support is effective. We also examine trading by insiders. While insiders generally sell when shorts sell, they hold onto shares during the price support quarter. This indicates insiders are confident they can maintain the current stock price.