Equity Overvaluation Research Articles

Equity overvaluation, insider trading activity, and M&A premium: Evidence from China

Based on catering theory and M&A arbitrage theory, this paper focuses on the motivation and economic consequences of high premium M&A in China's capital market. The main research conclusions are as follows: First, the more equity overvaluation, the higher the merger premium and the short-term excess market return. Second, the more insider trading behaviour after equity overvaluation, the higher the merger premium and the short-term excess market return. Third, the greater the short-selling pressure after the equity overvaluation, the lower the merger premium and the weaker the short-term excess market return. Finally, this paper studies the economic consequences of M&A after equity overvaluation, and finds that M&A driven by equity overvaluation can only improve M&A performance in the current year, but cannot achieve long-term synergies. Based on the theory of M&A arbitrage, this paper studies the explanation mechanism of equity overvaluation to high-premium M&A in China's capital market, provides new evidence for executive's agency behaviour in M&A. This paper has important policy implications for the healthy development of M&A in the current emerging capital market.

The role of corporate governance mechanisms on equity overvaluation

This study investigates how corporate governance mechanisms, particularly board characteristics, influence equity overvaluation. We use secondary data of 4,185 firm-year observations spanning 2009 to 2015 across 1,351 publicly listed U.S. firms to estimate a logistic regression model. We focus on governance metrics such as gender diversity, Chief Executive Officer (CEO) duality, independent board members, and board size in relation to overvaluation, primarily measured using the price-to-intrinsic-value ratio. We test Jensen’s (2005) proposition that the solution to overvaluation lies in the board of directors or the governance system of firms. In line with our hypothesis, our results present evidence to show that the governance system, specifically board gender diversity, has a significant and negative relationship with the overvaluation of equity. We do not find any significant association between other governance metrics and overvaluation. Equity overvaluation misinforms investors (Eisdorfer et al., 2019), prompting further examination of firm value factors. This study underscores the significance of governance mechanisms, particularly gender diversity, for equity value. Future research should expand governance metrics and explore diverse contexts to enhance the results’ robustness and applicability across industries and contexts.

Accounting Conservatism and the Agency Problems of Overvalued Equity

Accounting Conservatism and the Agency Problems of Overvalued Equity

Non-linearity in Equity Market Timing: Empirical Evidence From the UK

This paper empirically tests the market timing theory to prove that issuing behavior of managers is non-linear. Consistent with the literature we show that mangers increase use of equity to finance their deficit when equities are overvalued and resort to a higher proportion of debt when equities are undervalued. Our results further suggest that mangers however exhibit a distinctive pattern when timing the market. The increase in reliance on equity to finance their deficit during periods of equity overvaluation is non-linear and only significant when the degree of overvaluation is not excessive. Furthermore, during periods of undervaluation managers resort to higher levels of leverage to finance their deficit only when undervaluation levels are excessive. This has serious implications on the ability of the equity market timing as a stand-alone theory in explaining capital structure decisions and poses some interesting implications on the debt-equity choice question when financing the deficit.

The real effects of financial reporting quality: Agency costs of overvalue equity in takeover market

Does pre-existing financial reporting quality play a role in mitigating market-driven takeover bids and enhancing investment efficiency? An exogenous buying pressure from mutual funds with extreme capital inflows affords us a quasi-experimental setting for testing the real effects of acquirers’ financial reporting quality. We find that financial reporting quality disciplines acquiring firm managers at the front-end of the acquisition process and averts value-destroying takeover stock bids. Our findings suggest that managers discipline themselves and offer takeover bids less frequently as a reaction to equity overvaluation when high-quality financial reporting facilitates an effective board oversight and managers rationally anticipate that the board will reject their market-driven stock bids. If managers inflate earnings proactively to prop up the stock price for their upcoming M&As, we will also observe an inverse relation between financial reporting quality and the likelihood of M&As. Our identification strategy on exogenous equity overvaluation helps in ruling out the reverse causality explanation of our findings. We contribute to the literature by investigating the effects of transparent financial reporting on mitigating managers’ sub-optimal investment decisions and unraveling the mechanisms underlying the real effects of financial reporting quality. Our falsification test result suggests the presence of tensions in our hypothesis.

Is Capital Reallocation Really Procyclical?

Aggregate reallocation is procyclical. This empirical observation is puzzling given the documented fact that the benefits to reallocation are countercyclical. I show that this procyclicality is entirely driven by reallocation of bundled capital, which is highly correlated with market valuation and bears no consistent relation to measures of productivity dispersion. Reallocation of unbundled capital, on the contrary, is countercyclical and highly correlated with dispersion in productivity growth, both within industry and across industries. To rationalize these facts, I propose a heterogeneous agent model of investment featuring two distinct used-capital markets and a sentiment component. In equilibrium, unbundled capital is reallocated for productivity gains only, whereas bundled capital is also reallocated for real, or perceived synergies in the equity market. While equity overvaluation negatively affect total factor productivity (TFP) by encouraging excessive trading of capital, such an adverse impact is largely offset by eased frictions to reallocation in the unbundled capital market.

고평가 자본이 감사인의 감사보수와 감사시간에 미치는 영향

고평가 자본이 감사인의 감사보수와 감사시간에 미치는 영향

Stock-based compensation, financial analysts, and equity overvaluation

Stock-based compensation (SBC) reduces the value of shareholder equity, ceteris paribus, and is a significant and growing expense for many firms. Despite its valuation implications and its growing importance, anecdotal evidence suggests that market participants ignore SBC in valuation. We first find that firms with higher SBC exhibit both higher valuation ratios and lower returns, suggesting overvaluation. This pattern is stronger for firms with larger analyst coverage, implying that the sell-side optimism is an important driver of the overvaluation. We then examine how financial analysts treat SBC in their valuation models. We find that analysts exclude more expenses in their street earnings forecasts and provide more optimistically biased target prices for firms with higher SBC. A hand-collected sample of analyst reports indicates that analysts who ignore SBC in valuation derive optimistically biased price targets, whereas analysts who treat SBC as an expense are unbiased on average. Together, our evidence indicates that market participants’ failure to account for stock-based compensation as an expense leads to the overvaluation of equity.

Differences Between Savings from Equity Issuance and Savings from Cash Flow

Firms have different choices of using equity issuance and cash flow to save. Empirically, we find three differences between savings from equity issuance and cash flow. First, firms may not increase or decrease the savings rates of equity issuance and cash flow at the same time. Second, the savings rate of equity issuance is higher than that of cash flow. Third, in 1985-2016, the savings rate of equity issuance increases more than that of cash flow. To investigate the differences, we analyze the cash-savings motives from the following perspectives: growth options, financial constraints, and equity overvaluation. Our theory predicts that the savings rate of equity issuance increases in the above three scenarios, whereas the savings rate of cash flow only increases because of financial constraints. Empirical results suggest that the savings motives result in the first difference and the growth of intangible investment causes the second and third differences.

Shareholder litigation rights and corporate acquisitions

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.

Capital structure adjustment and market reaction following seasoned equity offerings

AbstractThis paper analyzes the market reaction towards capital structure adjustment through seasoned equity offerings in the United States. It recognizes that capital structure and equity mispricing are closely associated with seasoned equity offering. We specifically propose that if the trade‐off theory holds and firms follow target capital structures, then, firms that are overlevered would effectively exploit an overvalued equity in a cost‐effective adjustment of their capital structures through seasoned equity offerings. We also test how the market then reacts to such capital structure adjustment attempts. Controlling for other motives of seasoned equity offerings in a sample of 1,725 secondary issues by 1,016 U.S. nonfinancial firms from 2004 to 2013, we found that firms that were ex ante overlevered and overvalued were more likely to announce a seasoned equity offering. As regards the market reaction to such capital structure adjustments, it is found that the market favorably reacted in both the short term and long term, as evidenced by positive 3‐day cumulative abnormal returns and buy‐and‐hold abnormal returns, respectively. Moreover, post‐event evidence suggests that on the average, overlevered firms reduced their deviations from the target and that their leverage levels mainly stayed around the targets until at least 3 years after the secondary equity issues.

Supply‐side factors, CEO overconfidence, and zero‐leverage policy

AbstractThis paper investigates the effects of credit rating downgrades, equity mispricing, and CEO overconfidence on zero‐leverage policy, using data for listed U.S. firms during the period 1980–2012. The results show that (a) the likelihood of zero leverage increases significantly following a downgrade in credit rating; (b) zero leverage is the outcome of the past attempts by firms to issue more overvalued equity capital; and (c) firms with overconfident CEOs are more likely to choose zero leverage. The results clearly suggest that the conditions prevailing in both credit and equity markets exert significant influence on zero‐leverage policy. The analysis also advocates the inclusion of managerial biases in conjunction with the market‐wide conditions in the analysis of zero‐leverage policy. Overall, the findings reveal that zero‐leverage firms find that the benefits of issuing overvalued equity outweigh the benefits associated with debt financing. These results are robust to a battery of checks.

Why Do Firms Disagree with Short Sellers? Managerial Myopia versus Private Information

Though short sellers on average succeed at identifying overvalued equity, firms often signal disagreement with short sellers by repurchasing stock when short interest increases. We investigate whether this disagreement reflects a myopic defense of inflated prices, or positive private information. These repurchases appear motivated by managers’ private information, not agency issues, even when managerial benefits to short-termism are enhanced or monitoring is weaker. Managers’ informational advantage relates to subsequent news, earnings, and risk, but is attenuated if activists target management or insiders sell. A trading strategy based on our findings earns 7.5% annually.

What is Revealed When Firms Disagree with Short Sellers?

Though short sellers on average succeed at identifying overvalued equity, firms often signal disagreement with short sellers by repurchasing stock when short interest increases. We investigate whether this disagreement reflects a myopic defense of inflated prices, or positive private information. These repurchases appear motivated by managers' private information, not agency issues, even when managerial benefits to short-termism are enhanced or monitoring is weaker. Managers' informational advantage relates to subsequent news, earnings, and risk, but is attenuated if activists target management or insiders sell. A trading strategy based on our findings earns 7.5% annually.

Stock-based Compensation, Financial Analysts, and Equity Overvaluation

Stock-based compensation (SBC) reduces the value of shareholder equity, ceteris paribus, and is a significant and growing expense for many firms. Despite its valuation implications and its growing importance, anecdotal evidence suggests that market participants ignore SBC in valuation. We first find that firms with higher SBC exhibit both higher valuation ratios and lower returns, suggesting overvaluation. This pattern is stronger for firms with larger analyst coverage, implying that the sell-side optimism is an important driver of the overvaluation. We then examine how financial analysts treat SBC in their valuation models. We find that analysts exclude SBC in their street earnings forecasts and provide more optimistically biased target prices for firms with higher SBC. A hand-collected sample of analyst reports indicates that analysts who ignore SBC in valuation derive optimistically biased price targets, whereas analysts who treat SBC as an expense are unbiased on average. Together, our evidence indicates that market participants’ failure to account for stock-based compensation as an expense leads to the overvaluation of equity.

Duration of equity overvaluation and managers’ choice to use aggressive underlying earnings disclosure and accrual-based earnings management: Australian evidence

This paper examines whether equity overvaluation duration influences managers’ choice of different earnings management mechanisms and how corporate governance and the Australian Securities and Investment Commission’s underlying earnings disclosure guidelines influence managers’ choices. The study samples Australian Securities Exchange 200 firms from 2009 to 2016. Findings show that on average, firms more likely engage in accrual-based earnings management in the early overvaluation stage. In later stages, firms more likely disclose underlying earnings aggressively to sustain overvaluation. Additionally, firms with a high proportion of independent directors on the board prefer to disclose underlying earnings aggressively to sustain the equity overvaluation; firms with a low proportion of independent directors prefer both accrual-based earnings management and aggressive underlying earnings disclosure to sustain the overvaluation. Moreover, firms that conform to the Commission’s underlying earnings disclosure guidelines use neither accrual-based earnings management nor aggressive underlying earnings disclosure to sustain overvaluation, but non-conforming firms use both mechanisms.

Duration of Equity Overvaluation and Managers’ Choice to Use Aggressive Underlying Earnings Disclosure and Accruals Earnings Management: Australian Evidence

This paper examines whether the duration of equity overvaluation influences managers’ choice to use different earnings management mechanisms, and how corporate governance and the Australian Securities and Investment Commission’s underlying earnings disclosure guidelines influence managers’ choices. The study uses a sample of Australian Securities Exchange 200 firms between 2009 and 2016. The findings show that on average, firms are more likely to engage in accruals earnings management in the early stage of overvaluation. In the later stages, firms are more likely to disclose underlying earnings aggressively to sustain overvaluation. The study also finds that firms with a high proportion of independent directors on the board prefer to disclose underlying earnings aggressively to sustain the equity overvaluation; firms with a low proportion of independent directors on the board prefer to use both accruals earnings management and aggressive underlying earnings disclosure to sustain the overvaluation. Another finding is that firms that conform to the Commission’s underlying earnings disclosure guidelines use neither accruals earnings management nor aggressive underlying earnings disclosure to sustain overvaluation, but firms that do not conform to the guidelines use both of these mechanisms to sustain overvaluation.

Impact of Business Strategy on Stock Price Crash Risk: Role of Overvalued Equity

The objective of the current study is to investigate the impact of business strategies on the future crash risk of stock prices by considering the role of overvalued equity. This relationship is checked by taking non-financial firms from Pakistan Stock Exchange from 2008-2016. To evaluate the business strategy, composite strategy score is used which considers the firm's development and research costs to look for new products, sales ratio to determine the firm’s capacity to manufacture the product efficiently, standard deviation of employees, sales growth, marketing expense to sales ratio to locate the firms’ emphasis on marketing, and intensity of assets expenditures to capture the firms’ emphasis on production. Market to book decomposition method is used to calculate the equity overvaluation whereas the negative conditional skewness is used as a measure of crash risk. Random and fixed effect panel regression models are used to estimate the results. The results of the present study indicate that firms pursuing innovative strategies have a higher probability to face crash price risk. Outcomes of the study also confirm that such strategies also increase the likelihood of equity overvaluation which increases the risk of stock price crash in the future. The results of the current study are helpful for the investors in allocating the assets cautiously among companies with diverse strategies.

Does Accounting Conservatism Reduce Overpricing Caused by Short‐Sales Constraints?

ABSTRACTPrior research documents that, in the presence of investor disagreement, short‐sales constraints can lead to equity overvaluation. We examine whether conservative accounting practices reduce the susceptibility to such overpricing, as predicted by Miller (1980). Consistent with Miller's prediction, we find that when shorting constraints and disagreement are high, the degree of overvaluation decreases systematically with accounting conservatism. These findings suggest that financial reporting conservatism helps improve market efficiency by counteracting the tendency to overvaluation that typically occurs in the presence of short‐selling constraints and divergence of opinion.

Overvalued Equity and Financing Decisions (Presentation Slides)

These are the presentation slides for the paper. We test whether and how equity overvaluation affects corporate financing decisions using an ex ante misvaluation measure that filters firm scale and growth prospects from market price. We find that equity issuance and total financing increase with equity overvaluation; but only among overvalued stocks; and that equity issuance is more sensitive than debt issuance to misvaluation. Consistent with managers catering to maintain overvaluation and with investment scale economy effects, the sensitivity of equity issuance and total financing to misvaluation is stronger among firms with potential growth opportunities (low book-to-market, high R&D, or small size) and high share turnover. The paper is available at https://ssrn.com/abstract=1874726.