Misvaluation Measure Research Articles

Uncertainty in firm valuation and a cross-sectional misvaluation measure

The degree of uncertainty associated with the value of a company plays a relevant role in valuation analysis. We propose an original and robust methodology for company market valuation, which replaces the traditional point estimate of the conventional Discounted Cash Flow model with a probability distribution of fair values that convey information about both the expected value of the company and its intrinsic uncertainty. Our methodology depends on two main ingredients: an econometric model for company revenues and a set of firm-specific balance sheet relations that are estimated using historical data. We explore the effectiveness and scope of our methodology through a series of statistical exercises on publicly traded U.S. companies. At the firm level, we show that the fair value distribution derived with our methodology constitutes a reliable predictor of the company’s future abnormal returns. At the market level, we show that a long-short valuation (LSV) factor, built using buy-sell recommendations based on the fair value distribution, contains information not accessible through the traditional market factors. The LSV factor significantly increases the explanatory and the predictive power of factor models estimated on portfolios and individual stock returns.

Uncertainty in Firm Valuation and a Cross-Sectional Misvaluation Measure

In valuation analysis, the degree of uncertainty associated with the value of a company is as important as the value itself. We propose an original and robust methodology for company market valuation which replaces the traditional point estimate of the conventional Discounted Cash Flow model with a probability distribution of fair values that conveys information about both the expected value of the company and its intrinsic uncertainty. Our methodology depends on two main ingredients: an econometric model for the company revenues and a set of firm-specific balance sheet relations that are estimated using historical data. We explore the effectiveness and scope of our methodology through a series of statistical exercises on publicly traded U.S. companies. At firm level, we show that the fair value distribution derived with our methodology constitutes a reliable predictor of company’s future abnormal returns. At market level, we show that a long-short valuation (LSV) factor, built using buy-sell recommendations based on the fair value distribution, contains information not accessible through traditional market factors. The LSV factor increases significantly the explanatory and predictive power of factor models estimated on portfolios and individual stocks returns.

Mispricing or growth? an empirical analysis of acquisition premium

Comparing acquisition premium paid by private equity (PE) and non-PE bidders, we find that PE bidders offer significantly lower premium. Using short interest as a market misvaluation measure, we find that lower premium from PE bidders is associated with larger market misvaluation of the targets. In addition, we use a multiples-based market-to-book decomposition of Rhodes-Kropf, Robinson, and Viswanathan (RKRV, 2005), and find that private equity bidders would adjust acquisition premium based on firm level misvaluation and the long-term growth value of the targets. Our results suggest that the skill of private equity bidders play an important role in acquisitions.

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.

Investor Overconfidence, Firm Valuation, and Corporate Decisions

Behavioral theory predicts that investor overconfidence leads to overpricing because overconfident investors overestimate the quality of their information and underestimate risk. We test this prediction by using a measure of investor overconfidence derived from the characteristics and holdings of U.S. equity mutual fund managers. We find that firms with more overconfident investors are relatively overvalued based on the market-to-book ratio and a misvaluation measure. The result is stronger among stocks with greater mutual fund ownership, particularly by active mutual funds. Firms with more overconfident investors also exhibit lower subsequent stock returns, issue more equity, and invest more. Overall, our findings suggest that investor overconfidence is significantly related to firm valuation and corporate decisions. The Internet appendix is available at https://doi.org/10.1287/mnsc.2017.2806 . This paper was accepted by Neng Wang, finance.

Real activities manipulation and firm valuation

In this paper, we study the link between real earnings management and firm value. Consistent with prior studies, we expect the ability of a firm to generate future cash flows to be significantly impaired by its use of real activities manipulations. Using a cross-section of companies from the Standard & Poor’s Compustat database from 1990 to 2013, we find that firms with higher real earnings management are associated with lower industry-adjusted Tobin’s Q and firm-specific misvaluation measure. Our results are consistent under several regression techniques addressing potential endogeneity issues and alternative proxies for real earnings management after controlling for known factors to affect firm market values.

Pricing deviation, misvaluation comovement, and macroeconomic conditions

We measure an individual stock’s misvaluation based on the deviation of its price from predicted intrinsic value. Both under- and overvalued stocks identified by this misvaluation measure exhibit greater valuation uncertainty and arbitrage difficulty, and the misvaluation measure strongly predicts stock returns incremental to size, book-to-market ratio, past returns, and various return anomalies. Based on the misvaluation measure, we form a misvaluation factor and find that stock return covariances with this factor possess significant and robust return predictive power. We further show that the misvaluation factor predicts future economic conditions, providing additional insight into the real effect of systematic misvaluation in the stock market.

Overvalued Equity and Financing Decisions

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.

Pricing Deviation, Misvaluation Comovement, and Macroeconomic Conditions

We measure individual stocks' misvaluation based on their firm-specific deviations from predicted intrinsic values. The misvaluation measure exhibits association with stocks' valuation uncertainty and arbitrage difficulty, and has significant power to forecast stock returns incremental to size, book-to-market ratio, momentum, and various return anomalies. Based on the misvaluation measure, we form a misvaluation factor and find that stocks' return covariances with this factor strongly predict the cross-section of returns even after the control of stocks' sensitivities to other return factors. We further show that the misvaluation factor and market-wide misvaluation waves predict future macroeconomic conditions, which provides further insights into the pricing of systematic misvaluation in the market.

Fundamentals, Misvaluation, and Business Investment

Does stock market misvaluation affect business fixed investment? To answer this question, we provide evidence based on U.S. firm‐level panel data. We examine the orthogonality conditions for the investment Q and Euler equations, and our qualitative tests reject the null hypothesis that investment is unaffected by misvaluation (this result is not driven exclusively by the late 1990s). To measure the quantitative effects on investment, we introduce a measure of misvaluation into standard investment equations. Our estimates imply that a one‐standard‐deviation increase in misvaluation increases investment between 20% and 60% relative to the mean level of investment in the sample.

Overvalued Equity and Financing Decisions

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.

Investor Psychology and Misvaluation Comovement

In this paper we measure stock misvaluation following Rhodes-Kropf et al. (2005) and examine its relation to stock returns. We find that the misvaluation measure has incremental explanatory power for future returns over size, book-to-market ratio, momentum, and the share issuance effect. Based on the misvaluation measure, we form a misvaluation factor by longing undervalued stocks and shorting overvalued stocks, and find that stock covariances with this factor predict future returns. The properties of stocks with different degrees of misvaluation are investigated, and the evidence is consistent with the argument that stock misvaluation is caused by investor overreaction. Lastly, we show that the negative relation between idiosyncratic risk and return documented by Ang et al. (2006, 2009) is conditional on stock misvaluation.

The Timing of Stock Repurchases

Recent evidence indicates that cycles in valuation and managers ability to time the market partly explain the pattern of many corporate financing activities, such as equity issuances and mergers. In this paper, we challenge the importance of market timing in driving financing waves by examining the aggregate pattern of stock repurchases. We focus on repurchases because, though repurchases involve the opposite transaction, the pattern of repurchases mirrors that of equity issuances and mergers. We show that stock repurchase waves are not driven by potential misvaluations. Specifically, we show that market and relative returns, equity share in new issuances, the number of IPOs in a given year, the closed end fund discount, and relative market to book ratios do not explain the time-series of aggregate repurchases. To understand this result, we evaluate each of these measures of market timing relative to the pricing error from a present value model of cash flows and discount rates and show that the pricing error behaves more like a measure of misvaluation than the market timing measures. However, it too does not explain aggregate repurchase activity. Rather, we show that variations in repurchase activity are driven by changes in business cycles.

Market Misvaluation and Merger Activity: Evidence from Managerial Insider Trading

This paper tests the empirical predictions of the market misvaluation theory of mergers advanced by Rhodes-Kropf and Vishwanathan (2004) and Shleifer and Vishny (2003) using data on managerial insider trading around merger announcements. I first present evidence of opportunistic insider trading by acquirer-firm managers prior to mergers. Acquirer-firm managers abnormally increase their selling prior to stock mergers suggesting those deals might be overvalued. I then construct a misvaluation measure based on the magnitude and direction of managerial trades prior to the merger and use it to test the empirical predictions of the misvaluation theory. To the extent that managerial trading is motivated by misvaluation, I find consistent differences in the merger characteristics and long-run returns of overvalued and undervalued firms. Overvalued firms are more likely to conduct stock mergers, have high pre-merger but negative post-merger excess long-run returns and receive negative market reaction to their acquisition announcements. My results support the theory that market misvaluation affects merger activity.

The Decline of Inflation and the Bull Market of 1982-1999

If stocks were severely undervalued in the late 1970s and early 1980s, then the bull market starting in 1982 was partly just a correction to more normal valuation levels. This paper tests the hypothesis that investors suffer from inflation illusion, resulting in the undervaluation of equities in the presence of inflation, with levered firms being undervalued the most. Using firm level data and a residual income/EVA model, we find evidence that errors in the valuation of levered firms during inflationary times result in depressed stock prices. Our misvaluation measure can be used with expected inflation to make statistically reliable predictions for real returns on the Dow during the subsequent year. Our model suggests that stocks were overvalued at the end of the 1990s.