Stock Overvaluation Research Articles

Adding Value in Student-Managed Funds: Benchmark and Sector Selection

Student managed portfolios offer a practical learning environment but often miss opportunities for outperformance. We provide several recommendations for structuring fund trades to enhance the pedagogical experience for the students in addition to generating alpha. A strategy that targets mid cap stocks offers favorable risk-return characteristics and focuses on a market capitalization category that receives relatively less attention from professional money managers. Furthermore, a formal sector allocation strategy provides an additional source of portfolio outperformance when utilizing a metric that is robust to differences in companies across sectors. We document the high relative return dispersion among sectors in mid cap stocks and show that EV/EBITDA is a consistently effective ratio in both identifying undervalued and overvalued stocks.

Implied Cost of Capital versus Fundamental Valuation Efficiency: A Clarification and Empirical Implications

As the proxy for expected return, the implied cost of capital (ICC) is subject to a mispricing-driven measurement error because the price of a stock used to compute ICC can deviate from its intrinsic value. For undervalued stocks, the mispricing-driven measurement error is positive and increases with the degree of undervaluation while for overvalued stocks, the mispricing-driven measurement error is negative and decreases with the degree of overvaluation. Therefore, ceteris paribus, lower ICC is equivalent to higher (lower) fundamental valuation efficiency (FVE) for undervalued (overvalued) stocks. Furthermore, our evidence, based on 11 constructs, shows that the estimated relation of an FVE-associated construct with ICC is a potentially biased estimate of its relation with expected return because its estimated relation with ICC also captures its relation with the mispricing-driven measurement error, the sign of which switches between undervalued and overvalued stocks. Existing methods do not seem able to address the bias.

Idiosyncratic volatility, returns, and mispricing: No real anomaly in sight

Recent empirical evidence has shown that the relationship between idiosyncratic volatility and a stock's expected return depends on the pricing of the stock: it is negative among overvalued stocks and positive among undervalued ones. We provide both theoretical and numerical evidence that this risk-return relationship might be driven purely by mathematical properties of return distributions. Using a simulation-based approach, we document that even in completely random samples, the correlation between idiosyncratic risk and mean returns depends on the ex-post estimation of abnormal returns.

Short sale constraints, dispersion of opinion, and stock overvaluation: Evidence from earnings announcements in China

Using a clean setting in China, we test the Miller (1977) hypothesis that stocks are overvalued in the presence of short sale constraints and dispersion of opinion as an extension of Berkman et al. (2009). We find that stocks with short sale constraints have significantly negative abnormal returns during earnings announcement periods, especially when investors have diverse opinions. These results are robust to alternative measures of abnormal returns and endogeneity concern. The findings help to explain the impact of short sale constraints on pricing efficiency and have important policy implications for relaxing restrictions on short selling and improving regular information disclosure in emerging markets.

Alternative Profitability Measures and Cross Section of Expected Stock Returns: International Evidence

This paper provides an extensive international analysis of the cross-sectional return predictive power of a variety of firm-level profitability measures, calculated from different combinations of three important measures of earnings (gross profit, operating income, and EBIT) and four scaling variables (enterprise value, book value of assets, market value of equity, and book value of equity). The sample covers stock-returns data over the period 1991-2016 from four regions in the world: North America, Europe, Japan and Asia Pacific. Regarding the scaling measure, we find that irrespective of the choice of a profit measure, the cross-sectional predictive relation of firm profitability and stock returns is more pronounced when profits are scaled by enterprise value or market value of equity. Regarding the profit measure, we find that the predictive power is more pronounced when profit is measured by gross profit. Our findings are consistent with the hypotheses that the predictive power of “profits-to-market price” factor is partly attributable to stock overvaluation arising from systematic behavioral biases and partly to the choice of a “clean” measure of earnings.

The Magic Formula: Value, Profitability, and the Cross Section of Global Stock Returns

Buying profitable, undervalued stocks and shorting unprofitable, overvalued stocks yields significant return differentials in North America, Europe, Japan, and Asia. Using data from 1991-2016, we test Greenblatt’s (2006) “Magic Formula” (MF) and find that a modified MF which uses gross profits as a measure of profitability yields significant abnormal returns for all size groups and in all regions. Results from double sorts and Fama-MacBeth regressions show that MF explains the cross-section of returns in addition to size, book-to-market and momentum.

Why Do Serial Acquirers Switch Methods of Payment?

Serial acquirers conduct the vast majority of acquisitions in the U.S. Serial acquirers appear to strategically shift between methods of payment based on changes in their own characteristics, using overvalued stock in stock-financed acquisitions during short windows of opportunity. Acquirer overvaluation increases the speed to the next acquisition and the propensity to pay with stock. The market reacts positively to the initial stock-financed acquisitions by overvalued acquirers. As the overvaluation of stock acquirers declines while they complete more deals, they accelerate the speed to the next acquisition. Acquirers that pay with overvalued stock experience negative excess returns when the acquisition spree goes on too long.

The effects of expectations-based monetary policy on international stock markets: An application of heterogeneous agent model

This study develops an empirical approach to measuring the monetary policy effectiveness for price stability based on stock market expectations. First, we use the fraction of fundamentalists estimated by the model of heterogeneous agents as an indicator of agents' predictions of stock market movements. When the expectations of fundamentalists are the only basis for interest rate policy decision making, our results in seven countries show that those with an overvalued stock price use tight monetary policy so than the price falls to the fundamental level, and countries with an undervalued stock price use expansionary monetary policy so the price increases to the fundamental level. Furthermore, the stock price in the next six months in these countries continues to show a negative reaction to expectations-based monetary policy. In addition, in countries not subject to the influence of monetary policy based on the expectations of fundamentalists, our survey results showed that within the next three months, in more than 33% of cases, stock prices reacted negatively to policy. In short, the effect of expectations-based interest rate policy on price stability is superior to adjustments in the policy rate by monetary policy committees. Our results remain robust following a series of additional tests.

The role of analyst forecasts in the momentum effect

We evaluate the extent to which sell-side equity analysts can facilitate market efficiency when there is increasing uncertainty about a stock's future value. The prevalence of the 52-week-high momentum anomaly, that can be largely attributed to information uncertainty, provides a setting for examining the value and timing of analysts' earnings forecast revisions. Our study finds that analysts can provide value-relevant signals to investors by picking up indicators of momentum. The ability to identify under or over-valued stocks suggests that analysts are important information intermediaries in the price-continuation momentum effect. However, we also observe pervasive asymmetric reaction to good and bad news throughout our study that is consistent with incentive-driven reporting and optimistic biases. Nevertheless, analysts' forecast revisions are informative at different stages to re-establish stock prices back to their fundamental valuation.

Institutional investors: Arbitrageurs or rational trend chasers

This paper studies the relationship between institutional investor holdings and stock misvaluation in the U.S. between 1980 and 2010. I find that institutional investors overweigh overvalued and underweigh undervalued stocks in their portfolio, taking the market portfolio as a benchmark. Cross-sectionally, institutional investors hold more overvalued stocks than undervalued stocks. The time-series studies also show that institutional ownership of overvalued portfolios increases as the portfolios' degree of overvaluation. As an investment strategy, institutional investors' ride of stock misvaluation is neither driven by the fund flows from individual investors into institutions, nor industry-specific. Consistent with the agency problem explanation, investment companies and independent investment advisors have a higher tendency to ride stock misvaluation than other institutions. There is weak evidence that institutional investors make a profit by riding stock misvaluation. My findings challenge the models that view individual investors as noise traders and disregard the role of institutional investors in stock market misvaluation.

Should Investors Focus Their Attention on the Japanese Financial Statement?

Local and overseas investors have a high interest in the mature and developed Japanese stock market environment. Since some financial information is private information and hard to collect, published financial statements may be the only effective way for investors to better understand Japanese firm. However, few articles investigate the fundamental analysis of Japanese financial statements. This study aims to raise investors’ attention on how to improve their investment performance by using fundamental analysis on the Japanese financial statement. In addition, this study can provide valuable contribution to global researchers by improving some aspects of fundamental analysis methodologies. In this study, we use the cross-sectional model (logit model) to test the relationship between firms’ stock price (one-year-ahead earnings increase) and massive of variables picked from financial statements, and we then develop two types of firm valuation models for predicting stock returns, which is suitable for the Japanese market. Furthermore, we construct three kinds of investment portfolios based on the valuation models, and we find some meaningful ones among those, thus lead to better trading strategies. We find that there is a potential for making abnormal profits by distinguishing between undervalued and overvalued stocks, and forecasting one-year-ahead earnings changes. We also find that there is a relatively higher potential for making abnormal profits by combining the results of two different models (cross-sectional and logit model), which confirm that there is a modeling synergy effect between the trading strategies. The results of further analysis show that alternative trading strategies and subsample analysis in some aspects can increase trading profitability. Our methods and findings may inspire both investor and researchers’ enthusiasm for fundamental analysis based on financial statements.

Institutional Investors: Arbitrageurs or Rational Trend Chasers

This paper studies the relationship between institutional investor holdings and stock misvaluation in the U.S. between 1980 and 2010. I find that institutional investors overweigh overvalued and underweigh undervalued stocks in their portfolio, taking the market portfolio as a benchmark. Cross-sectionally, institutional investors hold more overvalued stocks than undervalued stocks. The time-series studies also show that institutional ownership of overvalued portfolios increases as the portfolios' degree of overvaluation. As an investment strategy, institutional investors' ride of stock misvaluation is neither driven by the fund flows from individual investors into institutions, nor industry-specific. Consistent with the agency problem explanation, investment companies and independent investment advisors have a higher tendency to ride stock misvaluation than other institutions. There is weak evidence that institutional investors make positive profit by riding stock misvaluation. My findings challenge the models that view individual investors as noise traders and disregard the role of institutional investors in stock market misvaluation.

The Role of Analysts' Forecasts in the Momentum Effect

We evaluate the extent to which sell-side equity analysts can facilitate market efficiency when there is increasing uncertainty about a stock’s future value. The prevalence of the 52-week-high momentum anomaly, which can be largely attributed to information uncertainty, provides a setting for examining the value and timing of analysts’ earnings forecast revisions. Our study finds that analysts can provide value-relevant signals to investors by picking up indicators of momentum. The ability to identify under or over-valued stocks suggests that analysts are important information intermediaries in the price-continuation momentum effect. However, we also observe pervasive asymmetric reaction to good and bad news throughout our study that is consistent with incentive-driven reporting and optimistic biases. Nevertheless, analysts’ forecast revisions are informative at different stages to re-establish stock prices back to their fundamental valuation.

Dividend changes and stock price informativeness

We investigate how private information in stock prices impacts quarterly dividend changes. We find that the positive relationship between past returns and current dividend changes strengthens when returns convey more private information. This finding is robust to the use of several price informativeness measures and the inclusion of managerial private information and stock overvaluation measures. Managers seem to learn new information from stock prices that they use when deciding on their dividend policy. This study highlights private information in stock prices as an important determinant of dividend policy and contributes to the literature on the real effects of financial markets.

Do residual earnings price ratios explain cross-sectional variations in stock returns?

Purpose – Variations in price/earnings (P/E) ratios are explained in a rational expectations framework by a number of fundamental factors, such as differences in growth expectations and risk. The purpose of this paper is to use a regression model and data from four sample periods (1996, 2000, 2001, and 2008) to separate the earnings/price (E/P) ratio into two parts – the portion of E/P that is related to fundamental determinants and a residual portion that cannot be explained by fundamentals. The authors use the residual portion as an indicator of over or undervaluation; a large negative residual is consistent with overvaluation while a large positive residual implies undervaluation. The authors find that stocks with larger negative residuals are associated with lower subsequent returns and reward-to-risk ratio, while stocks with larger positive residuals are associated with higher subsequent returns and reward-to-risk ratio. This pattern persists for both one and two-year holding periods. Design/methodology/approach – This study uses a regression methodology to decompose E/P into two parts – the portion of E/P than is related to fundamental determinants and a residual portion that cannot be explained by fundamentals. Focussing on the second portion allows us to isolate a potential indicator of stock over or undervaluation. Using a sample of stocks from four time periods (1996, 2000, 2001, and 2008, the authors calculate the residuals from a regression model of the fundamental determinants of cross-sectional variation in E/P. These residuals are then ranked and used to divide the stock sample into deciles, with the first decile containing the stocks with the highest negative residuals (indicating overvaluation) and the tenth decile containing stocks with the highest positive residuals (indicating undervaluation). Total returns for subsequent one and two-year holding periods are then calculated for each decile portfolio. Findings – The authors find that high positive residual stocks substantially outperform high negative residual stocks. This is true even after risk adjustments to the portfolio returns. The residual E/P appears to accurately predict relative stock performance with a relatively high degree of accuracy. Research limitations/implications – The findings of this paper provide some important implications for practitioners and investors, particularly for the stock selection, fund allocations, and portfolio strategies. Practitioners can still rely on a valuation measure such as E/P as a useful tool for making successful investment decisions and enhance portfolio performance. Investors can earn abnormal returns by allocating more weights on stocks with high E/P multiples. Portfolios of high E/P multiples or undervalued stocks are found to enjoy higher risk-adjusted returns after controlling for the fundamental factors. The most beneficial performance holding period return will be for a relatively short period of time ranging from one to two years. Relying on the E/P valuation ratios for a long-term investment may add little value. Practical implications – Practitioners and academics have long relied on the P/E ratio as an indicator of relative overvaluation. An increase in the absolute value of P/E, however, does not always indicate overvaluation. Instead, a high P/E ratio can simply reflect changes in the fundamental factors that affect P/E. The authors find that stocks with larger negative residuals are associated with lower subsequent returns and coefficients of variation, while stocks with larger positive residuals are associated with higher subsequent returns and coefficients of variation. This pattern persists for both one and two-year holding periods. Originality/value – The P/E ratio is widely used, particularly by practitioners, as a measure of relative stock valuation. The ratio has been used in both cross-sectional and time series comparisons as a metric for determining whether stocks are under or overvalued. An increase in the absolute value of P/E, however, does not always indicate overvaluation. Instead, a high P/E ratio can simply reflect changes in the fundamental factors that affect P/E. If interest rates are relatively low, for example, the time series P/E should be correspondingly higher. Similarly, if the risk of a stock is low, that stock’s P/E ratio should be higher than the P/E ratios of less risky stocks. The authors examine the cross-sectional behavior of the P/E (the authors actually use the E/P ratio for reasons explained below) after controlling for factors that are likely to fundamentally affect this ratio. These factors include the dividend payout ratio, risk measures, growth measures, and factors such as size and book to market that have been identified by Fama and French (1993) and others as important in explaining the cross-sectional variation in common stock returns. To control for changes in these primary determinants of E/P, the authors use a simple regression model. The residuals from this model represent the unexplained cross-sectional variation in E/P. The authors argue that this unexplained variation is a more reliable indicator than the raw E/P ratio of the relative under or overvaluation of stocks.

Analyst Forecast Skewness and Cross Section Stock Returns

In the paper, we show a signicant economic linkage between analyst EPS forecast skewness and cross section stock returns. The eect on stock return of our skewness measure is quite dierent from that based on skewness calculated from options or high frequency data. Literature shows that, using such skewness as a signal, trading prot is generated mostly from over-valued stocks with high positive skewness, which is consistent with Barberis and Huang (2008)’s lottery arguments. However, we nd that for our analyst forecast skewness, trading prot mainly comes from those stocks with negative skewness. Long-short strategy purchasing stocks with low forecast skewness and shorting those with high forecast skewness earns annualized abnormal returns 11% with sharpe ratio 0.64. Our study suggests that negative skewness stocks tend to be undervalued (risk-adjusted returns for negative skewness stocks are signicantly positive), while stocks with high positive skewness have fair prices (risk-adjusted returns for positive skewness stocks are not signicant). Our empirical results are closely related with investors learning behavior and consistent with Veronesi (1999) theory. In the model, Veronesi shows

Failures to Deliver, Short Sale Constraints, and Stock Overvaluation

AbstractStudying a large sample of publicly available data on failures to deliver, we find that stocks reaching threshold levels of failures become significantly overvalued. Where short sale constraints are especially binding, we report extreme overpricing and subsequent reversals. These findings support the overvaluation hypothesis, although the mispricing is likely to be difficult to arbitrage because of extreme shorting costs. In addition, threshold stocks with low short interest become more overvalued than threshold stocks with high short interest. This suggests that the level of short interest reflects supply‐side effects when the examination conditions on the difficulty of borrowing shares.

Failures to Deliver, Short Sale Constraints, and Stock Overvaluation

Studying a large sample of publicly available data on failures to deliver, we find that stocks reaching threshold levels of failures become significantly overvalued. Where short sale constraints are especially binding, we report extreme overpricing and subsequent reversals. These findings support the overvaluation hypothesis, although the mispricing is likely to be difficult to arbitrage because of extreme shorting costs. In addition, threshold stocks with low short interest become more overvalued than threshold stocks with high short interest. This suggests that the short interest reflects supply-side effects when the examination conditions on the difficulty of borrowing shares.

Small investor sentiment, differences of opinion and stock overvaluation

Recent research shows that small trade imbalances are negatively associated with future stock returns. I find that this negative association only exists when stocks have initially been mispriced. In addition, mispricing occurs before the sentimental trading of small investors. In stocks with high opinion divergence, buying pressure from small investors deters the realization of negative information. Therefore, trades from retail investors do not directly cause mispricing, but they prevent price discovery and facilitate mispricing.

Dividend Changes and Stock Price Informativeness

We investigate how private information in stock prices impacts quarterly dividend changes. We find that the positive relationship between past returns and current dividend changes strengthens when returns convey more private information. This finding is robust to the use of several price informativeness measures and the inclusion of managerial private information and stock overvaluation measures. Managers seem to learn new information from stock prices that they use when deciding on their dividend policy. This study highlights private information in stock prices as an important determinant of dividend policy and contributes to the literature on the real effects of financial markets.