Essays on mispricing of equity securities

Abstract

Mispricing of equity securities is an area of research with many implications for academicians, individual investors, money managers, and executives. The first essay in this dissertation explicitly studies the consistency of residual income based measures of mispricing and the second essay analyzes several determinants of mispricing. The first essay returns to fundamental principles of valuation by using multiple implementations of the residual income model to estimate intrinsic value. Estimates of intrinsic value are compared to market values and firm years are assigned to valuation deciles using the market's valuation error. Relative valuation decile assignments are very robust to different cost of equity specifications and also to two different earnings and book value specifications. Valuation decile assignments are remarkably persistent over time for the most overvalued and undervalued equities. Application of the valuation deciles to acquisitions produces results consistent with prior published research, indicating that the valuation deciles are capturing mispricing. The second essay assigns firms to valuation deciles for the full 1964-2009 period and examines the determinants of the observed mispricing. The results show that investors systematically overvalue scaled R&D expenditures and undervalue scaled cash flow. In addition, investor sentiment is positively related to overvaluation. However, when sentiment is high, investors undervalue scaled net fixed assets. Standard risk explanations for the observed mispricing are not supported by the results. Altman's Z-Score, leverage, beta, and the standard deviation of return on assets are all positively related to overvaluation, and firm age and firm size are negatively related to overvaluation.