Stock mispricing and corporate investment decisions

Abstract

This study analyzes the effect of stock market mispricings on corporate investment decisions. Particularly, this study addresses the three possible explanations of the relation between mispricings and corporate investments that are mentioned in Morck, Shleifer and Vishny (1990) and Stein (1996). The study finds evidence supporting the three explanations: Managers' market timing activities, managers' catering behavior, and managers' confusion about the future state of the industry.

By decomposing the market to book ratio into firm mispricing, industry mispricing, and growth components, the study shows that corporate investment decisions are determined by all of these components after controlling for financial slack. In addition, the study finds that corporate investments in general are determined by market timing-motivated equity and debt transactions. Consistent with our predictions, the study shows that the relation between mispricing and investment is more pronounced in financially constrained firms and in firms held by short horizon shareholders. Further testing the types of investment distortions caused by stock mispricing, the study finds that firms overinvest in capital expenditure, R&D, and acquisitions but underinvest in capital expenditure and R&D only. In addition, overvalued firms tend to reduce their fixed assets less while undervalued firms tend to reduce their current assets more.