Managerial Behavior and the Link between Stock Mispricing and Corporate Investments: Evidence from Market‐to‐Book Ratio Decomposition

• Date: 01 February 2014
• Published date: 01 February 2014
• DOI: http://doi.org/10.1111/fire.12027

The Financial Review 49 (2014) 89–116

Managerial Behavior and the Link between

Stock Mispricing and Corporate

Investments: Evidence from

Market-to-Book Ratio Decomposition

Mohammed Alzahrani

King Fahd University of Petroleum & Minerals

Ramesh P. Rao∗

Oklahoma State University

Abstract

We examine the impact of mispricing on corporate investments and its components:

capital expenditures, research and development, acquisitions, and asset sales. By decomposing

the market-to-book ratio into mispricing and growth components, we show that corporate

investments are linked to mispricing through market-timing and catering, after controlling for

growth and financial slack. This investment-mispricinglink is more pronounced in financially

constrained firms and in firms with short-horizon shareholders. Overall, our study indicates

that the sensitivity of investments to mispricing is a function of the nature of mispricing, the

type of investment, and the firm’scharacteristics.

Keywords: stock mispricing, financial constraints, investmenthorizon, corporate investments

JEL Classifications: G31, G32, G34, D92

∗Corresponding author: Oklahoma State University,309 Business Building, Stillwater, Oklahoma 74078;

Phone: (405) 744-1385; E-mail: ramesh.rao@okstate.edu.

C2014 The Eastern Finance Association 89

90 M. Alzahrani and R. P. Rao/The Financial Review 49 (2014) 89–116

1. Introduction

The role of stock mispricing on corporate real investments has been the subject

of considerable debate in the corporate finance literature. Stock mispricing occurs

when the stock price deviates from its fundamental value. Investors who assign a

value to the firm’s stock create this deviationwhen they are less informed and/or not

rational. The debate in the literature is on whether rational and informed managers

follow the market value in making their investment decisions even if it differs from

the firm’s fundamental value; and, if theydo, why and when they do it. The classical

view is that CEOs should ignore stock mispricing and base their investment decision

on whether or not it maximizes the fundamental value of the firm. However, the

behavioral school takes the view that managers undertake investmentdecisions based

on cues from the market, even though market prices may deviate from fundamental

values.1

We test the behavioral explanations put forth in the literature as to why and

when managers consider the market value in their investment decisions, and thus

help understand how mispricing affects corporate investment. Specifically, we use

Stein’s (1996) framework to examine the two channels through which mispricing

affects investments, which we label as: market-timing and catering.

The market-timing effect suggests that managers exploit mispricing by issuing

overvalued equity to enjoy a low cost of equity and refrain from issuing undervalued

equity to avoid the high cost of equity. The ability to issue equity at lower cost will

increase investments, encourage managers to exhaust their investment list, and even

accept low quality (negative net present value [NPV]) projects. On the other hand,

managers of undervalued firms will not issue equity, even when they have positive

NPV projects, because of the high cost of undervalued equity.

The catering effect implies that managers cater to the firm’sshort-horizon share-

holders and focus more on the current stock price rather than on the long-run value

of the firm. From the catering perspective, managers increase investments to justify

current high stock prices or decrease unappealing investments to suppress current de-

cline in prices. Unlike market-timing, the catering effect does not necessarily involve

equity issuance or stock repurchase. It is enough to assume that managers pay special

attention to their current stock price when they make their investment decision.

1The assumption that mispricing should be ignored has long been debated in the capital budgeting

literature. Abel and Blanchard (1986) and Bosworth (1975) argue that managers should ignore the side

show provided by the market and thus view mispricing as a distortion of the true impact of market on

investment.Another strand of the literature argues that managers should consider mispricing when making

investment decisions. The logic here is as follows: if mispricing leads to a lower cost of capital relative

to other sources of funds then the manager should invest based on this new cost of capital suggested

by the market (Keynes, 1936; Fischer and Merton, 1984). From another perspective, Panageas (2003)

views mispricing as a speculative part of stock prices and argues that managers should consider both the

fundamental and the speculative parts as sources of value to shareholders and investbased on the part that

will make investors better off.