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

Date01 February 2014
Published date01 February 2014
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
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:
C2014 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
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.

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