Myopic market pricing and managerial myopia

• Author: Alexandre Garel
• DOI: http://doi.org/10.1111/jbfa.12262
• Published date: 01 October 2017
• Date: 01 October 2017

DOI: 10.1111/jbfa.12262

Myopic market pricing and managerial myopia

Alexandre Garel

AucklandUniversity of Technology, New Zealand

Correspondence

AlexandreGarel, Auckland University of

Technology,FinanceDepartment, 55 Welles-

leySt E, Auckland, 1010, New Zealand.

Email:alexandre.garel@aut.ac.nz

JELClassification: G10, G19, G30

Abstract

This paper develops a firm-level measure of myopic marketpricing,

which captures the extent to which the market overvalues short-

term expected abnormal earnings relative to longer-term ones. The

empirical analysis shows that myopically priced firms manage earn-

ings more actively and investless in R&D. The impact of myopicmar-

ket pricing is concentrated in firms where managers cater more to

marketpricing, that is, in firms with greater short-term investor own-

ership, with CEO compensation that is more sensitive to the firm

share price, and with higher equity dependence. Additional tests

show that these findings are robust to the consideration of market

(under)overpricing.The results suggest that when managers cater to

market pricing, marketmyopia encourages managerial myopia.

KEYWORDS

earnings management, investment, mispricing, myopia, short-

termism

1INTRODUCTION

A recent stream of papers revisits the real effects of financial markets on corporate decisions (for a review,see Bond,

Edmans, & Goldstein, 2012). One central question is whether the stock-market mispricing of firm value affects corpo-

rateinvestment decisions. In this paper, we investigate whether myopically priced firms alter their earnings and invest-

ment decisions.

A myopic stock market overvalues short-term expected cash flows relative to longer-term ones (Miles, 1993).

Because the market value of myopically priced firms depends relatively more on short-term expected earnings, we

expect managers of such firms to be more likely to increase short-term expected earnings and to reduce long-term

expected earnings. Thus, we hypothesize that managers of myopically priced firms reduce R&D expenditures,a type

of investment that generates cash flows in the long term but depreciates short-term earnings expectations and over

which managers have more discretion (e.g., Bushee, 1998; Mizik, 2010). We also predict that managers of myopically

priced firms resort more to earnings management to increase short-term earnings expectations.We expect the impact

of myopic pricing on firm decisions to be concentrated in firms where managers are more concerned about the short-

term valuation of the firm. In particular,we expect managers to cater more to myopic market pricing when short-term

investorownership is greater, when managerial compensation is more sensitive to the firm share price, and when there

is a higher need of external funds to finance marginal investment (e.g., Baker, Greenwood, & Wurgler, 2009; Baker,

Stein, & Wurgler, 2003; Baker & Wurgler,2002, 2004a, 2004b; Derrien, Kecskés, & Thesmar, 2013; Polk & Sapienza

2009; Stein 1996).

1194 c

2017 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2017;44:1194–1213.

GAREL 1195

To empirically test these predictions, we develop a measure ofmyopic market pricing at the firm level. We start

from the Ohlson (1995) valuation model and express the value of a firm as the sum of its book value plus discounted

short-term and long-term expected abnormal earnings. Then, for each firm-quarter,we estimate the weights on short-

term and long-term expected abnormal earnings. Finally,we compute the absolute ratio of the weight on short-term

expectedabnormal earnings to the weight on long-term ones.1If this ratio is significantly greater than one, we consider

the firm to be priced myopically by the market.2Bydefinition, myopically priced firms should have a stock price more

sensitive to short-term earnings news. Weinvestigate whether this is indeed the case for the group of firms we identify

as being myopically priced by the market. Using a matching procedure, the empirical analysis revealsthat myopically

priced firms experiencestronger market reactions to earnings announcements than comparable non-myopically priced

firms. This finding validates our measure of firm-level myopicpricing.

To investigatethe impact of myopic pricing on firm R&D expenditures and earnings management, we regress the

firm policy of interest on standard control variables (size, leverage,market-to-book, cash flows, risk, institutional own-

ership, industry, and year) plus a dummy variable indicating whether the firm is myopicallypriced by the market. We

employ discretionary accruals as a proxy for earnings management (e.g., Bergstresser & Philippon, 2006; Dechow,

Sloan, & Sweeney, 1995; Gopalan, Milbourn, Song, & Thakor, 2014). We use a sample of 2,028 US firm-year obser-

vations for which we are able to compute the dependent and independent variables over the 2008–2014 period. In

this sample, 22% of the firm-quarter observations are priced myopically.Our empirical analysis reveals that myopically

priced firms manage their earnings significantly more and cut their R&D expenditures significantly more. This effect

is economically meaningful. For instance, myopically priced firms invest 12% less in R&D than non-myopicallypriced

firms. Takentogether, these results are suggestive of myopicallypriced firms favoring higher short-term earnings over

investments that yield remote cash flows. They are consistent with market myopia encouraging managerial myopia

(e.g., Bushee, 1998; Stein, 1989).

Tostudy whether the effect of myopic pricing depends on how much the manager cares about the firm’s short-term

valuation, we split our sample into two groups according to the median value of short-term investor ownership, equity

dependence, and the sensitivity of CEO compensation to the firm share price. We measure short-term investor own-

ership based on institutional investors’ portfolio turnover (e.g., Derrien et al., 2013; Gaspar,Massa, & Matos, 2005),

we measure equity dependence using the Kaplan and Zingales (1997) score, and we measure the sensitivity of CEO

compensation to the firm share price using the Bergstresser and Philippon (2006) incentive ratio. The results of the

empirical analysis indicate that the impact of myopic pricing on R&D expenditures and earnings management is con-

centrated in firms where managers cater to marketpricing.

A potential concern with our results is that they could be driven by stock (under)overpricing, which has been

empirically associated with (less) more investment (e.g.,Campello & Graham, 2013; Edmans, Goldstein, & Jiang, 2012;

Gilchrist, Himmelberg, & Huberman, 2005; Hau & Lai 2013). Our firm-level indicator of marketmyopia is by construc-

tion immune to an overall(under)overpricing of firm expected cash flows. However, to demonstrate more directly that

the effect of myopic pricing is robust to the consideration of the effect of overpricing,we add future excess returns to

our previous regressions as a proxyfor overpricing (e.g., Baker et al., 2003; Derrien et al., 2013; Polk & Sapienza, 2009).

When we control for overpricing, we still find a significant negativeimpact of myopic pricing on R&D expenditures and

a positive one on earnings management.

This paper incrementally contributes to the literature on market myopia. Researchers haveinvestigated the exis-

tence of market myopia on the UK, US, German, Japanese, and Australian markets using a market-level measure of

market myopia (Abarbanell & Bernard, 2000; Black & Fraser, 2002; Cuthbertson, Hayes, & Nitzsche, 1997; Davies,

Haldane, Nielsen, & Pezzini, 2014; Miles, 1993). This prior literature is inconclusive regarding whether stock markets

are myopic. Using a firm-level measure of myopicpricing, we show that the market does price some firms myopically.

1Weuse an absolute ratio to account for the potential market general (under)overvaluation of expected cash flows (Chou & Guo, 2004).

2That is, $1 of discounted short-term expected abnormal earnings is significantly more impounded into its stock price than $1 of discounted long-term

expectedabnormal earnings.