We test whether and how equity overvaluation affects corporate financing decisions using an ex ante misvaluation measure that filters firm scale and growth prospects from market price. We find that equity issuance and total financing increase with equity overvaluation; but only among overvalued stocks; and that equity issuance is more sensitive than debt issuance to misvaluation. Consistent with managers catering to maintain overvaluation and with investment scale economy effects, the sensitivity of equity issuance and total financing to misvaluation is stronger among firms with potential growth opportunities (low book-to-market, high R&D, or small size) and high share turnover.

1. Electronic copy available at: https://ssrn.com/abstract=3179340
Overvalued Equity and
Financing Decisions
Ming Dong*
David Hirshleifer**
Siew Hong Teoh**
*Schulich School of Business, York University
**Merage School of Business, University of
California Irvine

2. Electronic copy available at: https://ssrn.com/abstract=3179340
The Misvaluation Hypothesis
of Corporate Financing
 Overvalued firms raise more capital
 Issue cheap capital for investment
 Direct profit at the cost of new shareholders
 Misvaluation effects should be stronger for
equity issuance than for debt issuance
 Equity is more sensitive to firm value than debt
 Substitution between debt and equity
 Use ex ante misvaluation measure that
filters growth prospects from stock price

3. Stock Prices and Financing:
Previous Empirical Research
 New issues occur after stock price runups
 Eckbo & Masulis (1995)
 Korajczyk, Lucas, McDonald (1991), Bayless & Chaplinsky (1996)
 New issues puzzle – stock underperformance after
new issues
 Loughran and Ritter (1995), Spiess and Affleck-Graves (1995)
 Measurement error, causality
 Overvalued firms invest more
 Baker, Stein, Wurgler (2003), Polk & Sapienza (2006), Gilchrist,
Himmelberg, Huberman (2005), Chirinko & Schaller (2005)
 Indirectly related to financing

4. Previous Empirical Research (cont’d)
 Overvalued firms tend to use equity in takeovers
 Dong, Hirshleifer, Richardson, Teoh (2006)
 What about firms not involved in takeovers?
 Aggregate equity share in new issues negatively
predicts market returns
 Baker and Wurgler (2000), Henderson, Jegadeesh, Weisbach (2006)
 Does not address cross-sectional effects or amount of issues
 Survey evidence
 Graham & Harvey (2001)
 Misvaluation, overconfidence, or private information?
 Financial ratios predict equity issuance / repurchase
 SEO: DeAngelo, DeAngelo, Stulz (2010): M/B
 Repurchase: D’Mello & Shroff (2000): V/P based on ex-post earnings

5. Measures of Misvaluation
 Proxies based on managerial actions
 Accruals choice
 Polk & Sapienza (2004)
 Insider trading
 Jenter (2005)
 New Issues
 Hirshleifer & Jiang (2007)
 Fundamental/Price Ratios
 Baker, Stein, & Wurgler (2003)
 Long-Run Abnormal Returns
 Causality problems
 Controversy over risk benchmarks

6. A “Long-Run” ing Debate
 Abnormal post-event returns 3-5 years after the
event as misvaluation measure
 Reviews:
 Fama (JFE 1998)
 Loughran and Ritter (JF 2000)
 Daniel, Hirshleifer and Teoh (JME 2002)
 Benchmark, compounding, skewness, survivorship
issues
 Barber and Lyon (JFE 1997), Kothari, Sabino, and Zach (2001)
 Especially, causality issues
 Ex ante proxies for misvaluation also informative.

7. Misvaluation Proxies
 We apply:
 Book/Price B/P
 (Residual Income Value)/Price V/P
 Residual income value combines book value
with analyst forecasts of future earnings to
form a discounted valuation of the firm.

8. Motivation for B/P
 Remarkably strong and consistent predictor
of one-month-ahead returns
 B/P is associated with a risk factor
 Disagreement over whether effect can be
rationalized as a pure risk premium
 E.g., MacKinlay (JFE 1995), Chen (2002)
 But see Campbell and Vuolteenaho (2002)
 Distress risk story controversial
 Piotroski (JAR 2000), Griffin & Lemmon (JF 2002)
 Vassalou & Xing (2003), Campbell et al (****)
 … cont. …

9. Motivation for B/P
 B/P effect entirely at later earnings or
pre-announcement dates
 Skinner & Sloan (RAS 2002)
 Risk premium story: most of time high
B/P is risk-free?
 Much of B/P effect associated with
bias in analyst forecasts
 Frankel & Lee (JAE 1998)

10. Motivation for B/P
continued …
 Psychology-based pricing models
 B/P is a return predictor and a proxy for
market mispricing
 Barberis & Huang (JFE 2001)
 Daniel, Hirshleifer & Subrahmanyam (JF 2001)
 Book value helps filter out irrelevant scale
differences from market value (‘size’) 
purer measure of mispricing.
 Daniel, Hirshleifer & Subrahmanyam (JF 2001)

11. Motivation for V/P
 Used as measure of irrational misvaluation in
several studies
 Lee, Myers, & Swaminathan (JF 1999), Frankel &
Lee (JAE 1998), D’mello & Shroff (JF 2000),
Dong, Hirshleifer, Richardson, & Teoh (JF 2006)
 V/P predicts one-month-ahead returns on the
Dow 30 stocks
 Not subsumed by B/M
 Lee, Myers, & Swaminathan (JF 1999)
 …cont. …

12.  V/P predicts cross-section of one-year-ahead
returns
 Frankel & Lee (JAE 1998)
 V/P effect concentrated at subsequent E
announcement dates
 Ali, Hwang & Trombley (AR 2003)
 Standard risk measures or controls do not
subsume ability of V/P to predict returns
 Ali, Hwang & Trombley (AR 2003)

13. V/P is a Conservative Measure
 If analyst forecasts infected with biases
similar to those of investors, V may share
some of P ’s misvaluation.
 E.g.:
 Investors misled by strategic analyst behavior
 Analysts, investors share psychological biases.
 Partial cancellation of mispricing
 Bias tests toward no effect.

14.  Since neither measure perfect, useful to
examine both with a focus on V/P
 corr(B/P, V/P) = 0.16
 V/P filters away effects of growth
opportunities and managerial quality 
Main inferences from V/P
 Keep negative V/P (~6% of sample), which
suggest overvaluation

15. Contributions
Documents, probes economic sources of
relationship between stock prices and financing
 Purified ex ante valuation measure
 Forward-looking V filters out growth, distress, managerial
discipline, risk effects from V/P much better than B/P.
 Examine Equity Issuance (EI) as well as Debt Issuance
(DI)
 Also, Total Issuance (TI) to confirm the net effect
 Evidence of circumstances in which strongest misvaluation
effects on new issues
 Misvaluation level, asset tangibility, share turnover, firm size, and
insider selling

16. Importance of Using V/P
 Low B/P (or, high Tobin’s Q, low
sales/price) associated with high equity
issuance
 Overvalued firms exploit overvaluation to
issue and investment more?
 Baker & Wurgler (2002), Baker, Stein,Wurgler
(2003)
 Market efficient, growth firms issue more
equity?

17. Hypotheses
 H1: EI and TI increase with overvaluation
 H2: EI has a higher sensitivity to
misvaluation than DI
 H3: The sensitivities of EI and TI to
misvaluation are stronger among
overvalued firms

18. Hypotheses
 H4: The sensitivities of EI and TI to misvaluation are
stronger among growth firms
 H5: The sensitivities of EI and TI to misvaluation are
stronger among firms with high R&D
 H6: The sensitivities of EI and TI to misvaluation are
stronger among small firms
 H7: The sensitivities of EI and TI to misvaluation are
stronger among firms with high turnover (short-time
horizon)

19. Sample
 Intersection of CRSP/COMPUSTAT/IBES U.S.
stocks, 1976-2009
 Require both B/P and V/P
 Firms are traded on NYSE, AMEX, or NASDAQ with
share codes 10, 11, 12 (e.g., no ADR, REITS)
 Exclude financial firms
 With both EI and DI
 No restrictions on fiscal year end
 58,178 firm-year observations
 Subsamples sorted by V/P itself, insider selling,
B/P, R&D, share turnover, and size

20. Calculation of V/P
 Fundamental value V
= invested capital B + discounted stream of abnormal
earnings
Invested capital = book value of equity
Abnormal Earnings = Earnings in excess of normal return to
book value = Forecasted Earnings – Normal Earnings
Normal Earnings = re* beginning period book value ; re is
cost of capital
 Residual income model reflects growth, and assumes the
clean surplus equation (i.e. ΔBook value of equity =
Earnings – Dividends).

21. Calculation of V/P
 For each stock in month t, calculate V(t)
 Use same procedure as past researchers
 Use earnings forecast (FEPS) for year +1 and +2;
assume forecast in +3 is perpetuity
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22. Table 2: Descriptive information
Sample 1976-2009
 Pre-1990: DI > EI
 1990s: EI catches up with DI
 2000s: EI > DI (generally)
 After 1992, TI > CF
 Before 1985, V/P < B/P (low valuation)
 After 1991 (except 2001-02), V/P < B/P (high
valuation)

23. Cross-Sectional Tests
 Cross-sectional effects of relative firm misvaluation
on financing decisions
 Avoid spurious effects of time-series swings

24. Full Sample
 B/P or V/P: EI , DI, and TI all higher for
overvalued firms
 Monotonic across B/P or V/P quintiles
 B/P:
 13.66% quintile difference for EI
 10.75% difference for DI.
 EI or DI difference between B/P quintiles may be
due to growth opportunities

25. Full Sample (cont.)
 V/P: EI and DI both higher for overvalued firms, but EI
more valuation-sensitive
 13.39% quintile difference for EI. Largest jump comes from the
most overvalued quintile
 Only 3.23% quintile difference for DI

26. Table 3. New Issues Sorted by Valuation Measures: Full Sample
Valuation Portfolio N Valuation Ratio EI (%) DI (%) TI (%)
Sorting by B/P
1 (Growth) 341.8 0.17 15.48 13.18 28.65
2 342.4 0.34 7.03 9.35 16.38
3 342.5 0.52 4.34 7.38 11.72
4 342.4 0.77 2.95 5.66 8.61
5 (Value) 342.0 1.54 1.81 2.43 4.24
Difference 1 – 5 -1.38 13.66 10.75 24.41
(t-statistic) (5.04) (12.24) (7.24)
βBP = ∆Issuance / ∆(B/P) 10.74 8.54 19.28
(t-statistic) (5.04) (9.25) (6.66)
Sorting by V/P
1 (Overvalued) 341.8 0.03 16.02 9.80 25.83
2 342.4 0.38 6.76 7.96 14.72
3 342.5 0.59 3.70 7.26 10.96
4 342.4 0.83 2.50 6.39 8.89
5 (Undervalued) 342.0 1.41 2.63 6.57 9.21
Difference 1 – 5 -1.38 13.39 3.23 16.62
(t-statistic) (4.15) (3.78) (4.54)
βVP = ∆Issuance / ∆(V/P) 9.25 2.73 11.98
(t-statistic) (5.50) (3.41) (6.22)

27. Table 4. New Issues 2-Way Sorted by Valuation Measures

28. Multivariate Tests

29. Multivariate Tests
 Panel regressions (Table 5): additionally
control for cash flow, leverage, ROA, age, F-F
loadings, and industry
 Simultaneously include B/P, V/P

30. Multivariate Tests
 V/P highly significant in the EI regressions.
 Especially in 1990s
 V/P insignificant in the full sample DI
regression
 Significant and positive pre-1990

31. Table 5. Regressions of New Issues on Valuation Measures: Full
Sample
EI DI TI
V/P -2.56 0.06 -2.50
(-4.82) (0.14) (-3.40)
B/P -4.80 -5.08 -9.88
(-7.67) (-9.71) (-9.91)
CF -0.05 0.08 0.03
(-1.25) (4.42) (0.73)
ROA -0.19 -0.07 -0.26
(-3.91) (-4.81) (-5.18)
LEV -5.12 -2.76 -7.87
(-5.71) (-4.35) (-6.46)
AGE -0.39 -0.23 -0.62
(-8.54) (-7.25) (-9.55)
MKT 1.20 -0.27 0.93
(4.00) (-1.17) (2.22)
SMB 1.81 0.24 2.05
(4.49) (1.73) (4.65)
HML -1.30 0.04 -1.26
(-2.92) (0.24) (-2.35)

32. Factors Affecting the Sensitivity of Issuance to Valuation:
Regression Interaction Tests
EIit = β0 + β1 V/Pit + β2 B/Pit + β3 CFit + β4 ROAit + β5 LEVit + β6
AGEit + β7 MKTit + β8 SMBit + β9 HMLit
+ β10 I(RD)it + β11 V/Pit*I(RD)it + β12 B/Pit*I(RD)it + β13
CFit*I(RD)it + β14 ROAit*I(RD)it
+ β15 LEVit*I(RD)it + β16 AGEit*I(RD)it + β17 MKTit*I(RD)it +
β18 SMBit*I(RD)it + β19 HMLit*I(RD)it + εit
 I(X) is equal to 0.5 if X is in X-quintile 5, and equal to -0.5 if X
is in quintile 1

33. Table 9
Regression Interaction Tests

34. Conclusions (I)
 Evidence provides some support for misvaluation
hypothesis using an overall ex ante measure of
misvaluation that filters out earnings growth prospects
 Overvalued firms seem to raise more capital, especially
equity
 Misvaluation effects on EI and TI concentrated among
overvalued firms
 Consistent with Jensen (2005)

35. Conclusions (II)
 Growth firms and firms with high R&D have higher EI and
TI sensitivities to misvaluation
 Firms with high intangibility are more prone to misvaluation
 Small firms have higher EI and TI sensitivities to
misvaluation
 Small firms may be more prone to misvaluation and catering
pressures
 High-turnover firms have higher EI and TI sensitivities to
misvaluation
 Firms are more pressured to exploit overvaluation when investors
have short horizon