A Financing-Based Misvaluation Factor and the Cross-Section of Expected Returns

Abstract

Behavioral theories suggest that investor misperceptions and market mispricing will be correlated across firms. We use equity and debt financing to identify common misvaluation across firms. A zero-investment portfolio (UMO, undervalued minus overvalued) built from repurchase and issue firms captures comovement in returns beyond that in some standard multifactor models, and substantially improves the Sharpe ratio of the tangency portfolio. Loadings on UMO incrementally predict the cross-section of returns on both portfolios and individual stocks, even among firms not recently involved in external financing activities. Further evidence suggests that UMO loadings proxy for the common component of a stock's misvaluation. (JEL G12, G14) Several recent behavioral models predict commonality in the misvaluation of firms. In the style investing approach of Barberis and Shleifer (2003), commonality in misvaluation arises when irrational investor enthusiasm for stock characteristics shifts, inducing positive comovement among stocks with similar characteristics and negative comovement in stocks with dissimilar characteristics. In the overconfidence approach of Daniel, Hirshleifer, and Subrahmanyam (2001), investors misinterpret what they perceive to be private information The article was previously entitled "Equity Financing, Commonality in Misvaluation, and the Cross-Section of Stock Returns." We appreciate helpful comments and suggestions from

The Effects of Institutional Investor Objectives on Firm Valuation and Governance

“…These effects persist after controlling for common firm characteristics that may impact firm valuation and after considering alternative explanations such as perceived growth opportunities. In the appendix, we obtain similar results using alternative definitions of overvaluation and misvaluation based on the Hirshleifer and Jiang (2010) undervalued minus overvalued factor. 3 We posit that the differential impact of transient versus dedicated institutional investors on subsequent firm overvaluation and misvaluation is driven by differences in information gathering.…”

“…As expected, Momentum Returns, itself, increases firm overvaluation significant at the 1% level as firms experiencing upward 15 Momentum may increase firm-specific error due to an exacerbation of true misvaluation or due to a mechanical increase in firm-specific error caused by the slower adjustment of valuation multiples in the RKRV valuation model relative to market value. The fact that our results hold when using the alternative misvaluation measure based on Hirshleifer and Jiang (2010) that has a faster adjustment period provides additional evidence against the second possibility.…”

“…Finally, Columns (5) and (6) of Table VI We test the robustness of our findings by repeating the analysis in Table VI using an alternative measure of overvaluation and misvaluation based on Hirshleifer and Jiang (2010). Appendix B.1 details the methodology and results.…”

“…As such, there is a potential dual-hypothesis problem regarding our choice of valuation model. We address this issue by considering an alternative measure for overvaluation and misvaluation based on insider information from Hirshleifer and Jiang (2010) in the appendix.…”

“…In particular, Section B.1 presents findings using an alternative measure of misvaluation based managerial issuance and repurchase behavior following Hirshleifer and Jiang (2010). Section B.2 presents matched-firm results by misvaluation to rule out self-selection of institutional investor types into misvalued firms.…”