Equity Misvaluation and Default Options

Eisdorfer, Assaf; Goyal, Amit; Zhdanov, Alexei

doi:10.1111/jofi.12748

Cited by 18 publications

(3 citation statements)

References 118 publications

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“…There are several valuation models that may be used to estimate the stock’s intrinsic value, such as Discounted Dividend, Residual Income and Abnormal Earnings Models. However, following RKV (2005), we assume that these models rely on a number of restrictive assumptions that may lead to errors in equity pricing (Ritter and Warr, 2002; Fu et al , 2013; Eisdorfer et al , 2019) and there is no model that may perfectly estimate the stock’s fundamental value, but it helps provide the lowest pricing errors (Anesten et al , 2020). Therefore, we use RKV (2005)’s methodology that decomposes the M/B ratio into three components, to dissociate equity misvaluation from growth opportunities.…”

Section: Research Design and Empirical Resultsmentioning

confidence: 99%

“…RKV (2005)’s approach is derived from the residual income model (RIM) proposed by Ohlson (1995). However, in line with previous research, RKV (2005) acknowledges that the use of RIM may introduce biases and distortions in the estimated model due to its reliance on certain assumptions and the incorporation of analyst earning forecasts for calculating residual income to identify misvaluation (Ritter and Warr, 2002; Fu et al , 2013; Eisdorfer et al , 2019). Consequently, RKV (2005) develops a novel methodology for estimating stock’s intrinsic value, using a similar formula as RIM but using the difference between the firm’s current value and the predicted value as a proxy for misvaluation.…”

Section: Introductionmentioning

confidence: 99%

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Corporate investment sensitivity to equity market misvaluation

Mrad,

Hamza,

Manita

2023

RAF

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Purpose The purpose of this paper is to investigate the effect of equity market misvaluation on manager behavior. Using a sample of 535 French-listed over 2000–2018, the authors analyze whether corporate investment decision is sensitive to equity market overvaluation. Design/methodology/approach The study adopts market-to-book (M/B) decomposition developed by Rhodes-Kropf and Viswanathan (2004, RKV) that proxies for market misvaluation at the firm and industry levels. The authors conducted a long-term performance analysis via a portfolio sorting procedure and a Carhart (1997) four-factor pricing model. The authors tested the relationship between equity misvaluation, corporate investment decisions and equity issuance. The authors ran several robustness tests. Findings The empirical results show that equity market misvaluation affects corporate investment positively as the stock price deviates further away from its fundamental. Based on market timing theory, the authors find that corporate investment occurs in periods of high valuation motivated by equity issuance to benefit from the low cost of capital. This effect is more prominent for financially constrained firms. Consistent with the catering channel, the authors find that the misvaluation-investment nexus is more pronounced in firms with short-horizon investors. By examining the stocks’ long-term performance of misvalued firms, via a sorting portfolio procedure, the authors find that undervalued firms outperform and generate higher abnormal returns (Jensen’s alpha) than overvalued firms, suggesting that mispricing-driven investment appear to be short-lived and lead to lower return in the long term. Practical implications Corporate decision-makers and governance structures should pay attention to the rationality of the corporate investment decision in the context of equity market misvaluation. Managers who focus on maximizing the stock market value in the short-run at the expense of its long-term performance must give preference to value-creating investment, not driven by an external mechanism such as equity market mispricing. More generally, investors and portfolio managers must take into account the market mispricing process in decision-making. Nonetheless, from the portfolio sorting perspective, decision-makers must act in terms of high governance quality to mitigate suboptimal investment due to stock market mispricing (Jensen, 2005). Finally, equity market overvaluation, leading managers to invest via equity financing in particular, should be a signal to attract investors’ attention to seize the window of opportunity and embark on a short-term portfolio strategy. Such a strategy promises high returns in the short term. Originality/value This paper investigates jointly two theoretical channels: equity market timing and catering. The authors propose for the analysis three components of the M/B decomposition to dissociate market misvaluation at the firm and industry level from the fundamental component of market value (growth). This procedure provides a better understanding of the role of firm and industry misvaluation in explaining corporate investments. The authors provide evidence of the equity market misvaluation via a portfolio sorting procedure and a Carhart (1997) four-factor pricing model. The authors examine the effect of misvaluation on both the investment and the financing decisions.

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Section: Research Design and Empirical Resultsmentioning

confidence: 99%

Section: Introductionmentioning

confidence: 99%

Corporate investment sensitivity to equity market misvaluation

Mrad,

Hamza,

Manita

2023

RAF

View full text Add to dashboard Cite

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“…The empirical literature documenting the distress anomaly is quite extensive, for example, Elkamhi et al (2012), Hackbarth et al (2015), Gao et al (2017), and Boualam et al (2020). Several credit risk-based theories have been developed in response to this evidence, including Conrad et al (2014), Eisdorfer et al (2019), McQuade (2018), and Opp (2021). The proposed quasi-bounded-process approach to studying distress equity price dynamics is different from the credit risk-based approach.…”

Section: Introductionmentioning

confidence: 99%

Equity Price Dynamics under Shocks: In Distress or Short Squeeze

Hui,

Lo,

Liu

2023

Risks

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This paper proposes a simple bounded stochastic motion to model equity price dynamics under shocks. The stochastic process has a quasi-bounded boundary which can be breached if the probability leakage condition is met. The quasi-boundedness of the process at the boundary can thus provide an indicator of the possible risk of equities under price shocks or in distress. Empirical calibration of the model parameters of the proposed process for equities can be performed easily due to the availability of an analytically tractable probability density function which generates fat-tailed distributions consistent with empirical observations. The volatility and mean-reversion of the S&P500 dynamics calibrated by the process are positively and negatively co-integrated, respectively, with the VIX index representing the level of market distress. The process captures the high likelihood of Hertz’s default about two months earlier, using only information until that point, and before the firm filed for Chapter 11 bankruptcy in May 2020 as a result of the COVID-19 pandemic. Empirical calibration of the process for GameStop’s stock price shows that the short squeeze in the stock occurred when the condition for breaching the upper boundary was met on 14 January 2021, i.e., about two weeks before major short-sellers closed out their positions with significant losses. The trading volume of the stock was positively co-integrated with the probability leakage ratio.

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Borrowing Constraints, Debt Dynamics and Investment Decisions

Sagliaschi¹,

Savona

2021

Dynamical Corporate Finance

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Equity Misvaluation and Default Options

Cited by 18 publications

References 118 publications

Corporate investment sensitivity to equity market misvaluation

Corporate investment sensitivity to equity market misvaluation

Equity Price Dynamics under Shocks: In Distress or Short Squeeze

Borrowing Constraints, Debt Dynamics and Investment Decisions

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