Equity Market Misvaluation, Financing, And Investment

Missaka Warusawitharana

Board of Governors of the Federal Reserve System

Toni M. Whited

University of Michigan, Stephen M. Ross School of Business; National Bureau of Economic Research

November 6, 2014


We estimate a dynamic investment model in which firms finance with equity, cash, or debt. Misvaluation affects equity values, and firms optimally issue and repurchase overvalued and undervalued shares. The funds flowing to and from these activities come from investment, dividends, or net cash. The model fits a broad set of data moments in large heterogeneous samples and across industries. Our parameter estimates imply that misvaluation induces larger changes in financial policies than investment. The investment responses are strongest for small firms but nonetheless modest. Managers’ rational responses to misvaluation increase shareholder value by up to 3%.

Equity Market Misvaluation, Financing, And Investment – Introduction

We estimate the parameters of a dynamic model of investment and finance to understand and quantify the effects of equity mispricing on these policies. This inquiry is of interest in light of stock market volatility that often dwarfs the volatility of real activity (Shiller 1981). For example, the stock market crash of 2008 was followed by a complete rebound over the subsequent two years, and the technology boom in the late 1990s was followed by a marked reversal in the early 2000s. During these periods, although real activity moved in the same direction, the magnitudes were much smaller. The existence of such wide fluctuations in equity values relative to real activity raises the question of whether these swings reflect movements in intrinsic firm values, or even time-varying expected returns. If not, then it is natural to wonder whether these movements in equity values affect managerial decisions. Put simply, does market timing occur, and how large are its effects?

As surveyed in Baker and Wurgler (2012), many empirical studies have tackled the question of the effects of equity misvaluation and investor sentiment. However, the literature lacks model-based estimates of the forces behind market timing. We fill this gap by using the estimates obtained from a dynamic model to quantify the effects of market timing on various firm policies. The short answer to our question is that misvaluation does affect firm behavior, but the effects on financial decisions are much stronger than those on real investment decisions.

The intuition behind this result requires a description of our dynamic model, which captures decisions about a firm’s dividends, investment, net cash (cash net of debt), equity issuances, and repurchases. Its backbone is a neoclassical model of physical and financial capital accumulation with profitability shocks, constant returns to scale, costs of adjusting the capital stock, and underwriting costs in the equity and debt markets. The model then incorporates a new feature that is motivated by the behavioral finance literature. Possibly persistent misvaluation shocks separate the market value of equity from its true value, and managers exploit this misvaluation to benefit a block of long-term shareholders at the expense of other shareholders who trade with the firm.

Misvaluation affects the firm because it attenuates the extent to which equity issuances and repurchases cause dilution and concentration of the long-term shareholders’ stake. In response to misvaluation, firms predictably repurchase shares when equity is underpriced and issue shares when equity is overpriced. Model parameters then dictate the size of these equity transactions, as well as the size of the misvaluation shocks themselves. They also dictate whether the funds required for repurchases or received from issuances ow out of or into capital expenditures or net cash balances. Quantifying the relative magnitudes of these different effects therefore requires estimating the model’s parameters. We use simulated method of moments (SMM), which minimizes model errors by matching model generated moments to real-data moments. We obtain estimates of parameters describing the firm’s technology, equity market frictions, and most importantly, the variance and persistence of misvaluation shocks.

This structural approach confers several benefits. First, we can test rigorously whether the model fits key features of the data. We find that our model does a remarkably good job of fitting our data, given its simplicity. This good fit is evident not only in large heterogeneous samples of firms, but in homogeneous samples from different industries. In addition, we demonstrate the model’s external validity by showing that it can replicate features of the data not used in its estimation. In short, we find that the model credibly captures those features of the data we wish to understand and shows that misvaluation shocks are necessary for allowing the model to fit the data.

Second, we can directly estimate the variance of misvaluation shocks. In nearly all of our samples, we obtain significant estimates of this variance, which is larger during the technology boom of the late 1990s and in industries a priori more likely to be subject to equity misvaluation. These results constitute another test of external validity.

The third advantage of structural estimation is that we can conduct counterfactual exercises, which deliver several interesting results. First, we compute impulse response functions, which measure the reactions of firm policies to profit and misvaluation shocks. We find that equity repurchases and issuances respond more strongly to misvaluation shocks than to profit shocks, but that these reactions are short lived. Investment responds more strongly to profit shocks than to misvaluation shocks, but this result is more pronounced when the parameter estimates come from a sample of large firms than from a sample of small firms. While we observe a near zero response of investment to the misvaluation shock in the former case, we do observe a modest response in the latter case. An analysis of the sources and uses of funds implied by the small-firm parameter estimates indicates that overvaluation mitigates the effect of external finance costs and provides a source of funds for real investment expenditures.

Equity Market Misvaluation

Equity Market Misvaluation

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