Table of Contents
List of Tables
2 Literature Overview
2.1 Effect of Stock Price Evaluation on Firm Investment
2.1.1 Informational Channel
2.2 Reasons and Effects of Mispricing in Competitive Markets
4.2 Empirical Framework
5 Empirical Results
5.2 Robustness Tests
List of Tables
Table 1 Summary Statistics
Table 2 Regression Analysis (Hypothesis 1)
Table 3 Regression Analysis (Hypothesis 2)
Table 4 Robustness Test (Future Profitability)
Table 5 Robustness Tests (Q)
Table 6 Regression Analysis (subsamples on size)
Firms grow through their successful investment choices. These choices have been examined by many economists. My research focuses on the connection between investment pricing and real firm investment which is also largely covered by existing research. Still, the influence of industry concentration on this connection has yet to be investigated. This thesis explores precisely the following gap which current research leaves: How does industry concentration influence the relation between mispricing of stocks and real firm investment?
The existing research focuses on two channels how stock (mis-)pricing influences firm investment. On the one hand, the informational role of prices is examined. The general conclusion shared by many papers is as follows: managers learn from high prices that the aggregated opinion of investors sees promising investment opportunities. Hence, decision makers invest because they either learn from actual new information or they want to cater the investors and keep the stock prices high because of personal incentives. This view is based on the theory of Dow and Gorton (1997) and shared by, inter alia, Polk and Sapienza (2009), Bakke and Whited (2010) and Chen, Goldstein, and Jiang (2007).
On the other hand, the financing role of equity is investigated. Many papers come to the same conclusion. Mispriced stocks are equal to misvalued equity. Consequently, if stocks are overpriced the cost of financing through issuance of new shares declines. If the cost of financing declines, more investment opportunities seem to be promising. Therefore, the firm’s investment activity increases. Additionally, third parties and potential debt lenders like banks evaluate the firm based on the stock performance amongst other aspects. If the stock price is high banks are more likely to issue credit and reduce their demands concerning the terms of debt (e.g. decrease interest rate). This is particularly important for financially constrained firms which are only able to invest in new projects if they are able to raise capital on their own. The equity-channel is based on the theory of Bosworth, Hymans and Modigliani (1975) and shared by Gao and Lou (2013), Dong, Hirshleifer, and Teoh (2012) and Baker, Stein, and Wurgler (2003) amongst others.
By following the approach of Polk and Sapienza (2009, pp. 191-194), my thesis examines if the relation of firm investment to stock mispricing is influenced by market concentration. At first I regress firm investment on mispricing, investment opportunities and cash flow proxies on my whole sample. Afterwards I build subsamples based on market concentration and conduct the same regression on those subsamples again. Thereby, my research adds the dimension of market competition to the existing research.
The thesis is organized as follows. In section 2 I briefly sum up the status quo in terms of research on the relation between mispricing and investment behavior. I state and explain my hypotheses in my third chapter. Following the explanations, I describe the data and methodology further in section 4. After evaluating my empirical results and documenting my robustness tests in section 5, I present my conclusions in chapter 6.
2 Literature Overview
2.1 Effect of Stock Price Evaluation on Firm Investment
A large portion of recent research deals with the relationship of prices on secondary markets on real firm investment. Most of this research focuses on two ways of how stock prices affect real economy. The first channel is called the informational channel. The idea behind it is that managers learn from the aggregated information reflected in the stock price and guide their decisions according to it (Morck, Shleifer & Vishny, 1990, pp 164-165). The second channel is the equity based channel. It is based on the idea that the stock price influences the costs of capital. Higher valued stock may decrease the cost of equity and debt (Morck et al., 1990, pp 166-168). I give a detailed overview of the literature dealing with both channels in the sections below.
2.1.1 Informational Channel
Starting with the theoretical model of Dow and Gorton (1997), many empirical studies find evidence of an informational channel. The majority of economists also analyzes different ways of how managers benefit from information within the stock price as well as from different types of information.
Dow and Gorton (1997) develop a model in which managers can learn from the information given in the stock price. They show how shareholders can indirectly guide the managers’ decisions, such as firm investments. Hence the stock price is formed by the aggregated information of all shareholders. In case the stock price is high, Dow and Gorton argue, the shareholders evaluate the upcoming investment opportunities as promising. If managers have the right incentives (e.g. contracts based on future stock returns) to overcome agency problems, they will act according to the shareholders’ will. Dow and Gorton (1997, p. 1090) show in their model that also shareholders need incentives (e.g. observing that managers learn from their information) to produce information. Furthermore, they prove that price efficiency does not necessarily lead to economic efficiency. For instance, if the price contains no information, Dow and Gorton argue, the managers may not invest. Of course, if there is no investment, investors do not have any incentives to produce information. However, the price is efficient in this scenario while the economy is inefficient. To sum it up, Dow and Gorton (1997, p. 1089) emphasize on two types of information embedded in the stock price. On the one hand the forecasting information about future investment opportunities and on the other hand retrospective information about managers’ past decisions.
Based on Dow and Gorton (1997), Bakke and Whited (2010) find evidence that a variation of Tobin’s Q is positively correlated to the amount of private information influencing the stock price. In other words, this means that corporate investment has a positive relation to the amount of information incorporated into the stock price. Tobin’s Q is an indicator for business valuation which is defined by the market value of a firm divided by its book value. If Q is equal to one it means that the market value of a firm is equal to the underlying book value.1 Furthermore, Q is often used as proxy for investment opportunities. Chen, Goldstein and Jiang (2007) come to the same conclusion as Bakke and Whited (2010). They further analyze the impact of private information. They show that the relationship between the amount of private information embedded in the stock price and investment sensitivity is positive. In contrast to that, the amount of information of the manager not included in the price is negatively related to investment sensitivity. This shows that managers do not blindly follow the market but also use their own information for decision-making.
While the above-mentioned literature deals with firm investments of any kind, Kau, Linck, and Rubin (2008) as well as Luo (2005) focus on mergers and acquisitions. They observe strong relationships between stock price development after an announced merger and the actual final decision. If the stock prices of the merging companies decrease after their announcement, the acquisition is more likely to be canceled. Those observations are especially strong in the process of mergers and acquisitions because analysts and institutional investors have broader and deeper information about the macroeconomic effects on the deal and the effects the deal would trigger if pulled through (Luo, 2005, pp. 1951-1952).
The papers that I mentioned above demonstrate that stock prices may reflect new information for the manager and thus influence the managers in decision-making. This stands in contrast to the results of Morck et al. (1990, p. 199) who see the market not as a complete “sideshow” but, as their data show, it is not of prime importance either. Their data support the passive informant hypothesis which says that there is no influential interaction between stock market and the manager. (Morck et al., 1990, pp. 163-164) The data further show that the stock market does not contain any new information for the manager. (Morck et al., 1990, p. 198)
The informational channel implies not only the positive aspect of improving investment decisions but also a negative side. If managers feel pressured to follow the market’s expectation on future investment and with such it’s intent, they will destroy future value. Brandenburger and Polak (1996, pp. 524-525) show that this pressure can even lead managers to make inefficient decisions because they do not use their own knowledge and information anymore.
The pressure examined by Brandenburger and Polak (1996) often leads to catering. The behavior of giving investors what they want to boost short term prices is called “catering”. (Polk & Sapienza, 2009, 187). Polk and Sapienza (2009, p. 189) show that catering exists and that it has an independent effect on investment decisions. They find a positive relation between mispricing and abnormal investment while controlling for the equity issuance channel (cf. section below). Furthermore, they show that abnormal investment leads to low future return. They analyze that the positive relation between stock mispricing and corporate investment creates incentives to pursue projects with negative net present value while being overpriced and, in contrast, to pass investment opportunities while being underpriced. Followingly, their findings support the thesis of Brandenburger and Polak (1996) that catering investors and boosting short-term prices lead to loss in value in the future. These findings imply that catering behavior is more pronounced if managers are short-term oriented. This relation is further examined by Jensen (2005) and Blanchard, Rhee, and Summers (1993).
Jensen (2005, p. 10) argues that overvalued equity demands an expected performance which is impossible to deliver. Managers feel a pressure to perform as expected or at least try to do so. This leads to overinvestment in projects which destroys value in the long-term. These long-term effects cause Blanchard et al. (1993, p. 119) to argue that managers following long-term goals should not be influenced in investment decisions by the stock market valuation and rather follow their own information and decisions. In contrast, short-term driven managers should listen to the market and therefore boost short-term price. They further find empirical evidence that stock pricing plays a minor role in investment behavior, if controlled for fundamentals. Fundamentals can be seen as indicator for the financial well-being and valuation of a firm (Blanchard et al., 1993, p. 124).
In contrast to that, managers have another positive incentive to pursue overvaluation of equity. Shleifer and Vishny (2003) state the importance of a firm’s (over-)valuation in the field of mergers and acquisitions. If equity is overvalued, firms can acquire other firms with stock at a lesser cost. Their ability to make acquisitions rises significantly. Simultaneously, firms that are undervalued have a higher risk of being taken over (Shleifer & Vishny, 2003, p. 309). This form of financing is directly linked to the equity-channel examined in the next section.
Overall, the theoretical and empirical research about the informational channel supports the idea that managers learn from information given in the stock price and hence can improve their investment decisions. Nonetheless, managers do not blindly follow the market but rather assess their own private information as well. The stock price should be seen as an additional opinion rather than the sole decision criterion. Furthermore, managers need to be aware that strong catering can be beneficial for them in the short-run but will backfire in the long-run. Firms and their boards need to find incentives for managers to pursue optimal long-term development. However, investigating research and literature dealing with right incentives for managers any further would go beyond the scope of this bachelor thesis.
As previously mentioned the second channel through which stock prices influence firm investment is equity based. The equity-channel is introduced in Bosworth, Hymans and Modigliani (1975) who contend that the stock price has influence on the cost of capital. Cost of capital is the “weighted average of the cost of different sources of financing” (Bosworth et al., 1975, p. 281). The paper defines the cost of equity as dividend/price-ratio (Bosworth et al., 1975, p. 283). Therefore, an increasing stock price would ceteris paribus result in decreasing cost of capital which may influence corporate decisions. Furthermore, debt also gets cheaper with increasing stock prices because institutions like banks who offer debt will adjust their terms (e.g. discount rate) according to the stock price amongst other things.
The theory of Bosworth et al. (1975) is adapted by Stein (1996), who adds the effects of mispricing and financial constraints to consideration. Stein argues that managers know that the market is inefficient and that they take advantage of it (Stein, 1996, p. 14). He distinguishes between financial constrained firms and firms without financial constraints. This leads Stein to the conclusion that unconstrained firms might issue more shares when being overvalued. However, those firms do not necessarily invest the exceeding profits, but use them to get more cash or repay their debt. Financially constrained firms will issue new (overvalued) stocks to make investments which would have had a positive net present value even with correct valuation (Stein, 1996, pp. 19-26).
Based on this idea similar evidence is widely found in further literature. Baker, Stein, and Wurgler (2003) empirically prove that the investment of equity dependent firms is more sensitive to stock mispricing than of non-dependent firms. Equity dependent firms are characterized as young firms with low cash reserves and cash-flow, while having strong investment opportunities (Baker et al., 2003, p. 971). Since those firms do not easily get debt financing from banks they have to fund even marginal investments by issuing new shares. As a consequence, if stocks are overpriced those firms can get cheaper funding for their investment projects.
Gao and Lou (2013) as well as Dong, Hirshleifer, and Teoh (2012) focus not only on the relation of stock pricing to equity-financed investment but also examined the relation to debt financing. The original idea is that firms with overpriced stocks issue more equity and less debt. The cause is a “relative misvaluation” (Gao & Lou, 2013, p. 2) between debt and equity because equity is affected more strongly by mispricing than debt is. Gao and Lou (2013, p. 1) find out that this view is incomplete. It may hold for firms which are financially unconstrained and possess enough internal funds, yet firms which rely on outside financing act differently. Those firms increase issuance in both, debt and equity, if their shares are overpriced. In this case the firms can exploit the misvaluation in both types of financing to have more opportunities to invest. In contrast, Dong et al. (2012, p. 3648) do not find a significant relation between debt issuance and overvaluation of equity. They observe a shifting from debt to equity issuance which is concurring to the original idea explained above.
Disregarding the relation between issuing debt and overvalued stocks, Dong et al. (2012, pp. 3669-3670) state a reason why overvaluation is related to the raising of capital. The reason for this is the pressure caused by catering and its incentives. (cf. section above). In order to keep up with these expectations firms need to raise more capital. Catering is especially strong for short-term orientated managers. Consequently, the sensitivity of equity issuance to overvaluation rises the more managers act with a short-term focus. Dong et al. hereby strongly refer to Jensen (2005).
Research from Campello and Graham (2013) finds more empirical evidence for the importance of financial constraints especially for the relation between stock pricing and corporate investment behavior. They argue that financially constrained companies also save part of their proceeds in cash in order to enhance future investment (Campello & Graham, 2013, pp. 108-109). Khanna and Sonti (2004) likewise find evidence for a positive relation between stock prices and investments. Their arguments relate to financial constraints as well. Gilchrist, Himmelberg and Huberman (2005) have the same results without focusing as much on financial constraints as other papers. They do not distinguish between firms regarding their financial possibilities.
The research mentioned above assesses particular overvaluation in stock prices. Hau and Lai (2013) examine the recent financial crisis to analyze the effect of underpricing caused by fire sales of big funds. They observe that financially constrained firms reduce their investment significantly. Meanwhile, less-constrained firms do not reduce investments compared to their industry. These observations suggest that the relationship of mispricing to corporate investment also exists in times of undervaluation.
While most of the above-mentioned research focuses on the U.S. market, Chang, Tam, Tan, and Wong (2007) find a similar pattern of behavior in Australia and Chirinko and Schaller (2001) show empirical evidence from the more volatile market of Japan that high stock prices are positively related to corporate investment.
Only few economists have found data speaking against the theory of the equity based channel. Bakke (2010) rejects the correlation of mispricing and the investment pattern of large firms. He argues that large companies do not have to finance their investments by issuing equity. Furthermore, issuing new shares creates underwriting costs. The overvaluation must be high enough to cover those costs. Additionally, large firms may tend to save the proceeds of new seasoned equity (Bakke, 2010, p. 1968).
Nonetheless, most research finds strong evidence for the existence of an equity-channel. As a conclusion, the equity-channel is the positive relation between stock prices and equity issuance. This equity issuance is used, depending on financial constraints, for real or capital investments. Financially constrained firms are more likely to invest in real projects than financially unconstrained firms. The absence of financial constraints leads firms to save their proceeds in cash or in capital investments rather than pursuing new projects. In this manner, cheaper funding for future projects can be gained.
As a matter of fact, this can result in many positive developments. Especially financially constrained firms get access to more capital while being overvalued. They can invest in profitable projects. In this case, overvaluation promotes innovation and growth. The drawback of the equity-channel is that also unconstrained firms get access to cheaper financing for the period of overvaluation. Since those firms have already invested in all profitable projects (from the viewpoint of correct firm valuation), they are more likely to invest in projects, which may destroy value in the long-term. The equity-channel is thus perceived ambiguously. The access to cheap capital is a reason why firms invest more when being overvalued. Additionally, it is also the means how companies get the capital for their investments.
2.2 Reasons and Effects of Mispricing in Competitive Markets
I have focused on the general relationship between stock pricing and firm investments in the sections above. In this section I go into more detail about this relationship in competitive markets. I hereby lay a strong focus on the informational channel. This is due to the fact, that the equity-channel has yet to be examined in detail by recent research in regard to special aspects in competitive markets. Furthermore, it seems that the equity-channel is not as much influenced by industry concentration as the informational channel. Afterwards, I connect the theories of the informational and equity-channel and finally conclude my literature overview.
As shown in Section 2.1.1 the stock price is a result from information aggregation of all individual and private information of shareholders. Hellwig (1980) examines this aggregation of information in competitive industries. He concludes that the market price in large markets depends on investors’ risk preferences and precision of their information (Hellwig, 1980, p. 493). Individual errors of single investors are adjusted and hence no individual investor has an influence on the price. Therefore, only information which is common among many investors affects the price (Hellwig, 1980, p. 479). Private information may be right but does not have the influential power of common knowledge. Naik (1993) extends Hellwig’s model by a dynamic and multi-period setting. He comes to the same conclusion as Hellwig. The market price in competitive industries only reflects information which is common to many investors. Consequently, insider information does not affect the stock price.
Hoberg and Phillips (2010) show that this missing individual information is a problem for competitive firms. In their paper, they examine how market competition affects individual firms in booms and busts. They conclude that in competitive industries there is a strong relation between high market valuation and subsequent lower operating cash flow. But for my own research their analysis why this is the case is more important than their actual findings. According to Hoberg and Phillips the cost of information is high in competitive markets. Thus, competitive firms rely on common signals, just as the market price. Hoberg and Phillips go one step further than Hellwig (1980). They analyze that the information reflected in the market price is not only common to many investors but also common for the whole industry. Specific information about rivals or own investment opportunity is simply too expensive to collect. This also explains the strong comovement of stock prices in competitive industries. Furthermore, acting on common information may lead to inefficient decisions. When stocks are overvalued the market signals strong investment opportunities but those opportunities might not be the best for all firms in the market. Because they rely on common information, individual firms do not know whether the mentioned opportunities are the best options to take for them (Hoberg & Phillips, 2010, pp. 49-50). This explains the findings of Hoberg and Phillips (2010) that after high stock valuations subsequent returns and operating cash flows are rather low.
Hoberg and Phillips (2010, p. 50) furthermore state that the relation between valuation and investment is stronger in competitive markets than in concentrated markets. With new common positive information about investment opportunities and thus higher valuation the firms in competitive industries have to react more quickly than firms in concentrated markets. For the companies, it might be best to respond earlier to newly emerging opportunities than their competitors. However, in concentrated markets (e.g. a monopoly) a firm can take more time to evaluate the opportunities and collect more (and less expensive) information about them. This leads to a stronger relationship of stock prices and corporate investment in a competitive environment.
1 The explanation for Tobin’s Q is derived from the calculations in the examined research (e.g. Polk & Sapienza, 2009, p. 192 or Campello & Graham, 2013, p. 97).
- Quote paper
- Jonas Junk (Author), 2017, Mispricing of Stocks and Firm Investment in Competitive Industries. How Do They Influence Each Other?, Munich, GRIN Verlag, https://www.grin.com/document/540417