Behavioural disequilibrium

Abstract

This thesis examines the role of stock misvaluation in explaining the dynamics of corporate financing strategies, investment decisions, earnings management practices, and earnings performance of firms. It aims to contribute to the literature on the effect of stock price misvaluation on corporate financial decisions and outcomes. The first study examines how equity misvaluation affects firm equity issuance, debt issuance and the proportion of earnings retained. Further, it examines the financing channels through which firms invest in capital expenditures and research and development in response to equity misvaluation. The second study investigates the role of equity misvaluation and investor psychological reference points embodied in earnings targets in driving earnings management behaviour. The third study explores the effect of misvaluation on future firm profitability measured by growth in earnings. The results indicate firms react to misvaluation of their shares primarily through the issuance of equity. Issued equity is used to finance increases in capital expenditures as well as research and development investments. Further, the findings suggest the element of stock misvaluation which is idiosyncratic to the firm rather than shared amongst industry peers is associated only with research and development investment. The second study presents evidence that misvaluation-induced earnings management is positively associated with the probability that the firm reports earnings above the profitability and analyst forecast targets. This suggests that managers cater to investor psychological reference points through earnings manipulation. Robustness tests also show that a positive relationship between misvaluation and earnings management holds for firms reporting earnings above and below their targets, implying capital market motivations are not the only incentive driving misvalued firms to manage earnings, as assumed in prior literature. In the third study, findings indicate misvaluation is positively associated with future growth in earnings per share. Furthermore, the results evidence that misvaluation is more strongly related to future earnings changes in the long-run, rather than the short run. These results support the findings that misvaluation has a positive effect on long-term investments such as research and development. Further, the findings indicate that the relationship between misvaluation and earnings growth varies with level of growth opportunities. Firms with higher growth opportunities exhibit a stronger link with misvaluation than do firms with lower growth opportunities. These findings align with the theoretical expectation that growth firms are more sensitive to equity valuations in their corporate financing and investment decisions.