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Managerial Behavior and the Link between

Stock Mispricing and Corporate Investments:
Evidence from Market-to-Book...
Article in Financial Review · February 2014

DOI: 10.1111/fire.12027
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The Financial Review 49 (2014) 89–116
Managerial Behavior and the Link between

Stock Mispricing and Corporate
Investments: Evidence from
Market-to-Book Ratio Decomposition
Mohammed Alzahrani
King Fahd University of Petroleum & Minerals
Ramesh P. Rao∗
Oklahoma State University
Abstract
We examine the impact of mispricing on corporate investments and its components:

capital expenditures, research and development, acquisitions, and asset sales. By decomposing
the market-to-book ratio into mispricing and growth components, we show that corporate
investments are linked to mispricing through market-timing and catering, after controlling for
growth and financial slack. This investment-mispricing link is more pronounced in financially
constrained firms and in firms with short-horizon shareholders. Overall, our study indicates
that the sensitivity of investments to mispricing is a function of the nature of mispricing, the
type of investment, and the firm’s characteristics.
Keywords: stock mispricing, financial constraints, investment horizon, corporate investments
JEL Classifications: G31, G32, G34, D92
∗ Corresponding author: Oklahoma State University, 309 Business Building, Stillwater, Oklahoma 74078;
Phone: (405) 744-1385; E-mail: ramesh.rao@okstate.edu.

C 2014 The Eastern Finance Association 89
90 M. Alzahrani and R. P. Rao/The Financial Review 49 (2014) 89–116
1. Introduction
The role of stock mispricing on corporate real investments has been the subject
of considerable debate in the corporate finance literature. Stock mispricing occurs
when the stock price deviates from its fundamental value. Investors who assign a
value to the firm’s stock create this deviation when they are less informed and/or not
rational. The debate in the literature is on whether rational and informed managers
follow the market value in making their investment decisions even if it differs from
the firm’s fundamental value; and, if they do, why and when they do it. The classical
view is that CEOs should ignore stock mispricing and base their investment decision
on whether or not it maximizes the fundamental value of the firm. However, the
behavioral school takes the view that managers undertake investment decisions based
on cues from the market, even though market prices may deviate from fundamental
values.1
We test the behavioral explanations put forth in the literature as to why and
when managers consider the market value in their investment decisions, and thus
help understand how mispricing affects corporate investment. Specifically, we use
Stein’s (1996) framework to examine the two channels through which mispricing
affects investments, which we label as: market-timing and catering.
The market-timing effect suggests that managers exploit mispricing by issuing
overvalued equity to enjoy a low cost of equity and refrain from issuing undervalued
equity to avoid the high cost of equity. The ability to issue equity at lower cost will
increase investments, encourage managers to exhaust their investment list, and even
accept low quality (negative net present value [NPV]) projects. On the other hand,
managers of undervalued firms will not issue equity, even when they have positive
NPV projects, because of the high cost of undervalued equity.
The catering effect implies that managers cater to the firm’s short-horizon share-
holders and focus more on the current stock price rather than on the long-run value
of the firm. From the catering perspective, managers increase investments to justify
current high stock prices or decrease unappealing investments to suppress current de-
cline in prices. Unlike market-timing, the catering effect does not necessarily involve
equity issuance or stock repurchase. It is enough to assume that managers pay special
attention to their current stock price when they make their investment decision.
1 The assumption that mispricing should be ignored has long been debated in the capital budgeting
literature. Abel and Blanchard (1986) and Bosworth (1975) argue that managers should ignore the side
show provided by the market and thus view mispricing as a distortion of the true impact of market on
investment. Another strand of the literature argues that managers should consider mispricing when making
investment decisions. The logic here is as follows: if mispricing leads to a lower cost of capital relative
to other sources of funds then the manager should invest based on this new cost of capital suggested
by the market (Keynes, 1936; Fischer and Merton, 1984). From another perspective, Panageas (2003)
views mispricing as a speculative part of stock prices and argues that managers should consider both the
fundamental and the speculative parts as sources of value to shareholders and invest based on the part that
will make investors better off.
M. Alzahrani and R. P. Rao/The Financial Review 49 (2014) 89–116 91
We test the above hypotheses using U.S. firm-level data for the period 1972–
2012 in a panel regression framework. The dependent variable consists of aggregate
and component measures of corporate investments (capital expenditures, research
and development [R&D], acquisitions, and asset sales), whereas the independent
variables consist of mispricing and other conditioning and control variables. To
measure mispricing, we use the Rhodes-Kropf, Robinson and Viswanathan (2005)
market-to-book ratio decomposition method that permits a more refined examina-
tion of how the various components of stock price affect investment behavior. The
methodology of Rhodes-Kropf, Robinson and Viswanathan (2005) allows us to de-
compose the market-to-book ratio into three components: firm-level stock mispricing,
aggregate mispricing, and growth. The breakdown of market-to-book ratio into these
components basically disentangles stock mispricing from the fundamental and other
mispricing components of market price and allows for better understanding of the
role of stock mispricing in determining investments.
Our study contributes to the literature in several ways. First, previous studies
examine market-timing and catering effects separately (e.g., Baker, Stein and Wurgler,
2003, and Gilchrist, Himmelberg and Huberman, 2005, for market-timing; and Polk
and Sapienza, 2009, for catering), whereas we examine them jointly.
Second, we consider several types of corporate investment and disinvestment
decisions, such as capital expenditures, acquisitions, R&D, and asset sales. This
comprehensive look at corporate investments enables us to see if certain classes of
investments are more sensitive to mispricing than others.
Finally, unlike previous studies, we examine investment distortions due to over-
pricing and underpricing separately. Extant studies focus on just one side of the
story, usually underinvestment due to underpricing (e.g., Baker, Stein and Wurgler,
2003), or overinvestment due to overpricing (e.g., Gilchrist, Himmelberg and Huber-
man, 2005), or do not test for possible asymmetric effects (e.g., Polk and Sapienza,
2009). We test whether one side of mispricing impacts investments more than the
other.
Our findings are as follows. We find that total investments are influenced by
market-timing motivated equity issuance. With regard to the individual investment
categories, capital expenditure and asset sales are driven by market-timing motivated
equity issuances, whereas acquisitions and R&D are not driven by managerial market-
timing. Theory and prior evidence suggest that the market-timing effect is especially
strong for financially constrained firms. Consistent with this, we find that highly
financially constrained firms exhibit higher sensitivity between investment and stock
mispricing.
In favor of the catering hypothesis, we find a significant relation between total
investments and firm-level mispricing after controlling for the market-timing effect.
At the disaggregated level, we find capital expenditure, R&D, acquisitions, and as-
set sales to be prone to a catering effect after controlling for equity financing and
market-timing. In addition, we document that the investment-mispricing sensitivity
is significantly higher in firms with short-horizon shareholders than in firms with
long-horizon shareholders. This is true for all investment decisions under considera-
tion except for asset sales.
After confirming the existence of investment distortion in response to stock
mispricing through the channels mentioned above, we examine separately the two
types of mispricing—overvaluation and undervaluation. Our results reveal that firms
react to overvaluation in almost all types of investments by the issuance of overvalued
capital and by catering to optimistic shareholders. Firms react to undervaluation in
all investment types except capital expenditures.
In sum, our study finds that the investment-mispricing relationship is affected
by the nature of mispricing, type of investment, and source of financing.
2. Literature review and hypotheses development

2.1. Literature review
Mørck, Shleifer and Vishny (1990) is one of the early studies that suggests a
direct effect of mispricing on the firm’s investment by hypothesizing three ways in
which mispricing impacts investment. The impact on investments may occur due
to (1) financing cost changes because managers issue overvalued equity, (2) market
pressure because managers cater to investors who care about the current stock price
(which may be inaccurate), and (3) faulty information because managers use market
prices as a guide for predicting the future state of the economy and industry. Mørck,
Shleifer and Vishny’s (1990) test for these hypotheses is twofold. Initially, they test for
the general impact of the stock market on corporate investments after controlling for
the firm’s fundamentals. If the stock market has a significant impact on investments
beyond that of the fundamentals, then there is a possible impact of mispricing, which
would indicate support for any one or all three hypothesized effects. Second, they
run further tests to differentiate between the three hypothesized mispricing effects.
Mørck, Shleifer and Vishny (1990) show that the initial stock market test did not
get a solid pass, which renders a mispricing effect unimportant. In particular, Mørck,
Shleifer and Vishny (1990) show that in firm-level regressions, movements in share
prices significantly impact investment when fundamentals are held constant, but the
incremental explanation of the variations in investment by the market is fairly small
(incremental R2 between 2% and 4%). The main results from Mørck, Shleifer and
Vishny (1990) suggest that the stock market reflects what is already known about
the firm’s fundamentals and that mispricing and fundamental components of the
market value do not have a significant incremental impact on investment beyond the
fundamentals.2
2 Other studies provide conflicting conclusions on how important market valuation is to the investment
decision. Von Furstenberg (1977), Clark (1979), Summers (1981), and Blanchard, Rhee and Summers
(1993) show that market valuation has limited power in explaining shocks to firm investments. Controlling
for the fundamental variables, Barro (1990), on the other hand, concludes that the stock market has a
Our paper differs from Mørck, Shleifer and Vishny’s (1990) paper in that we
follow the well-established Q literature on investment model specification by using
the market-to-book ratio to proxy for the market impact rather than stock returns;
doing so avoids the possibility that stock returns may reflect time varying risk premia
rather than mispricing (Lamont, 2000). Unlike Mørck, Shleifer and Vishny (1990),
our decomposition methodology provides a more direct test of the mispricing impact
on investment.3 Our methodology also extends Mørck, Shleifer and Vishny’s (1990)
tests by providing a clear distinction between the various channels of mispricing’s
impact on investments at the firm level. In addition, we control for new issues that are
motivated by mispricing in particular, rather than controlling for financing variables
as in Mørck, Shleifer and Vishny (1990).
Stein (1996) developed a model that is consistent with Mørck, Shleifer and
Vishny’s (1990) first and second explanations. Stein (1996) describes the corpo-
rate investment decisions of firms that issue or repurchase equity, have a long-term
investment horizon, and exist in an inefficient market. Under these conditions, he
shows that overvalued firms issue equity to gain from the reduced cost of capital and
hence increase investments. Stein (1996) points out that the sensitivity of investment
to equity over- or undervaluation depends on the accessibility to other sources of
financing. If the manager can use retained earnings or debt to finance investment,
she will be less reactive to equity mispricing when making investment decisions.
However, if the firm is financially constrained and has to depend on equity, equity
valuation becomes central to the investment decision. Stein (1996) also considers
the situation where firms do not issue or repurchase equity but have a short-term
investment horizon and exist in an inefficient market. He argues that a manager who
is maximizing short-horizon investors’ wealth will be interested in maximizing the
current stock price, even without considering market-timing.
Baker, Stein and Wurgler (2003) provide a test for Stein’s (1996) argument using
future realized stock returns to proxy for mispricing. In support of the mispricing
significant effect on the investment decision beyond that of the fundamental variables, for example, cash
flows.
3 Decomposing market-to-book ratio into mispricing and fundamental components may address, to some
extent, the weak link between market-to-book and investment that is driven by the fact that market-to-
book is measured with error (Gilchrist and Himmelberg, 1995; Abel and Eberly, 1996; Erickson and
Whited, 2000). In unreported results, the incremental R2 of including market-to-book ratio components
relative to including only the undecomposed market-to-book ratio is statistically significant. Additionally,
in unreported investment regression results, we find a nonlinear effect of mispricing on the market-to-book
ratio coefficient. The market-to-book ratio coefficient takes an inverse U shape as we move from lowest to
highest quartiles of mispricing. The small coefficient at high mispricing levels may indicate that a greater
error in market value leads to a less clear relation between market value and investment. However, the
small coefficient at low mispricing levels is consistent with the view that managers do consider mispricing
when making their investment decision. At a low mispricing level, the market value mainly reflects the
fundamental component of the value which is also reflected in part by other controlling variables, namely
cash flows. Thus, in the absence of mispricing, and since part of the fundamental information is already
reflected in other regressors, the coefficient becomes small.
impact, Baker, Stein, and Wurgler (2003) find a negative relation between invest-
ments and future returns. The relation is stronger for equity dependent firms. In their
analysis, Baker, Stein, and Wurgler (2003) assume underinvestment by underval-
ued firms and did not incorporate the possibility of overinvestment by overvalued
firms. Conversely, Gilchrist, Himmelberg and Huberman (2005) consider the case
of overvaluation only and find that managers issue new equity and increase capital
expenditure in response to the overvaluation.4 The limitation of these two studies
is that neither study examines both sides of the mispricing direction simultaneously
as they are constrained by the structure of their models. In addition, in Baker, Stein
and Wurgler (2003) interpreting the negative relation between future stock returns
and investment as a mispricing effect could be undermined by time-varying discount
rates and changes in the rational cost of capital (Lamont, 2000), long-run return event
study criticisms (Eckbo and Norli, 2005), and pseudo-market-timing effects (Schultz,
2003).
Polk and Sapienza (2009) test the catering explanation by showing a stronger
effect of mispricing on capital expenditure in firms with short-horizon shareholders.
However, there are several issues with regard to the mispricing proxy used in their
analysis. First, they use discretionary accruals and equity issuance as a proxy for
mispricing because these are usually followed by negative future returns. However,
they fail to recognize that accruals and equity issuance can be two faces of the
same coin since Teoh, Welch and Wong (1998) document that issuing firms tend
to have high discretionary accruals. Thus, the significant relation between accruals
and investments may stem from the relation between accruals and equity issuance.
Second, using equity issuance and accruals makes it hard to separate the market-
timing effect from the catering effect. Third, a significant relation between equity
and investment does not necessarily prove the investment-mispricing relation; rather,
it may point to the mechanical process of raising more capital to finance already
scheduled investment projects. Fourth, even if high accruals indicate overvaluation,
low accruals do not necessarily indicate undervaluation. Therefore, accruals may help
detect overinvestment but not underinvestment.
Other related studies explore various other aspects of the mispricing-investment
relation. For example, Bakke and Whited (2006) use an errors-in-variables remedy
to distinguish between useful nonfundamental information in stock prices and pure-
noise, and find that firm investments are sensitive to the former but not the latter,
especially when firms are equity dependent. In this paper, we also divide market
information into fundamental and nonfundamental components; however, we do not
take a stand on whether the nonfundamental part constitutes useful information or
is just pure-noise. Our study is different in that we focus on the question of why
4 The model presented by Gilchrist, Himmelberg and Huberman (2005) is not based on investors’ irra-
tionality; rather, it is based on assuming unbiased dispersion of investors’ beliefs on average with short-sale
constraints.
managers follow the market information but not which market information is being
followed by managers.
Hertzel and Li (2010) use the same method we use to decompose the market-to-
book ratio into fundamental and mispricing components in order to study the behavior
of seasoned equity issuing firms. They show that firms issuing equity in reaction to
mispricing use the proceeds to retire debt and/or increase cash and experience low
abnormal ex post stock returns, whereas firms whose equity issuance is related to the
fundamental component use the proceeds to invest in capital expenditures, R&D, and
acquisitions and do not earn low abnormal ex post stock returns. Our study examines
the direct effect of mispricing on investment rather than on equity issuance and find
that investments react to mispricing, not only through equity issuance, but through
other channels. In addition, Hertzel and Li (2010) examine only the impact of issuing
overvalued equity, whereas we consider both overvaluation as well as undervaluation.
A more recent analysis in Baxamusa (2011) examines the market-timing and
catering hypotheses simultaneously by examining investment decisions in reaction to
the manager’s perception of the firm’s value. Our paper is fundamentally different as
we consider the market’s perception as opposed to manager’s own perception about
firm value.
Our paper contributes to the aforementioned literature by providing an easy way
to test all possible channels of mispricing’s impact on investment in an integrated
framework. Unlike previous studies, which are constrained by their own methodology
to assume one side of mispricing (over- or undervaluation), our methodology is
flexible enough to accommodate both sides and to test for their impacts separately.
Additionally, we acknowledge the heterogeneity across different types of investments
and investigate the impact of mispricing on several investment categories separately
and collectively, whereas previous studies consider only capital expenditures.
2.2. Testable hypotheses

As noted in the literature review above, the two primary channels through
which mispricing affects investments are market-timing and catering. In this section,
we formalize our two main testable hypotheses drawing on Stein’s (1996) work
referenced in the previous section. Our first hypothesis concerns market-timing.
Under market-timing, recall that firms issue equity when they are overvalued and
repurchase equity when they are undervalued. Issuing more equity will help finance
more investments and repurchasing equity may be more profitable than engaging
in undervalued investment projects. Under this scenario, market-timing conditions
determine the cost of investing the firm’s capital. For overvalued equity, the cost of
raising additional equity is lower, which permits the acceptance of some negative NPV
projects that would not be accepted otherwise. In this case, the gain from exploiting
overvaluation will compensate for any possible loss resulting from accepting negative
NPV investment. However, if the stock is undervalued, the firm may pass up some
positive NPV projects because it will not be worth doing, that is, the gain in value
will not offset the loss of issuing undervalued socks. These conclusions lead to our
first testable hypothesis:
Hypothesis 1a: Stock mispricing affects corporate investments positively through

corporate equity transactions that are driven by market-timing
strategies.
Stein (1996) points out that the sensitivity of investment to equity over- or
undervaluation depends on the accessibility to other sources of financing. If the
manager can use retained earnings or debt to finance investments, she will be less
responsive to equity mispricing when making investment decisions. However, if the
firm is financially constrained and has to depend on equity, equity valuation becomes
central to the investment decision. This reasoning is fairly obvious when the firm
has to rely exclusively on equity for its financing. In the extreme case, where the
project is funded solely by equity, the market’s assessment of the project’s quality
and, hence, the required return on it, becomes the main determinant of the corporate
investment decision. Thus, when a financially constrained firm becomes overvalued,
the cheaper cost of equity will allow it to increase investments. This leads to the
following subhypothesis:
Hypothesis 1b: The more the firm depends on equity (financially constrained) the
higher the sensitivity of corporate investments to stock mispricing.
Our second main hypothesis deals with the catering effect. As noted in the
literature review section, Stein (1996) makes the argument that the manager who
is maximizing short-horizon investors’ wealth, that is, catering to short-horizon in-
vestors, will be interested in maximizing the current stock price, even in the absence
of market-timing considerations.5 In this scenario, the manager will find it cheaper
to invest in projects that appeal to short-term investors and continue to do so even
above what is considered optimal under efficient market conditions. Thus, when the
stock is overvalued and shareholders have a short-horizon, managers will increase
investments or package the firm’s assets in a way that justifies the overoptimistic
view about the firm’s growth, as shareholders are presumed to have a lower required
return when they overvalue the stock. This gain from catering is presumed to more
than offset any future losses from inefficient investments. On the other hand, when
the stock is undervalued and shareholders have a short-horizon, managers will refrain
from investing in projects that do not seem to attract shareholders, as they expect a
5 Narayanan (1985) argues that managers who are concerned about their labor market reputations may
engage in actions that enhance the short-term value of the stock at the expense of the long-term value.
Managers concerned about their career future may favor safe projects over riskier ones (Hirshleifer and
Thakor, 1992), hesitate to start a new line of business (Bertrand and Mullainathan, 2003), and hesitate to
shut down a poorly performing line of business (Bertrand and Mullainathan, 2003).
higher required return on these projects. In this situation, the losses from investment
in undervalued projects will not be fully compensated by the projects’ future gains.
It is important to note that the manager will respond, that is, cater, to current
stock price when investors themselves are concerned about it, that is, if they are short-
horizon investors. The catering effect implies the following testable hypothesis:
Hypothesis 2: The shorter the investment horizon of shareholders, the more pro-
nounced the effect of stock mispricing on corporate investments.
We test the above hypotheses differently from other studies. Unlike prior re-
search, we study the market-timing and catering hypotheses in an integrated frame-
work that allows us to test both effects in a single regression framework. Additionally,
we examine these hypotheses for total firm investments as well as firm investments
at a disaggregated level.
We also consider the hypothesized effects for both sides of mispricing—
overvaluation and undervaluation, while previous studies focused on only one side
of mispricing.
3. Data and methodology

The sample consists of panel data of all U.S. firms in the Compustat database
between 1971 and 2012 with information on investments, financing, stock price,
and other accounting and control variables discussed below (see the Appendix for
variable definitions and calculation details). Due to the one period lag structure in
the methodology, the sample period effectively begins in 1972. We require that each
firm have at least two consecutive years of data. The sample excludes financial firms
(Standard Industrial Classification [SIC] codes between 6000 and 6999) and firms
in the utility industry (SIC codes between 4900 and 4949). We exclude firms with
negative total equity. The resulting sample yields 114,805 firm-year observations, for
an average of 3,103 firms a year.
Our basic methodology involves regressing measures of firm investment activity
on measures of stock mispricing, equity financing, the fundamental variables of
cash flows and growth, and other control variables. We define corporate investment
activity to include capital expenditures, acquisitions, R&D expenses, and sale of
assets. To obtain the mispricing variables we rely on Rhodes-Kropf, Robinson and
Viswanathan’s (2005) market-to-book decomposition methodology.6 Specifically,
Rhodes-Kropf, Robinson and Viswanathan (2005) decompose (M/B)it for firm i at
time t into three components: mispricing at the firm level (DevFirm
it ), mispricing at the
Agg
aggregate level (Devit ), and the growth component (Git ).
6 We only provide a brief summary here. For complete details of the decomposition methodology, see
Rhodes-Kropf, Robinson and Viswanathan (2005).
Mispricing at the firm level (DevFirm

it ) is the difference between the market value
of firm i at time t and the fundamental value of firm i at time t, (lnMit − v(θit ; αt )). If
mispricing at the firm level (DevFirm
it ) is positive (negative) then the firm is overvalued
(undervalued). The fundamental value of the firm (v(θit ; αt )) is a function of certain
accounting variables (θ ) and their multiples (αs) and is calculated in two steps: First,
we estimate the model
ln(M)it = α0j t + α1j t ln(B)it + α2j t ln(|NI|)it + α3j t ln(|NI|)it

×D(NIit <0) + α4j t LEV it + εit (1)
annually for each industry where M is the firm market value calculated as:7 common
shares outstanding (#25) times price (#199) + book assets (#6) − book equity (#60) −
deferred taxes (#74), B is the book value of total assets (#6), NI is net income (#172),
D(NIit <0) is a dummy variable equal to 1 when NI is negative, and LEV is the ratio
of total debt (sum of #9 and #34) to total debt and stockholders’ equity (#216). This
estimation process is repeated annually for the entire sample period. Next, using
the estimated multiples (regression coefficients αs) and the accounting data (θ ), we
predict the fundamental value of firm i at time t (v(θit ; αt )).
Agg
Mispricing at the aggregate level (Devit ) is the difference between the funda-
mental value of the firm at time t (v(θit ; αt )) and the fundamental value of the firm
at time t based on long-run industry multiples (ᾱs), [v(θit ; αt ) − v(θit ; ᾱ)]. The long-
Agg
run industry multiples (ᾱs) are the overtime average of (αt s).8 A positive (Devit )
Agg
indicates positive market sentiment and vice versa when Devit is negative. Here,
although fundamentals are kept constant, the value of the firm is different because
of different loadings on those fundamentals based on market sentiment. The distinc-
tion that Rhodes-Kropf, Robinson and Viswanathan (2005) make between firm-level
and aggregate-level mispricing is an interesting one and one that provides addi-
tional insight into the role of mispricing on firm investments. Stein (1996) and
other related studies try to describe the investment decision of informed and ratio-
nal managers in response to mispricing. In this environment, managers will respond
to (exploit) mispricing through market-timing and catering regardless of whether
such mispricing is unique to the firm or happens across firms in the market or the
industry. Conversely, at the aggregate level, Mørck, Shleifer and Vishny (1990) do
not necessarily assume the manager to be well informed. In this case, rather than
exploiting mispricing, managers mistakenly use false signals from the market and
the industry in their investment decisions. Thus, when we relax the assumption of
7 The number next to each variable is the Compustat item number where applicable.
8 The aggregate level can be evaluated at the industry level or at the overall market level. Although all
analyses are done using both levels, only results using industry as the aggregate are reported as both
approaches yield qualitatively similar conclusions. For our purposes we define industries using the Fama
and French (1997) 12-industry classification scheme.
well-informed manager at the aggregate level, as in Mørck, Shleifer and Vishny

(1990) the distinction between firm-level and aggregate-level mispricing becomes
important.
Mørck, Shleifer and Vishny (1990) test the impact of aggregate mispricing using
macro level data rather than firm-level data. Although their test helps us understand the
role of mispricing at the aggregate level of data, it does not inform us on whether firms
are cross-sectionally impacted by aggregate mispricing contained in stock prices,
independent from other effects. Additionally, as Mørck, Shleifer and Vishny (1990)
indicate, testing the aggregate mispricing at the macro level makes it impossible to
disentangle the catering impact from the aggregate mispricing impact at the firm level.
Rhodes-Kropf, Robinson and Viswanathan’s (2005) aggregate mispricing component
Agg
Devit allows us to test the role of aggregate mispricing at the firm level directly. As
Agg
constructed by Rhodes-Kropf, Robinson and Viswanathan (2005), Devit captures
the portion of mispricing that is correlated across firms in an industry or even across
the economy as a whole and therefore aligns well with Mørck, Shleifer and Vishny’s
(1990) concept of aggregate-level and industry-level mispricing. On the other hand
DevFirm
it picks up firm-level mispricing. In keeping with most of the literature, our
main focus will be on firm-level mispricing, but we interpret findings with respect
Agg
to Devit in the context of Mørck, Shleifer and Vishny’s (1990) findings about
aggregate stock mispricing. The third component of Rhodes-Kropf, Robinson, and
Viswanathan’s (2005) market-to-book decomposition measure is Growth (Git ), which
is the difference between the valuations implied by long-run industry multiples and
current book values, (v(θit ; ᾱ) − lnBit ) and captures the nonmispricing component of
the market-to-book ratio.
Besides the market-to-book ratio decomposition variables, other regressors in-
clude measures of cash flow and external equity financing. Cash flow is defined as
income before extraordinary items (#18) plus depreciation and amortization (#14).
External equity financing is captured on a net basis and calculated as equity issued
(#108) minus equity repurchased (#115).
Our hypotheses testing requires a measure of financial constraint. The degree of
financial constraint (Zit ) captures the firm’s dependence on equity. The measure is
based on an index developed by Kaplan and Zingales (1997). We follow Baker, Stein
and Wurgler (2003) and calculate Z based on a modified four-variable version of the
index as follows:
CF it DIV it Cit
Zit = −1.002 − 39.368 − 1.315 + 3.139DEBT it . (2)
Ai(t−1) Ai(t−1) Ai(t−1)
In this equation, CF is cash flow defined as income before extraordinary items

(#18) plus depreciation and amortization (#14), DIV is cash dividends defined as the
sum of preferred dividends (#19) and common dividends (#21), and C is cash and
short-term investments (#1). All three preceding variables are scaled by beginning
of the period book assets (#6). DEBT is the sum of long-term debt (#19) and current
portion of debt (#34) divided by the sum of long-term debt (#9), current portion of
debt (#34), and stockholders’ equity (#216). Using this model, firms with higher Z
scores are more financially constrained.
Finally, our hypotheses tests also require a measure of shareholder investment
horizon. We follow Gaspar, Massa and Matos (2005) and Polk and Sapienza (2009),
and use share turnover ratio as a proxy for the average length of time that investors
hold their stocks. Firms that are owned by short- (long-)horizon shareholders are
more likely to have high (low) share turnover ratios. Share turnover ratio is calculated
as the average of the monthly ratios of traded shares to shares outstanding during
the fiscal year. To get the share turnover ratio, the initial sample is intersected with
the CRSP database to create a Compustat-CRSP sample that yields 85,977 firm-year
observations. The Appendix presents calculation details of all variables used in the
study.
Table 1 presents summary statistics for the investment, financing, market pricing,
and other control variables. Panel A presents data on the various investment activity
variables. Capital expenditures to total assets ratio has the highest median value
among the investment variables thus making it the key investment variable for firms
on an ongoing basis. Investment in R&D comes in second. This is followed by
acquisitions and asset sales, respectively (based on mean values; median values are
zero for both of these categories). Panel B of Table 1 presents the mean ratio of net
external equity to assets (5.6%).
Panel C presents summary statistics for market-to-book ratio as a whole and
its decomposition components using the Rhodes-Kropf, Robinson and Viswanathan
(2005) methodology. The market value of the average firm is 1.8 times its book value.
When we decompose market-to-book ratio into growth and mispricing components
and compare the absolute values of their means, we observe that a large portion of
the incremental value of the average firm above its book value is associated with
the fundamental growth component rather than any mispricing element. On average,
firms are slightly undervalued (Dev Firm = −0.021) when we consider mispricing
at the firm level. However, at the aggregate mispricing level, firms appear to enjoy
higher values because of overall positive sentiment in the market (Dev Agg = 0.017).
Panels D and E contain data for other investment determinants and control variables.
The mean cash flow to total assets ratio is 4.8%, the mean cash to total assets ratio is
20.7%, and the mean dividend to total assets ratios is 1.4%. The mean leverage ratio
for the sample is 29.3% and the mean firm size is $1,151 million though the median
firm size is only $112 million.
4. Results
Our results are organized in line with our two main hypotheses dealing with
market-timing and catering effects. A final subsection examines the sensitivity of the
two main hypotheses to overvaluation and undervaluation separately.
Table 1
Summary statistics for key variables
This table presents summary statistics for key variables including measures of investment activity, financ-
ing, market-to-book decomposition, other determinants of investments, and other variables. Information
is presented on number of observations, mean, median, and standard deviation of the variables. Data are
taken from Compustat for the period between 1971 and 2012. Financial and Utilities firms are not included
in the sample. Negative values for investment variables are ignored. Variable definitions and calculation
details for construction of variables are provided in the Appendix.
Variable Symbol N Mean Median Std. deviation

Panel A: Investments
Investment to total assets It /At−1 114,805 0.137 0.077 0.409
Capital expenditures to total assets CAP Xt /At−1 114,805 0.086 0.049 0.347
Acquisition to total assets ACQt /At−1 110,310 0.034 0.000 0.256
R&D to total assets RDt /At−1 66,375 0.087 0.034 0.340
Sale of PPE to total assets SalePPEt /At−1 90,945 0.009 0.000 0.051
Panel B: Financing
Net equity issued to total assets NetEqt /At−1 107,615 0.056 0.000 0.463
Panel C: Market-to-book decomposition
Market-to-book ratio (M/B)it−1 114,805 1.815 1.275 2.206
Mispricing at the firm level DevFirm
it 114,805 −0.021 −0.061 0.491
Agg
Mispricing at the aggregate level Devit 114,805 0.017 0.042 0.219
Growth Git 114,805 0.394 0.380 0.306
Panel D: Other investment determinants
Degree of financial constraint Z 114,805 0.065 0.236 4.529
Cash flow to total assets CF t /At−1 114,805 0.048 0.086 0.743
Dividends to total assets DIV t /At−1 114,805 0.014 0.000 0.102
Cash to total assets Ct /At−1 114,805 0.207 0.087 0.852
Leverage LEV 114,805 0.293 0.270 0.247
Investor horizon H 85,977 0.001 0.000 0.001
Panel E: Other variables
Total assets (millions) A 114,805 1,151.26 111.859 3,897.91
Net income (millions) NI 114,805 50.22 2.598 238.01
4.1. Market-timing
Recall that Hypothesis 1(a) predicts that equity transactions, especially transac-
tions that are motivated by market-timing, affect the investment decision of the firm.
We test this hypothesis by estimating the following regressions:
Iit CF it Agg
= β0 + β1 + β2 DevFirm
it−1 + β3 Devt−1 + β4 Git−1 + β5 RMBit−1
Ait−1 Ait−1
NetEqit
+ β6 + εit (3a)
Ait−1
and
Iit CF it Agg
it−1 + β3 Devt−1 + β4 Git−1 + β5 RMBit−1
Ait−1 Ait−1

NetEqit NetEqit
+ β6a Time × + β6b NOTime × + εit . (3b)
Ait−1 Ait−1
In Equation (3a), the dependent variable consists of measures of investments
scaled by total assets. We define investments (I) as the sum of capital expenditures
(CAPX), acquisitions (ACQ), and R&D expenses (RD) minus asset sales (SalePPE).
We estimate the regressions with the aggregate measure of investments (I) as just
defined and also at the disaggregated level for each of the four components of I. The
first independent variable is cash flow (CF) scaled by total assets, the second through
fourth independent variables represent the market-to-book ratio decomposition ele-
ments, the fifth variable captures the residual market-to-book ratio effect (RMB) not
accounted for by the three decomposition variables,9 and the final variable captures
the net equity issuance activity of the firm.
Equation (3a) does not discriminate between equity issuances that are timed to
coincide with periods of stock overvaluation and issuances that occur in other periods.
A proper test of the market-timing hypothesis should differentiate between
equity issuances during periods of relative overvaluation and other times with the
former being significant but not the latter. Equation (3b) allows us to draw this
distinction by splitting net equity issuance into a portion that is motivated by market-
timing considerations and a portion that is not. The split is accomplished by interacting
current net equity issuance variable with two dummy variables that capture whether
or not the net issuance is market-timing driven. Specifically, the dummy variable,
Time, is set equal to 1 (Time = 1) if the firm is overvalued and has positive net issuance
activity or if the firm is undervalued and has negative net issuance activity. The second
dummy variable, NOTime, is set equal to 1 (NOTime = 1) if the firm is overvalued and
does not have positive net issuance activity or if the firm is undervalued and does not
have negative net issuance activity. Firms are classified as over- or undervalued based
on the beginning of the period firm-level mispricing: If DevFirm it−1 is greater (less) than
zero, then the firm is overvalued (undervalued). We use firm and year fixed effects
panel regression methodology to estimate the above regressions.10
Table 2 presents regression estimates for Equations (3a) and (3b) in rows 1 and 2,
respectively, for each investment variable: I, its components—CAPX, R&D, ACQ, and
SalePPE. As can be seen, estimates of Equation (3a) reveal that net equity issuance
9 RMB is the residual from the regression of the market-to-book ratio on the three decomposition variables
and is included to capture any remaining effect of market-to-book ratio that is orthogonal to the three
components, the RMB coefficient estimates are not reported for space considerations.
10 For further robustness, we control for lagged net equity as well as the interaction of lagged net equity
with the time dummies. Our results (not reported) are similar to those reported in Table 2.
Table 2
Equity issuance, mispricing and firm investment decisions
This table shows panel regression estimates for Equations (3a) and (3b). Estimates are shown for five measures of investment activity: total investments, capital
expenditures, acquisitions, R&D, and asset sales, respectively. Two rows of estimates are presented for each measure of investment activity. The first row contains
estimates for Equation (3a), whereas the second row presents estimates for Equation (3b). p-Values are shown below coefficient estimates and are based on
heteroskedasticity-robust standard errors. The last column shows the adjusted R2 and the number of observations immediately beneath it. The intercept is not
reported.
Agg T ime× NOT ime×
Dependent variable CF t /At−1 DevFirm
t−1 Devt−1 Gt−1 NetEqt /At−1 R 2 (%) N
NetEqt /At−1 NetEqt /At−1
It /At−1 0.2207 (0.051) 0.0490 (0.000) 0.0567 (0.000) 0.1099 (0.000) 0.4429 (0.000) 35.18 N = 107,615
0.2207 (0.051) 0.0373 (0.000) 0.0584 (0.000) 0.1206 (0.009) 0.4310 (0.000) −0.0186 (0.945) 38.95 N = 107,615
CAP Xt /At−1 0.2191 (0.051) 0.0311 (0.000) 0.0268 (0.000) 0.0551 (0.009) 0.2682 (0.000) 39.30 N = 107,615
0.2199 (0.051) 0.0280 (0.000) 0.0289 (0.000) 0.0621 (0.000) 0.2543 (0.000) 0.0914 (0.544) 40.82 N = 107,615
ACQt /At−1 0.0432 (0.000) 0.0070 (0.000) 0.0320 (0.000) 0.0329 (0.000) 0.0783 (0.000) 3.25 N = 103,506
0.0397 (0.000) 0.0078 (0.000) 0.0329 (0.000) 0.0351 (0.000) 0.0745 (0.000) 0.0773 (0.001) 3.85 N = 103,506
RDt /At−1 −0.0810 (0.000) 0.0229 (0.000) 0.0146 (0.000) 0.0473 (0.000) 0.1041 (0.000) 46.36 N = 61,593
−0.0873 (0.000) 0.0230 (0.000) 0.0155 (0.000) 0.0500 (0.000) 0.1043 (0.000) 0.0973 (0.000) 47.26 N = 61,593
SalePPEt /At−1 0.0016 (0.019) −0.0005 (0.035) −0.0010 (0.015) −0.0003 (0.448) 0.0022 (0.000) 1.7 N = 85,312
0.0013 (0.053) −0.0006 (0.017) −0.0010 (0.016) −0.0002 (0.609) 0.0020 (0.003) −0.0030 (0.355) 2.13 N = 85,312
M. Alzahrani and R. P. Rao/The Financial Review 49 (2014) 89–116
103
is a significant determinant of investment activity across the board, regardless of how

it is defined. It is interesting to note that the relation between asset sales variable and
net equity is positive. This suggests that sales of fixed assets are an additional source
of financing used along with equity issuance.
Consistent with market-timing effect, we find aggregate investment activity (I),
capital expenditures (CAPX), and asset sales (SalePPE) to be driven by equity is-
suances (repurchases) that coincide with periods of overvaluation (undervaluation)
(significant β 6a coefficient) and not with other periods (insignificant β 6b coeffi-
cient).11 In the remaining instances—ACQ and RD—both Time and NOTime inter-
actions are significant with almost the same magnitude for the two coefficients. An
interesting pattern that emerges from Table 2 is that capital expenditures are financed
differently relative to acquisitions and R&D. For example, in Table 2, in addition
to internal resources, capital expenditures rely on overvalued external equity while
R&D and acquisitions rely on external equity in general. On balance, it appears that
Hypothesis 1a on the market-timing effect is supported when considering aggregate
investments and its largest component, CAPX.
As we can see from the preceding results, the presence of mispricing takes us
away from Modigliani and Miller’s (1958) world of investment-financing indepen-
dence to a world in which investment type and security market-timing play a role in
how investments are financed. Our result is in line with the market-timing hypothesis
of Baker and Wurgler (2002) and Welch (2004), but goes beyond their simple market-
timing hypothesis to show that at least part of the overvalued equity is used to invest
in capital expenditures. Our evidence is consistent with Stein’s (1996) market-timing
investment link and consistent with the recent work of Dittmar and Thakor (2007)
who hypothesize that firms will issue overvalued equity to invest in projects in which
there is an agreement between the managers and the shareholders about its merits.
When testing their hypothesis, Dittmar and Thakor (2007) find that capital expendi-
tures are financed with overvalued equity. Our results are consistent with more recent
findings of Gatchev, Spindt and Tarhan (2009) who show that capital expenditures
are more likely to be financed by equity.
In Table 2, R&D is shown to be positively related to external equity regardless
of its mispricing status. The use of equity to finance R&D reduces the possibility of
underinvestment associated with debt financing (Myers, 1977) and provides managers
with more discretion over the funds (Jung, Kim and Stulz, 1996). Thus, the flexibility
provided by equity financing and the alleviation of agency costs of debt can be
assumed to outweigh the benefits of using debt such as debt tax-shield net of distress
costs (Modigliani and Miller, 1963), agency cost reduction (Jensen and Meckling,
1976), and the reduction of adverse selection costs (Myers and Majluf, 1984). Our
11 It is interesting to note that market timers are always significantly less than nontimers in all samples.
Thus, the significance of market-timing transactions compared to nonmarket-timing transaction is not
driven by the possibility that timers significantly outweigh nontimers.
Table 3
Financial constraints and investment-mispricing sensitivity
This table examines the sensitivity of the investment-mispricing relationship to firm financial constraints.
Firms are sorted into quartiles based on the degree of financial constraints measured by the Kaplan and
Zingales (1997) index, Z, which is calculated using Baker, Stein and Wurgler’s (2003) four variable ver-
Cit
sion: Zit = −1.002 ACF it
i(t−1)
− 39.368 ADIV it
i(t−1)
− 1.315 Ai(t−1) + 3.139DEBT it . The higher the value of Z, the
more financially constrained the firm. For each group, we estimate the following panel regression (Equa-
Iit Agg
tion (4) in the text): Ait−1 = β0 + β1 ACF it
it−1
+ β2 DevFirm
it−1 + β3 Devt−1 + β4 Git−1 + εit . The coefficients
β 2 is reported for each group as well as the difference in these coefficients between the top and bottom
quartiles. Regression estimates are shown for five measures of investment activity: total investments,
capital expenditures, acquisitions, R&D, and asset sales, respectively. p-Values are shown below for indi-
vidual coefficient estimates and are based on heteroskedasticity-robust standard errors. Significance of the
difference between the top and bottom quartiles is based on the t-test with p-values shown in parentheses.
β2
Dependent variable Bottom quartile 2nd quartile 3rd quartile Top quartile Top – bottom
It /At−1 0.0667 (0.000) 0.0610 (0.000) 0.0778 (0.000) 0.1191 (0.000) 0.0524 (0.000)
CAP Xt /At−1 0.0297 (0.000) 0.0319 (0.000) 0.0437 (0.000) 0.0621 (0.000) 0.0324 (0.000)
ACQt /At−1 0.0119 (0.000) 0.0134 (0.000) 0.0355 (0.000) 0.0434 (0.000) 0.0315 (0.000)
RDt /At−1 0.0474 (0.000) 0.0367 (0.000) 0.0399 (0.000) 0.0554 (0.000) 0.0081 (0.005)
SalePPEt /At−1 −0.0023 (0.001) −0.0010 (0.145) −0.0025 (0.001) 0.0025 (0.013) 0.0045 (0.002)
results are consistent with survey evidence in Pinegar and Wilbricht (1989) and
Graham and Harvey (2001) who report that maintaining financial flexibility is one
of the most important considerations when firms choose between various sources of
funds. The dependence of acquisitions on external equity, regardless of mispricing,
is consistent with the widespread use of equity as medium of payment (Fama and
French, 2005).
Hypothesis 1b asserts that the relation between stock mispricing and investments
is economically stronger in financially constrained firms. As mentioned in the data
section, we use the KZ financial constraint index to proxy for the degree of financial
constraint experienced by a firm. Using the index score, firms are assigned to quartiles
with quartile 4 comprising the most financially constrained firms. We then estimate
the following regression equation for each quartile:
Iit CF it Agg
it−1 + β3 Devt−1 + β4 Git−1 + εit . (4)
Ait−1 Ait−1
The pattern of coefficients on the firm mispricing variable (β 2 ) is examined
across the different quartiles. Hypothesis 1b implies that the coefficient for the mis-
pricing variable increases as we move from the lowest to highest financial constraint
quartile.
Table 3 presents tests of Hypothesis 1b. Each row represents a different measure
of investment activity. The table shows the mean firm-level mispricing coefficient
(β 2 ) across the different quartiles along with its significance level (based on the
t-test), and the difference between the highest and lowest quartile means along with
its significance level (based on the t-test). Overall, Table 3 shows a generally mono-
tonic relation between the degree of financial constraint and the effect of mispricing
on investments. Total investments, capital expenditures, acquisitions in financially
constrained firms are two to three times as sensitive to firm-level mispricing as sim-
ilar decisions in unconstrained firms. R&D activity shows smaller but significant
differences between top and bottom quartiles. In addition, the asset sales variable
is positively related to firm mispricing in the top quartile, but negatively related to
firm mispricing in the bottom quartile. This result suggests that highly constrained
firms may use asset sales as a source of funds rather than as an investment strat-
egy. Thus, when a financially constrained firm is overpriced and wants to increase
its investments, it uses proceeds from the sale of old assets to invest in these new
projects. The overall evidence for the firm mispricing coefficients across the financial
constraint quartiles supports Hypothesis 1b, that is, the sensitivity of investment to
firm mispricing is increasing in the degree of financial constraint faced by the firm.12
4.2. Catering effect

We provide both an indirect and a more direct test of the catering effect formal-
ized in Hypothesis 2. The indirect test involves documenting a significant relationship
between investment activity and firm mispricing even after controlling for market-
timing issuance activities. Therefore, after controlling for net financing activities, any
remaining effect of firm mispricing on investment activity is presumed to be due to
managerial catering. This is, of course, an indirect test as there may be some other
unknown factor that may account for this residual relationship. With that caveat in
mind, the continued significance of the firm mispricing variable, even in the presence
of the market-timing interaction variables, would be suggestive of a catering effect.
The results in Table 2 reveal a significant mispricing variable (Dev Firm ) even after
controlling for market-timing.13
The more direct test of the catering effect involves examining the difference in
mispricing-investment sensitivity between firms with short-horizon shareholders and
12 For robustness, we use the A-S index as an alternative financial constraint measure (Hadlock and Pierce,
2010) and find similar results for all investment types except asset sales.
13 Table 2 also reveals a significant coefficient for the aggregate mispricing variable (Dev Agg ) even
after controlling market-timing of equity issuance. Though not a focus of our study, recall from our
discussion of the methodology that this element of the Rhodes-Kropf, Robinson and Viswanathan (2005)
market-to-book ratio decomposition addresses Mørck, Shleifer and Vishny’s (1990) point that managers’
investment decision may not only be affected by mispricing at the firm level but also at the more aggregate
industry/economy levels. Mørck, Shleifer and Vishny (1990) observe that managers use information about
the aggregate economy contained in stock prices to make investment decisions. This implies that any
mispricing at the industry or the market level can affect investment activity if managers are unable to filter
out errors at the aggregate level (industry and economy). Our results suggest that managers’ investment
decisions are affected by aggregate mispricing even after controlling for firm mispricing and market-timing
of equity issuance.
Table 4
Shareholders’ investment horizon and investment-mispricing sensitivity
This table examines the sensitivity of the investment-mispricing relationship to shareholder investment
horizon (i.e., catering hypothesis). Firms are sorted into quartiles based on their relative shareholder
investment horizon (H). Investor horizon is measured by the turnover ratio calculated as the average of
the monthly ratio of shares traded to shares outstanding during the fiscal year. The higher the turnover
ratio the shorter the shareholder investment horizon. For each group we estimate the following panel
Iit Agg
regression (Equation (4) in the text): Ait−1 = β0 + β1 ACF it
it−1
+ β2 DevFirm
it−1 + β3 Devt−1 + β4 Git−1 + εit .
The coefficients β 2 is reported for each group as well as the difference in these coefficients between
the top and bottom H quartiles. Estimates are shown for five measures of investment activity: total
investments, capital expenditures, acquisitions, R&D, and asset sales, respectively. p-Values are shown
below for individual coefficient estimates and are based on heteroskedasticity-robust standard errors.
Significance of the difference between the top and bottom quartiles is based on the t-test with p-values
shown in parentheses.
β2
Dependent variable Bottom quartile 2nd quartile 3rd quartile Top quartile Top – bottom
It /At−1 0.0560 (0.000) 0.0689 (0.000) 0.0755 (0.000) 0.0761 (0.000) 0.0201 (0.000)
CAP Xt /At−1 0.0271 (0.000) 0.0319 (0.000) 0.0376 (0.000) 0.0395 (0.000) 0.0124 (0.000)
ACQt /At−1 0.0108 (0.000) 0.0141 (0.000) 0.0133 (0.000) 0.0165 (0.000) 0.0057 (0.015)
RDt /At−1 0.0244 (0.000) 0.0321 (0.000) 0.0316 (0.000) 0.0340 (0.000) 0.0096 (0.000)
SalePPEt /At−1 −0.0016 (0.000) −0.0021 (0.000) −0.0008 (0.009) −0.0011 (0.000) −0.0006 (0.231)
firms with long-horizon investors. Hypothesis 2 asserts that firms owned by short-
horizon shareholders are associated with higher mispricing-investment sensitivity.
As discussed in the data section, we measure shareholder investment horizon by
the share turnover ratio. Specifically, for each firm-year, we calculate the average
of the monthly share turnover ratio during the fiscal year. We then sort firms into
quartiles based on the average turnover ratios for all firm-years with the top quartile
consisting of firms with the highest turnover ratio, that is, shortest investment horizon.
For each quartile, we estimate Equation (4) using alternate measures of investment
activity. Hypothesis 2 implies that the coefficients for the firm mispricing variable
will increase from the lowest to the highest quartile.
The results are presented in Table 4. Each row represents a different measure
of investment activity. The table shows the mean firm-level mispricing coefficient
(β 2 ) across the different quartiles along with its significance level (based on the t-
test), and the difference between the highest and lowest quartile means along with its
significance level (based on the t-test). The firm mispricing coefficient, for the most
part, exhibits a pattern consistent with the catering effect—firms with the shortest
horizon investors (top quartile) have greater sensitivity to investment activity than
firms with longest horizon investors. The relationship is not always strictly monotonic
when considering the intermediate quartiles. However, when extreme quartiles are
considered, the coefficients are significantly different in the direction hypothesized
for all investment activity variables except for SalePPE. In addition to the statistical
significance, the differences appear to be economically significant based on their
magnitudes. At a minimum, the coefficient in the top quartile is 1.4 times that in the
bottom quartile. The results support the findings of Polk and Sapienza (2009) and
are in line with Jensen’s (2005) argument that managers of overvalued firms will
cater to their short-horizon shareholders by increasing investment to justify the high
value. Jensen (2005) notes that managers may cater to short-term investors because
they are afraid of being fired or of the firm being taken over. As these investors
care more about stock movements on the short run, myopic managers will engage in
actions that increase the current stock price. Thus, when a stock suffers from short-
term mispricing, the manager will not wait for the market to correct the mispricing;
instead, she will react in a way that will either support the mispricing if the stock
is overvalued or negate the mispricing if the stock is undervalued. This reaction by
the myopic manager creates the link between mispricing and investment activity. In
the case of acquisitions, our results on the catering effect support the findings of Luo
(2005) and Kau, Linck and Rubin (2008) that managers take cues from the market
and are more likely to cancel investments when the market reacts unfavorably to the
related announcement.
4.3. Is the mispricing-investment relation a one-sided phenomenon?

The preceding analyses assume a symmetric response for overvalued and under-
valued firms. Separate analyses of the two mispricing directions (undervaluation and
overvaluation) should be of interest since extant theoretical models generally focus
only on one side of the mispricing direction. For example, Baker, Stein and Wurgler
(2003) develop the equity dependence model of the mispricing-investment relation,
but it is assumed to work only for undervalued firms. Panageas (2003) and Gilchrist,
Himmelberg and Huberman (2005) present models based on heterogeneous beliefs
and short-sale constraints which imply overvaluation only. Polk and Sapienza (2009)
argue that the relation between mispricing and investment works for both sides of
mispricing, under- and overvaluation; however, in their test methodology, they do
not separate the two types of mispricing to reveal whether the mispricing-investment
relation is symmetric or asymmetric. Consequently, in this section we re-estimate
Equation (3a) for overvalued firms (Table 5) and undervalued firms (Table 6) sepa-
rately to learn how the two sides behave.
Overvalued firms are likely to issue equity in response to the overvaluation,
which is presumed to lead to overinvestment. The overinvestment can be caused
either by market-timing (i.e., the issuance of overvalued equity) or by managerial
catering or by a combination of the two. The effect of market-timing is measured by
the coefficients for the equity variables. The effect of managerial catering on the other
hand is measured by the coefficient of the firm mispricing variable after controlling
for the financing variables. On the other hand, undervaluation can distort investments
through rechanneling investment funding into stock repurchases (market-timing) or
reducing investments at times of undervaluation (catering).
Table 5
Overvaluation and firm investment decisions
This table shows results of the investment-mispricing relationship for overvalued firms (>0 DevFirm
t−1 ). Estimates are shown for five measures of investment activity:
total investments, capital expenditures, acquisitions, R&D, and asset sales, respectively. For each investment measure, panel regression Equation (3a) is presented.
p-Values are shown below coefficient estimates and are based on heteroskedasticity-robust standard errors. The last column shows the adjusted R2 and the number
of observations immediately beneath it. The intercept is not reported.
Firm Agg NetEqt
Dependent variable CF t /At−1 >0 Devt−1 Devt−1 Gt−1 At−1
R 2 (%) N
It /At−1 0.4244 (0.000) 0.0372 (0.000) 0.0536 (0.000) 0.1142 (0.000) 0.4554 (0.000) 56.48 N = 45,927
CAP Xt /At−1 0.4111 (0.000) 0.0265 (0.003) 0.0213 (0.027) 0.0514 (0.000) 0.2823 (0.000) 65.89 N = 45,927
ACQt /At−1 0.0365 (0.000) 0.0042 (0.038) 0.0342 (0.000) 0.0346 (0.000) 0.0677 (0.000) 3.62 N = 43,787
RDt /At−1 −0.0875 (0.000) 0.0225 (0.000) 0.0100 (0.001) 0.0528 (0.000) 0.0989 (0.000) 47.08 N = 27,790
SalePPEt /At−1 0.0017 (0.073) −0.0008 (0.049) −0.0017 (0.009) −0.0004 (0.459) 0.0017 (0.010) 2.75 N = 36,388
109
110
Table 6
Undervaluation and firm investment decisions
This table shows results of the investment-mispricing relationship for undervalued firms (<0 DevFirm t−1 ). Estimates are shown for five measures of investment
activity: total investments, capital expenditures, acquisitions, R&D, and asset sales, respectively. For each investment measure, panel regression Equation (3a) is
presented. p-Values are shown below coefficient estimates and are based on heteroskedasticity-robust standard errors. The last column shows the adjusted R2 and
the number of observations immediately beneath it. The intercept is not different from zero in all regressions and thus, not reported.
Firm Agg NetEqt
Dependent variable CF t /At−1 <0 Devt−1 Devt−1 Gt−1 At−1
R 2 (%) N
It /At−1 0.0773 (0.000) 0.0535 (0.000) 0.0499 (0.000) 0.0961 (0.000) 0.2274 (0.000) 22.13 N = 61,686
CAP Xt /At−1 0.2021 (0.000) −0.0440 (0.261) −0.0141 (0.559) −0.0157 (0.704) 0.3219 (0.058) 37.53 N = 61,686
ACQt /At−1 0.0480 (0.000) 0.0230 (0.000) 0.0413 (0.000) 0.0498 (0.000) 0.1053 (0.000) 3.84 N = 59,717
RDt /At−1 −0.0632 (0.000) 0.0359 (0.000) 0.0263 (0.000) 0.0529 (0.000) 0.1102 (0.000) 41.73 N = 33,802
SalePPEt /At−1 0.0016 (0.160) −0.0036 (0.002) −0.0018 (0.043) −0.0011 (0.320) 0.0027 (0.028) 0.24 N = 48,922
We control for aggregate mispricing and growth variables. However, we do not

focus on these variables here; our main focus is on the firm-level mispricing effect on
investment activity and its potential asymmetry between overvalued and undervalued
firms.
Regression results in the case of overvaluation (Table 5) suggest that
both market-timing and managerial catering impact investment when examining
investment activity at the aggregate and disaggregated levels as indicated by the
generally significant coefficients for the mispricing and equity variables.
In case of undervaluation, market-timing measured by the coefficient on net
equity reflects that undervalued firms engage in share repurchases that reduce in-
vestments. The results in Table 6 show that market-timing effect is significant for all
investment decisions, with significance at 10% level in the case of capital expendi-
tures.
When reconciling the results with the earlier results (in Table 2), the market-
timing explanation is only evident in capital expenditures, whereas the significant
equity variable for acquisitions could be a result of using equity to pay for target firms.
Likewise, the significant equity variable in R&D reflects the general dependency on
equity financing.
After controlling for net equity issuance, capital expenditures do not seem to
react to undervaluation. Other investment types, on the other hand, show significant
reaction to undervaluation after controlling for net equity issuance. Tables 5 and 6
also report a negative (as expected) and significant relation between asset sales and
firm mispricing. Therefore, the reduction of fixed assets (asset sales) seems to be
affected by the level of over- and undervaluation.
The results, in general, suggest that mispricing affects investments in both over-
valuation and undervaluation cases. Overvaluation seems to affect aggregate invest-
ments, capital expenditures, acquisitions, R&D, and asset sales through market-timing
and catering. Undervaluation seems to affect aggregate investments, acquisitions,
R&D, and asset sales through market-timing and catering, but affects capital expen-
ditures only through market-timing.
5. Conclusion
In this study, we examine the role of stock market mispricing as a determinant of
corporate investments. We focus on two primary behavioral motivations discussed in
the literature. First, stock mispricing affects the cost of external financing and thus the
cost of capital used to evaluate investments. According to this view, managers raise
funds when the stock is overvalued to enjoy a lower cost of external financing and
avoid raising funds when the stock is undervalued to avoid the high cost of external
financing. Second, managers base their investment decisions, in part, on shareholders’
investment horizon (managerial catering behavior). When shareholders have a short-
investment horizon (i.e., care about current stock price), any temporary mispricing in
the stock price will affect the investment decisions of the firm.
The study uses the market-to-book decomposition methodology of Rhodes-

Kropf, Robinson and Viswanathan (2005) to identify the various mispricing com-
ponents and relates it to corporate investment activity. We use share turnover as a
proxy for investor horizon to test the catering hypothesis. We examine both aggregate
and disaggregated measures of investment activity including total investments, cap-
ital expenditures, acquisitions, R&D, and asset sales. We also examine the relative
sensitivity of the effects to degree of financial constraints and, in our additional tests,
examine if the reactions are symmetric to relative under- and overvaluation.
Our main findings are as follows: (1) both fundamental (growth) and nonfun-
damental components of the market-to-book ratio significantly determine the level
of corporate investments. (2) The cost of external financing explains significantly
the relation between total investment-mispricing and firm mispricing. Mainly, capi-
tal expenditures are driven by market-timing motivated equity issuance. (3) Highly
financially constrained (and thus equity dependent) firms show higher sensitivity
between investments and stock mispricing. (4) Investment-mispricing sensitivity is
significantly higher in firms with a short-shareholder investment horizon (firms with
a high share turnover ratio) than it is in firms with a long shareholder investment
horizon (firms with a low share turnover ratio).
We find that to the extent that overvalued firms tend to overinvest and underval-
ued firms tend to underinvest, we observe evidence of overinvestment in acquisitions,
R&D, and capital expenditures, whereas underinvestment is confirmed in R&D and
acquisitions but not in capital expenditures. Also, overvalued firms use equity to fi-
nance their investments, whereas undervalued firms reduce their investments as they
repurchase equity. Finally, disinvestment measured by asset sales is significantly im-
pacted by firm over- and undervaluation. Our results are robust to alternative measures
of financial constraints.
In sum, we find that the investment-mispricing sensitivity is influenced by the
nature of the mispricing and type of investment. Future research should focus on why
these differences exist.
Appendix: Data Definitions and Calculation Details

This Appendix presents variable definitions and how they are calculated. All
data are taken from Compustat unless otherwise noted. The numbers next to each
variable refer to Compustat variable numbers.
Variable Symbol Definition and calculation details

Investment I Corporate investment (I) is defined as the sum of capital expenditures
(CAPX) #128 + acquisitions (ACQ) #129 + R&D expense (RD) #46
minus asset sales (SalePPE) #107.
(Continued)
Appendix: continued

Asset sales SalePPE Asset sales are considered to be disinvestments or negative investments.
Asset sales is measured as sale of property, plant, and equipment
(SalePPE) #107.
Mispricing at Dev Firm Refers to the difference between the market price of the stock and the
the firm fundamental value of the stock implied by the firm’s accounting
level information and aggregate multiples. It is calculated as:
Dev Firm = lnMit − v(θit ; αt ), which is the difference between the
market value of firm at time t and the fundamental value of the firm at
time t. The fundamental value of the firm is obtained by applying
annual, aggregate regression multiples αs to the firm-level accounting
values θ . The individual time t values of the αs are obtained using the
model: ln(M)it = α0j t + α1j t ln(B)it + α2j t ln(|NI|)it + α3j t ln(|NI|)it ×
D(NIit <0) + α4j t LEV it + εit . The methodology is adapted from the
market-to-book ratio decomposition methodology of Rhodes-Kropf,
Robinson and Viswanathan (2005).
Mispricing at Dev Agg Refers to the difference between the fundamental value of the stock
the implied by current aggregate multiples and the fundamental value of the
aggregate stock implied by long-run aggregate multiples. Any difference between
level the long-run value and the current fundamental value suggests a time
series error and indicates a certain valuation wave at the aggregate level.
The variable is calculated as: Dev Agg = [v(θit ; αj t ) − v(θit ; αj )], which
is the difference between the fundamental value of the firm at time t
based on time t accounting values θ and time t aggregate multiples αs
and fundamental value of the firm at time t based on time t accounting
values θ and long-run aggregate multiples. The fundamental value of the
firm is obtained by applying annual, aggregate regression multiples αs
to the firm-level accounting values θ .
The individual time t values of αs are obtained using the model:
ln(M)it = α0j t + α1j t ln(B)it + α2j t ln(|NI|)it + α3j t ln(|NI|)it ×
D(NIit <0) + α4j t LEV it + εit . The long-run aggregate multiples ᾱs are
the over time average of αs.
Growth G Is the difference between the valuations implied by long-run multiples and
component current book values. The difference between these two values is used as
a proxy for the growth of the firm. It is calculated as: Growth =
v(θit ; α) − lnBit . The fundamental value of the firm is based on the
long-run multiples ᾱs and the accounting numbers at time t. The book
value is the book assets #6.
Market-to- M/B Refers to ratio of the market value of the firm to the book value of the firm.
book It is calculated as: M/B = the market value of equity (Common shares
ratio outstanding #25 × closing stock price #199) + book assets #6 book
equity #60 – deferred taxes #74 all divided by total assets #6.
Net equity NetEq Refers to net equity issued. It is calculated as: NetEq = equity issued
#108 – equity repurchased #115.
(Continued)
Appendix: continued

Investor H Measures relative shareholder investment horizon at the firm level. Investor
horizon horizon is measured by the turnover ratio calculated as the average of the
monthly ratios of shares traded to shares outstanding during the fiscal
year. Data is taken from CRSP monthly files database.
Degree of Z Z measures the extent to which the firm is financially constrained. A high
financial value of Z implies more binding constraints and less ability to issue debt
constraint and thus more dependence on equity. This measure was taken from
Kaplan and Zingales (1997) and calculated as:
Cit
Zit = −1.002 ACF it
i(t−1)
− 39.368 ADIV it
i(t−1)
− 1.315 Ai(t−1) + 3.139DEBT it
where cash flow (CF) ratio is income before extraordinary items #18
plus depreciation and amortization #14 over beginning of the period
book asset #6. (DIV) is the cash dividends (preferred dividends #19 +
common dividends #21. (C) is cash and short-term investments #1.
(DEBT) is the ratio of debt over the total of debt and equity. DEBT =
[long-term debt #9 + current portion of debt #34]/[long-term debt #9 +
current portion of debt #34 + stockholders’ equity #216].
Timing Time Dummy variable equal to 1 (Time = 1) if the firm is overvalued and has
dummy positive net issuance activity or if the firm is undervalued and has
negative net issuance activity.
NO timing NOTime Dummy variable equal to 1 (NOTime = 1) if the firm is overvalued and
Dummy does not have positive net issuance activities or if the firm is
undervalued and does not have negative net issuance activities.
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Managerial Behavior and the Link between

Article in Financial Review · February 2014

Managerial Behavior and the Link between

We examine the impact of mispricing on corporate investments and its components:

Keywords: stock mispricing, financial constraints, investment horizon, corporate investments

JEL Classifications: G31, G32, G34, D92

2. Literature review and hypotheses development

2.2. Testable hypotheses

Hypothesis 1a: Stock mispricing affects corporate investments positively through

3. Data and methodology

Mispricing at the firm level (DevFirm

ln(M)it = α0j t + α1j t ln(B)it + α2j t ln(|NI|)it + α3j t ln(|NI|)it

well-informed manager at the aggregate level, as in Mørck, Shleifer and Vishny

In this equation, CF is cash flow defined as income before extraordinary items

Variable Symbol N Mean Median Std. deviation

is a significant determinant of investment activity across the board, regardless of how

4.2. Catering effect

4.3. Is the mispricing-investment relation a one-sided phenomenon?

We control for aggregate mispricing and growth variables. However, we do not

The study uses the market-to-book decomposition methodology of Rhodes-

Appendix: Data Definitions and Calculation Details

Variable Symbol Definition and calculation details

Variable Symbol Definition and calculation details

Variable Symbol Definition and calculation details

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