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E-MailMing Dong is an associate professor of finance at York University Schulich School of Business; David Hirshleifer is Paul Merage Chair in Business Growth and professor of finance at University of California at Irvine Paul Merage School of Business, and a Research Associate at NBER; Siew Hong Teoh is Dean’s Professor of Accounting at University of California at Irvine Paul Merage School of Business. This post is based on their recent paper.
We test how stock market overvaluation affects corporate innovative activities and success. Under what we call the misvaluation hypothesis of innovation, firms respond to market overvaluation by engaging more heavily in innovative activities, resulting in higher future innovative output. We further argue that overvaluation encourages the most risky and creative forms of innovation (“moon shots”). We empirically test this hypothesis by relating measures of stock misvaluation to corporate innovative investment in the form of research and development (R&D), innovative output (measured by the number of patents and patent citations), and innovative inventiveness (measured by novelty, originality, and scope of patents and citations).
Under the misvaluation hypothesis, equity overvaluation stimulates investment via both financing and non-financing channels. In the financing channel, overvaluation encourages the firm to raise more equity capital to exploit new shareholders. If firms are inclined to invest the additional funds, overvaluation encourages innovative investment. In a governance channel, managers of an overvalued firm may feel insulated from board or takeover discipline, and therefore may be more willing to undertake risky innovative activity. Managers who desire publicity may also be attracted to ambitious, glamorous and attention-grabbing projects. There is also a possible catering channel: Managers who prefer high current stock prices may spend heavily, even at the expense of long-term value, to cater to investor optimism about those investment opportunities that investors find appealing to maintain high stock prices. Finally, managers themselves may share in the positive sentiment of investors that is the source of overvaluation. If, for example, managers overestimate innovative growth opportunities, the firm will undertake more such activity.
A key challenge for estimating the relationship between innovative activity or output to misvaluation is that valuation is endogenous: firms with excellent opportunities for innovative investment should, in an efficient market, have high prices. We address this issue by using measures of misvaluation which are designed to purge, as much as possible, this rational component of valuation. Specifically, we use two measures of misvaluation from previous literature. The first, is the ratio of “intrinsic value” to market price. The intrinsic value is a forward-looking measure of fundamental value derived from the residual income model using analyst forecasts of future earnings. As such, it filters such prospects from market price, except insofar as such prospects are associated with misvaluation rather than just growth.
The second misvaluation measure is not based on market price; it uses mutual fund hypothetical sales of stocks as a function of investor outflows. Previous literature finds that mutual fund outflows lead to selling pressure on stocks held in the funds, thereby temporarily depressing the prices of fund stock holdings for non-fundamental reasons.
We find that overvaluation has a very strong and robust association with higher intangible investments and resulting outputs and inventiveness, and the sensitivity of R&D to misvaluation is about 4-8 times greater than the sensitivity of capital expenditures to misvaluation using either of our mispricing proxies. One reason to expect misvaluation to be more important for innovative spending than for capital expenditures is that, under the misvaluation hypothesis, measured misvaluation should be most strongly related to the form of investment that investors are most prone to misvaluing. Intangible investments such as R&D have relatively uncertain payoff, and therefore are harder to value than ordinary capital expenditures. Another reason is that industry- or market-wide overvaluation can help solve externality problems in innovation; a breakthrough by one firm can open opportunities for other firms. Network externalities in technology adoption and innovation are a common explanation offered for the rise of centers of innovation such as Silicon Valley.
To assess the relative importance of equity-financing versus other channels through which misvaluation can affect innovation, we conduct a path analysis of the R&D and capital expenditure responses to misvaluation. Using either of our misvaluation proxies, we find over two thirds of the total effect of misvaluation on both R&D and capital spending derives from the non-equity channel. The larger magnitudes of the non-equity channel suggest that stock misvaluation affects corporate investment mainly via the pathways of catering and/or shared sentiment effects rather than via the equity-financing channel.
To dig more deeply into the misvaluation effect, we examine interactors which, under different hypotheses, should strengthen or weaken the sensitivities of innovative spending and outcomes to misvaluation. We interact our misvaluation measures with indicators for firms in the highest quintile for growth opportunities, equity catering pressure as proxied by share turnover, or overvaluation itself. We find that R&D spending, innovative output, and the three types of innovative inventiveness are more strongly positively associated with overvaluation among growth firms. This suggests that overvalued firms can more persuasively cater to investors via R&D, or issue equity to finance R&D, when they have good growth prospects; that such increased innovative expenditure of growth firms leads to commensurate innovative output; and that the effects of misvaluation on inventiveness are especially important among growth firms. We also find that the sensitivity of innovative output and inventiveness to misvaluation is greatest in the top turnover quintile, although this is not the case for the sensitivity of R&D to misvaluation. These findings suggest that greater catering to investor misperceptions or high sentiment among high turnover firms takes the form of undertaking more inventive (“moon shot”) projects rather than by increasing R&D.
Finally, we expect misvaluation effects on innovation to be non-linear, with the strongest marginal effects on innovation occurring among the most overvalued firms. Fixed costs of issuing equity, lumpy investment projects, within-firm knowledge spill-overs, and positive network externalities in innovation all imply convexity in the relation of innovative activities and outputs to misvaluation. Consistent with this hypothesis, we find that R&D, innovative output, and inventiveness are far more sensitive to misvaluation in the top overvaluation quintile. For example, the effect of overvaluation on novelty, originality or scope is 4-7 times greater in the most overvalued quintile when compared with the effect in the full sample. In other words, extreme overvaluation is associated with “moon shots”—projects that are exceptionally innovative. This strong convexity also suggests that misvaluation effects do not just average out. The possibility of either under- or overvaluation may on average increase innovative activity and inventiveness, potentially increasing welfare.
The complete paper is available for download here.
One Comment
I am currently enrolled at Arizona State University studying business, doing business, and actively engaging in everything I may be capable of learning. I taught myself stocks a couple years back and I remember learning about the Great Recession. I remember watching neighbors move and people were not able to afford their living situations anymore. I have been researching the Overvaluations we have placed within almost every market in the United States and I believe the confidence margin plays a large role in these valuations. I think many investors have recently pulled because like the research states in the paper we are due for a likelihood of an evaluation to be overvalued four-to-eight times. In some cases I would cite this is as relative in others I would say this ratio is obsolete. Markets such as Autonomous Vehicles have increased at unheard of rates and so has the E-Commerce platforms all over the world. Thank you for your publishing, please feel free to contact me.
Justin Kuehn