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Abstract:
If investors have limited attention, then accounting outcomes that saliently highlight positive aspects of a firm's performance will promote high market valuations. When cumulative accounting value added (net operating income) over time outstrips cumulative cash value added (free cash flow), it becomes hard for the firm to sustain further earnings growth. When the balance sheet is 'bloated' in this fashion, we argue that investors with limited attention will overvalue the firm, because naïve earnings-based valuation disregards the firm's relative lack of success in generating cash flows in excess of investment needs. The level of net operating assets, the difference between cumulative earnings and cumulative free cash flow over time, is therefore a measure of the extent to which operating/reporting outcomes provoke excessive investor optimism. Therefore, if investor attention is limited, net operating assets will negatively predict subsequent stock returns. In our 1964-2002 sample, net operating assets scaled by beginning total assets is a strong negative predictor of long-run stock returns. Predictability is robust with respect to an extensive set of controls and testing methods.

limited attention, market efficiency, investor misvaluation

Abstract:
This paper addresses the debate about R-square as an indicator of information quality: Does low R-square indicate early resolution of uncertainty through the arrival of firm-specific information, or does it indicate a high level of uncertainty that remains unresolved? Tests based on the post-earnings-announcement drift, V/P, accruals, and net operating assets anomalies all reject the view that low R-square indicates a high quality information environment (early resolution of uncertainty). Low R-square firms have lower future earnings response coefficient, indicating that their current stock price incorporates a smaller amount of future earnings news, and thus more uncertainty about future earnings news remains unresolved. Furthermore, low R-square firms have worse information environment as measured by earnings quality, earnings persistence, and earnings predictability, and have higher probability of distress.

R-square, idiosyncratic volatility, firm-specific information

Abstract:
Hirshleifer et al. (2004) argue that scaled Net Operating Assets (NOA) measures the extent to which operating/reporting outcomes provoke excessive investor optimism. In this paper, I argue that at least part of the information conveyed by NOA is industry common and cannot be diversified when forming industry portfolios conditioning on NOA for investors with limited attention and investor misperceptions should be related to both the industry and the firm-specific components of NOA. Consistent with this hypothesis, in the 1964-2002 sample, both the cross industry and the within industry components of NOA are strong negative predictors for future stock returns. In contrast, I find that the Accruals effect of Sloan (1996) comes entirely from the industry-adjusted component of Accruals. The industry NOA trading strategy survives the statistical arbitrage test introduced by Hogan et al. (2004), which is designed to distinguish between risk premium and mispricing explanations. I also present evidence that the industry NOA effect cannot be explained by the ICAPM (Khan 2006). Finally, I examine the importance of the time series aggregation property of NOA and its inclusion of investment information, and provide evidence that the industry NOA effect is not driven by the clustering of either new equity issuance or M&A activities within industries.

market efficiency, industry returns

Abstract:
We investigate empirically whether mispricing of a firm's stock affects CEO equity-based compensation, controlling for industry and year effects, economic determinants, board characteristics, and institutional ownership. We hypothesize that an overvalued firm may award higher grants to meet the manager's reservation utility from another job, to maintain performance incentives, to acquiesce to greater rent extraction, or to reduce the likelihood of paying for luck. Among firms that award stock options, we find that CEOs of overvalued firms receive higher stock option compensation, lower cash compensation and higher overall total compensation. Furthermore, we find that when a firm awards higher option grants in response to overvaluation or because of a weak board, it subsequently underperforms more. However, the firm subsequently overperforms when it awards more option grants because it has high growth prospects or a high fraction of institutional shareholders.

corporate governance, misvaluation, compensation