Identifying Overvalued Equity

Abstract

We develop a profile of overvalued equity, and show that firms meeting this profile experience abnormal stock returns net of transaction costs of -22 to -25 percent over the twelve months following portfolio formation. We show our model is distinct from predictors proposed in prior work, and our results robust to alternative measurements of expected returns. We also show that overvaluation is not confined to small firms and that institutions do not trade as if they identify overvalued equity. The profitable predictability we document suggests a pricing anomaly relating to the 2.5% of the firms in the population that our model identifies as substantially overvalued. Although we believe markets are generally efficient within the bounds of transaction costs, our evidence suggests that violations of minimally rational use of publicly available information do occur. To the extent that anomalies disappear or attenuate once documented in the literature (Doukas et al. 2002, Schwert 2003), our results are of interest to financial economists and investors.

Keywords: Overvalued Equity, Agency Costs, Earnings Manipulation, Earnings Overstatement, Financial Fraud, O-Score

JEL Classification: M4, M43, G11, G12, G14, K22