Overinvestment and Stock Price Crashes: Evidence from Mergers and Acquisitions

Abstract

A sizeable amount of empirical research attributes stock price crashes to agency reasons, predominantly on managerial bad news hoarding behaviour manifested through the financial reporting opacity channel. Admittedly, another prominent agency-based explanation, namely the overinvestment channel, remains largely unexplored. Using a sample of 68,735 firm-year observations―with 8,096 firm-year observations featuring completed M&A deals―of US-listed firms from 1990 to 2018, this study documents a strong positive relationship between past M&As (over)investment activity and future stock price crashes. This positive overinvestment-crash risk relationship is more pronounced when firms face strong product market competition. The relationship appears to be driven by M&A deals that exhibit negative abnormal returns on their announcement. More importantly, this study further demonstrates that stock price crashes triggered by the overinvestment channel have a significant negative impact on the firm’s future operating profitability.

Keywords: firm-specific stock price crashes, bad news hoarding, agency theory, stock price crash channels, overinvestment, merger and acquisitions

JEL Classification: G13, G34