Do Investors Overvalue Firms with Bloated Balance Sheets?

53 Pages Posted: 3 Aug 2004  

David A. Hirshleifer

University of California, Irvine - Paul Merage School of Business; NBER

Kewei Hou

Ohio State University (OSU) - Department of Finance

Siew Hong Teoh

University of California - Irvine - Accounting Area

Yinglei Zhang

The Chinese University of Hong Kong (CUHK) - School of Accountancy

Date Written: February 2004

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.

Keywords: limited attention, market efficiency, investor misvaluation

JEL Classification: M41, M43, G12, G14

Suggested Citation

Hirshleifer, David A. and Hou, Kewei and Teoh, Siew Hong and Zhang, Yinglei, Do Investors Overvalue Firms with Bloated Balance Sheets? (February 2004). EFA 2004 Maastricht Meetings Paper No. 3233; Dice Center Working Paper No. 2004-18. Available at SSRN: https://ssrn.com/abstract=404120 or http://dx.doi.org/10.2139/ssrn.404120

David A. Hirshleifer

University of California, Irvine - Paul Merage School of Business ( email )

Irvine, CA California 92697-3125
United States

HOME PAGE: http://sites.uci.edu/dhirshle/

NBER ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Kewei Hou

Ohio State University (OSU) - Department of Finance ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States
614-292-0552 (Phone)
614-292-2418 (Fax)

Siew Hong Teoh (Contact Author)

University of California - Irvine - Accounting Area ( email )

Irvine, CA 92697-3125
United States

Yinglei Zhang

The Chinese University of Hong Kong (CUHK) - School of Accountancy ( email )

Shatin, N.T.
Hong Kong

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