Do Investors Overvalue Firms with Bloated Balance Sheets?

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