Mistaking Bad News for Good News: Mispricing of a Voluntary Disclosure

Abstract

We challenge the prevailing belief among investors that a company’s evaluation of strategic alternatives is good news by showing it is mispriced. First, we evaluate whether the negative future returns are consistent with risk, limits to arbitrage, or mispricing explanations. Second, to explain why overpricing occurs, we propose that investors succumb to the ‘availability heuristic’ (Kahneman and Tversky, 1973) and find corroborating evidence: (i) analysts form over-optimistic expectations of earnings and price; (ii) analysts revise target prices upward but earnings forecasts downward; (iii) investors over-anticipate a possible acquisition premium; and (iv) future returns cluster around earnings announcements. Moreover, some sophisticated investors appear to understand the initial overpricing, and the announcement reaction is dampened when psychological cues are present.

Keywords: Asset Pricing, Stock Returns, Announcements, Market Efficiency, Mergers and Acquisitions, Behavioral Finance, Investor Rationality, Voluntary Disclosure

JEL Classification: G12, G14, G34, G41, M41