Equity Overvaluation and Capital Misallocation? A Revealed Preference Approach

43 Pages Posted: 16 Mar 2007

See all articles by Huntley Schaller

Huntley Schaller

Carleton University - Department of Economics

Robert S. Chirinko

University of Illinois at Chicago, Department of Finance; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: March 5, 2007

Abstract

Many economists believe that the stock market plays an important role in efficiently allocating capital to its most productive uses. This standard story of the stock market was called into question by events in the late 1990s, when some observers believed that there was stock market misvaluation that led to a misallocation of capital. Both the standard and misallocation stories involve discount rates and, to differentiate between the two stories, this paper examines the discount rates used by firms in making their investment decisions.

The most common story for how misvaluation might affect investment runs as follows. Investors become excited about particular firms. In their excitement, they bid up the prices of these firms. Overvalued shares lower the perceived cost of equity capital. If managers act on this lower perceived cost, they will issue new shares, lower the discount rate used in evaluating investment projects, and increase investment spending.

This story could be wrong (or at least of minor importance). Firms with high stock market prices may simply be firms that have particularly good investment opportunities. The central core of the standard story of capital allocation involves rates of return and discount rates. Favorable shocks - an increase in demand or a technical improvement - raise returns to capital for the fortunate firm. A firm earning high returns (relative to its cost of capital or discount rate) increases its capital stock until the return on the marginal unit of capital again equals the discount rate. Absent externalities, capital is being allocated optimally.

We use a revealed preference approach that relies on the pattern of investment spending - combined with investment theory - to estimate the discount rates used by managers. The standard story predicts that glamour firms should have discount rates equal to the risk-adjusted market rate. The misallocation story predicts that glamour firms should have discount rates below the market rate. The standard story also predicts the discount rates for glamour firms should have a flat time path, while the misallocation story predicts a U-shaped time path.

Based on a panel dataset of over 50,000 firm-year observations, we find support for both stories. The behavior of glamour firms with good measured investment opportunities is best described by the standard story, while the misallocation story provides the most appropriate interpretation of the behavior of glamour firms with poor measured investment opportunities.

Keywords: Investment, Equity Markets, Bubbles, Real Effects of Financial Markets, Glamour, Value

JEL Classification: E44, E22, G3, E32

Suggested Citation

Schaller, Huntley and Chirinko, Robert S., Equity Overvaluation and Capital Misallocation? A Revealed Preference Approach (March 5, 2007). Available at SSRN: https://ssrn.com/abstract=970623 or http://dx.doi.org/10.2139/ssrn.970623

Huntley Schaller (Contact Author)

Carleton University - Department of Economics ( email )

1125 Colonel By Drive
Ottawa, Ontario K1S 5B6
Canada
613-520-3751 (Phone)
613-520-3906 (Fax)

Robert S. Chirinko

University of Illinois at Chicago, Department of Finance ( email )

2431 University Hall (UH)
601 S. Morgan Street
Chicago, IL 60607-7124
United States

HOME PAGE: http://tigger.uic.edu/~chirinko/

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

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