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Do Investors Overvalue Firms With Bloated Balance Sheets?

Author

Listed:
  • David Hirshleifer

    (Fisher College of Business, Ohio State University)

  • KEWEI HOU

    (Fisher College of Business, Ohio State University)

  • Siew Hong Teoh

    (Fisher College of Business, Ohio State University)

  • YINGLEI ZHANG

    (Fisher College of Business, Ohio State University)

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.

Suggested Citation

  • David Hirshleifer & KEWEI HOU & Siew Hong Teoh & YINGLEI ZHANG, 2004. "Do Investors Overvalue Firms With Bloated Balance Sheets?," Finance 0412001, EconWPA.
  • Handle: RePEc:wpa:wuwpfi:0412001 Note: Type of Document - pdf; pages: 50. PDF
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    References listed on IDEAS

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    More about this item

    Keywords

    valuation; financial reporting; limited attention; behavioral economics; behavioral accounting; behavioral finance; market efficiency; psychology and economics;

    JEL classification:

    • G - Financial Economics

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