Do Investors Overvalue Firms With Bloated Balance Sheets?

David Hirshleifer, Kewei Hou, Siew Hong Teoh and Yinglei Zhang
Additional contact information
Yinglei Zhang: Fisher College of Business, Ohio State University

Finance from University Library of Munich, Germany

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: valuation; financial reporting; limited attention; behavioral economics; behavioral accounting; behavioral finance; market efficiency; psychology and economics (search for similar items in EconPapers)
JEL-codes: G (search for similar items in EconPapers)
Pages: 50 pages
Date: 2004-12-04
New Economics Papers: this item is included in nep-acc and nep-fin
Note: Type of Document - pdf; pages: 50. PDF
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (229)

Downloads: (external link)
https://econwpa.ub.uni-muenchen.de/econ-wp/fin/papers/0412/0412001.pdf (application/pdf)

Related works:
Journal Article: Do investors overvalue firms with bloated balance sheets? (2004)
Working Paper: Do Investors Overvalue Firms with Bloated Balance Sheets? (2004)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:wpa:wuwpfi:0412001

Access Statistics for this paper

More papers in Finance from University Library of Munich, Germany
Bibliographic data for series maintained by EconWPA ( this e-mail address is bad, please contact ).