CEO Compensation Characteristics

Managerial compensation characteristics may be a determinant of over- valuation as different compensation structures may create incentives for managers to engage in different investment behaviors and possibly earnings management. Coles et al. (2006) found that a CEO with a high sensitivity of the CEO’s wealth to the volatility of the stock (vega) invested more in R&D and less in fixed assets. Because the intangible nature of R&D expenditures would reasonably be expected to make firm valuation more difficult, executive compensation may be related to misvaluation by affect- ing the choices of managers. This hypothesized connection between the vega of managers and overvaluation is a second order effect as the impact upon overvaluation is derived from the choices of managers. One specific area of managerial choice is to pursue or avoid expenditures on R&D. Thus, the vega of managers is expected to produce an effect on overvalua- tion through the choices made by managers, with the R&D channel serving as one possible mechanism through which vega may affect overvaluation. The first null and alternative hypotheses are the following:

H10: Ceteribus paribus, the sensitivity of the CEO’s wealth to the volatility

of the stock is unrelated to overvaluation.

H1A: Ceteribus paribus, the sensitivity of the CEO’s wealth to the volatility

of the stock is related to overvaluation.

The second null and alternative hypotheses relating managerial com- pensation to the overvaluation measures employed in this study may be derived from Coles et al. (2006). In that study, a CEO with a high sensi- tivity of the CEO’s wealth to the stock price (delta) invested less in R&D and more in fixed assets. As this combination of investment choices would be expected to result in less ambiguous prospects for a firm, such invest- ment choices would be expected to result in less mispricing generally. Due to the reduced investments in R&D, to which investors may overreact, man- agerial delta is expected to be related to overvaluation. As with managerial vega, the effect of managers’ delta upon overvaluation is expected to flow through the effects of the choices made by managers, including through the R&D channel. This means that delta is expected to be a second order issue. The second null and alternative hypotheses are the following:

H20: Ceteribus paribus, the sensitivity of the CEO’s wealth to the stock

price is unrelated to overvaluation.

H2A: Ceteribus paribus, the sensitivity of the CEO’s wealth to the stock

price is related to overvaluation.

2.4.2 Firm Characteristics

Although managerial incentives have been discussed as potentially influ- encing expenditures upon intangible assets such as R&D, thereby exacer- bating mispricing, the direct impact of intangible assets upon mispricing may also be explored. The literature reviewed previously supports the idea that intangible assets may be related to mispricing. Evidence presented by Woolridge and Snow (1990), Chan et al. (1990), Sundaram et al. (1996), Green et al. (1996), and Lev and Sougiannis (1996) indicates that market participants view R&D spending to be value relevant. A study by Ali et al. (2003) found that visibility from advertising was associated with decreased credit spreads, suggesting a lower assessment of risk for bondholders. In- terestingly, Aboody and Lev (1998) found that analysts’ forecast errors increased with more R&D capitalization, which highlights the difficulty in properly assessing the degree of value relevance of R&D. Stock price increases were shown by Chan et al. (1990) to accompany announced in- creases in R&D expenditures. Given the realized earnings valuation models used in this study, elevated stock prices resulting from the announced in- creases in R&D would still be compared to an estimated firm value with largely the same realized earnings data as the prior estimation period, likely resulting in a positive relationship between R&D expenditures and the overvaluation measures used in this study. A similar result is expected for advertising expenditures. The resulting hypotheses are stated below:

H30: Ceteribus paribus, advertising expenditures are unrelated to overval-

uation.

H3A: Ceteribus paribus, advertising expenditures are positively related to

overvaluation.

H40: Ceteribus paribus, R&D expenditures are unrelated to overvaluation.

H4A: Ceteribus paribus, R&D expenditures are positively related to over-

valuation.

Barth and Clinch (1998) examined asset revaluations for Australian firms and found that revaluations of property, plant, and equipment for nonfinancial firms were positively related to the stock price. This finding is particularly notable due to their additional finding that the revaluation of property, plant, and equipment was negatively associated with the es- timated value of nonfinancial firms. This divergence in the response of the estimated value and the corresponding market response indicates that property, plant, and equipment may also be related to overvaluation. On one hand, the results presented by Barth and Clinch (1998) imply that the asset revaluations they examined led to more overvaluation as the stock

price responded positively while the estimated value responded negatively. On the other hand, one of the themes throughout the literature review pre- sented previously regarding intangible assets is that intangible assets may be subject to more misvaluation due to the more ambiguous nature of the prospects associated with the intangible assets in comparison to tangible assets such as fixed assets. This line of thought suggests that investments in property, plant, and equipment should lead to more accurate valuations generally as the prospective returns are more certain. In other words, in- vestors respond to new information about fixed assets on the balance sheet in a way which results in overvaluation, yet the more tangible nature of fixed assets should make fixed assets easier for investors to value than in- tangible assets. The curious overvaluation of equity which results from the revaluation of property, plant, and equipment calls into question the ability of investors to accurately value property, plant, and equipment generally, suggesting that investments in property, plant, and equipment may be re- lated to overvaluation. To explore this issue further, the following null and alternative hypotheses are formed:

H50: Ceteribus paribus, investments in property, plant, and equipment are

unrelated to overvaluation.

H5A: Ceteribus paribus, investments in property, plant, and equipment

are related to overvaluation.

As mentioned in the literature review, Daniel and Titman (1999) noted that the subjectivity associated with intangible assets should result in more misvaluation. This suggested effect was linked to overconfidence and bi- ased self-attribution on the part of investors. Daniel et al. (2001) presented a theoretical model which ultimately suggested that fundamental-to-price ratios should have more predictive power for firms with more ambiguous values, implying that higher concentrations of intangible assets may be related to larger amounts of mispricing. A study by Jiang et al. (2005) considered the impact of overconfidence and the magnitude of information uncertainty and found that stocks with high information uncertainty ex- perienced stronger price and earnings momentum effects over a short time horizon, and stocks with low prior returns experienced a stronger negative relationship with the information uncertainty. Taken together, these stud- ies imply that higher levels of intangible assets should be related to higher levels of misvaluation. The following null and alternative hypotheses result from that assessment:

H60: Ceteribus paribus, intangible assets are unrelated to overvaluation.

H6A: Ceteribus paribus, intangible assets are related to overvaluation.

In a paper considering the effects of limited investor attention Hirsh- leifer et al. (2011) proposed that firms with high cash flow or low accruals might be undervalued by investors while firms with low cash flow or high ac-

cruals might be overvalued by investors. Therefore a negative relationship may exist between cash flow and overvaluation and a positive relationship may exist between accruals and overvaluation. The hypotheses which re- sult are as follows:

H70: Ceteribus paribus, cash flow is unrelated to overvaluation.

H7A: Ceteribus paribus, cash flow is negatively related to overvaluation.

H80: Ceteribus paribus, accruals are unrelated to overvaluation.

H8A: Ceteribus paribus, accruals are positively related to overvaluation.