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Do Investors Overvalue Balance Sheets@David Hershleifer

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Do Investors Overvalue Balance Sheets?
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  Journal of Accounting and Economics 38 (2004) 297–331 Do investors overvalue firms with bloatedbalance sheets? $ David Hirshleifer, Kewei Hou, Siew Hong Teoh  , Yinglei Zhang Fisher College of Business, The Ohio State University, Columbus, OH 43210, USA Received 3 March 2003; received in revised form 17 June 2004; accepted 13 October 2004Available online 25 December 2004 Abstract When cumulative net operating income (accounting value-added) outstrips cumulative freecash flow (cash value-added), subsequent earnings growth is weak. If investors with limitedattention focus on accounting profitability, and neglect information about cash profitability,then net operating assets, the cumulative difference between operating income and free cashflow, measures the extent to which reporting outcomes provoke over-optimism. During the1964–2002 sample period, net operating assets scaled by total assets is a strong negativepredictor of long-run stock returns. Predictability is robust with respect to an extensive set of controls and testing methods. r 2005 Elsevier B.V. All rights reserved. JEL classification:  M41; M43; G12; G14 Keywords:  Capital markets; Financial reporting; Limited attention; Market efficiency; Behavioral finance ARTICLE IN PRESS www.elsevier.com/locate/econbase0165-4101/$-see front matter r 2005 Elsevier B.V. All rights reserved.doi:10.1016/j.jacceco.2004.10.002 $ We thank David Aboody, Sudipta Basu, Mark Bradshaw, Kent Daniel, Sandro Canesso de Andrade,Nigel Barradale, Ilia Dichev, S.P. Kothari (editor), Charles Lee, Jonathan Lewellen (referee), Jing Liu,Stephen Penman, Scott Richardson, Doug Schroeder, Robert Shiller, Richard Sloan, Marno Verbeek, WeiXiong, Jerry Zimmerman, seminar and conference participants at University of California, Berkeley; OhioState University; Stanford University; the  Journal of Accounting and Economics  2003 Conference at theKellogg School, Northwestern University; the 2004 National Bureau for Economic Research, BehavioralFinance Program at the University of Chicago; the 2004 annual meeting of the American AccountingAssociation in Orlando, Florida; and the 2004 annual meeting of the European Finance Association inMaastricht, The Netherlands for helpful comments.  Corresponding author. Tel.: +16142926547; fax: +16142922118. E-mail address:  teoh_2@cob.osu.edu (S.H. Teoh).  1. Introduction Information is vast, and attention limited. People therefore simplify their judgments and decisions by using rules of thumb, and by processing only subsetsof available information. Experimental psychologists and accountants documentthat individuals, including investors and financial professionals, concentrate on a fewsalient stimuli (see e.g., the surveys of  Fiske and Taylor (1991) and Libby et al. (2002)). Doing so is a cognitively frugal way of making good, though suboptimaldecisions. An investor who values a firm based on its earnings performance ratherthan performing a complete analysis of financial variables is following such astrategy.Several authors have argued that limited investor attention and processing powercause systematic errors that affect market prices. 1 Systematic errors may derive froma failure to think through the implications of accounting rule changes or earningsmanagement. However, even if accounting rules and firms’ discretionary accountingchoices are held fixed, some operating/reporting outcomes highlight positive ornegative aspects of performance more than others.In this paper, we propose that the level of net operating assets—defined as thedifference on the balance sheet between all operating assets and all operatingliabilities—measures the extent to which operating/reporting outcomes provokeexcessive investor optimism. We will argue that the financial position of a firm withhigh net operating assets is less attractive than superficial appearances suggest. Inother words, we argue that a high level of net operating assets, scaled to control forfirm size, indicates a lack of sustainability of recent earnings performance, and thatinvestors do not fully discount for this fact.A basic accounting identity states that a firm’s net operating assets are equal to thecumulation over time of the difference between net operating income and free cashflow (see Penman (2004, p. 230) for the identity in change form):Net Operating Assets T   ¼ X T  0 Operating Income t   X T  0 Free Cash Flow t : (1)Thus, net operating assets are a cumulative measure of the deviation betweenaccounting value added and cash value added—‘balance sheet bloat’.An accumulation of accounting earnings without a commensurate accumulationof free cash flows raises doubts about future profitability. In fact, we document thathigh normalized net operating assets (indicating relative weakness of cumulativefree cash flow relative to cumulative earnings) is associated with a rising trend inearnings that is not subsequently sustained. Furthermore, as argued in more detail inSection 2, high net operating assets may provide a warning signal about theprofitability of investment. ARTICLE IN PRESS 1 See, e.g., Hirshleifer and Teoh (2003), Hirshleifer et al. (2003), Hong et al. (2003), Hong and Stein (2003), Pollet (2003), Della Vigna and Pollet (2003), and the review of  Daniel et al. (2002). D. Hirshleifer et al. / Journal of Accounting and Economics 38 (2004) 297–331 298  If investors have limited attention and fail to discount for the unsustainability of earnings growth, then firms with high net operating assets will be overvalued relativeto those with low net operating assets. In the long run, as public information arrivessuch mispricing will on average be corrected. This implies that firms with high netoperating assets will on average earn negative long-run abnormal returns, and thosewith low net operating assets will earn positive long-run abnormal returns.To understand the determinants of investor perceptions in greater depth, we canalternatively decompose net operating assets as follows. Since free cash flow is thedifference between cash flow from operations and investment, we obtain:Net Operating Assets T  ¼ X T  0 Operating Income t   X T  0 ð Operating Cash Flow t    Investment t Þ¼ X T  0 ð Operating Income Before Depreciation t    Operating Cash Flow t Þþ X T  0 ð Investment t    Depreciation t Þ :  ð 2 Þ Eq. (2) indicates that net operating assets is the sum of two cumulative differencesbetween accounting and cash value added: (Operating Income BeforeDepreciation    Operating Cash Flow), and  ð Investment    Depreciation Þ :  Thus,firms with high net operating assets have high cumulative deviation betweenaccounting and cash profitability derived from both operating and investingactivities. Simplifying (2) yieldsNet Operating Assets T   ¼ X T  0 Operating Accruals t  þ X T  0 Investment t ;  (3)which expresses net operating assets as the sum of cumulative operating accruals,and cumulative investment.Two simple examples illustrate how a transaction can increase accountingprofitability relative to cash basis profitability, contributing to balance sheet bloat(Section 2 describes the range of possible cases more fully). First, when a firm booksa sale as a receivable before it has received the actual cash inflow, its net operatingassets increase. Second, when a firm records an expenditure as an investment ratherthan an expense, its net operating assets increase. In both these cases, currentaccounting profitability may not be sustained in the future, so investors who focuson accounting income may overvalue the firm.A possible reason why high net operating assets may be followed bydisappointment is that the high level is a result of an extended pattern of earningsmanagement that must soon be reversed; see Barton and Simko (2002). 2 ARTICLE IN PRESS 2 If investors overvalue a firm that manages earnings upward, the price will tend to correct downwardwhen further earnings management becomes infeasible. Barton and Simko provide evidence from 1993 to D. Hirshleifer et al. / Journal of Accounting and Economics 38 (2004) 297–331  299  Alternatively, even if firms do not deliberately manage investor perceptions,investors with limited attention may fail to make full use of available accountinginformation. Thus, the interpretation of net operating assets that we provide in thispaper accommodates, but does not require, earnings management. 3 Net operating assets can provide a more complete proxy for investor mispercep-tions than the measures used in past literature for two reasons. First, net operatingassets by definition consist of the deviations between cash and accountingprofitability, rather than merely being correlated with these deviations. 4 Second, under our hypothesis, flow variables such as accruals provide only afragmentary indicator of the degree to which operating/reporting outcomes provokeexcessive investor optimism. As Eqs. (1) and (2) indicate, net operating assets reflectthe full history of flows. If investors with limited attention do not make full use of balance sheet information, then net operating assets is potentially a morecomprehensive return predictor than the single-period slices considered in pastliterature. 5 Alternative measures of accruals, a flow variable, have been found tohave different explanatory power for returns (see, e.g., Collins and Hribar, 2002;Teoh et al., 1998a, b; Thomas and Zhang, 2002). Richardson et al. (2003) and Fairfield et al. (2003) report evidence of one-year-ahead stock return predictabilitybased upon the most recent period operating and investing accruals. We documenthere that the level of normalized net operating assets has greater power, over alonger horizon, to predict returns than the associated flow variables.To test for investor misperceptions of firms with bloated balance sheets, wemeasure stock returns subsequent to the reporting of net operating assets. The levelof net operating assets scaled by beginning total assets (hereafter NOA) is a strongand robust negative predictor of future stock returns for at least three years afterbalance sheet information is released. We call this the  sustainability effect , becausehigh NOA is an indicator that past accounting performance has been good butthat equally good performance is unlikely to be sustained in the future; and thatinvestors with limited attention will overestimate the sustainability of accountingperformance. ARTICLE IN PRESS (  footnote continued  )1999 that the level of net operating assets inversely predicts a firm’s ability to meet analysts’ forecasts.Barton and Simko’s perspective further suggests that low net operating assets constrain firms’ ability tomanage earnings downward (in order to take a big bath or create ‘rainy day’ reserves; see DeFond (2002)). Choy (2003) documents that the Barton and Simko (2002) finding derives from industry variations in net operating assets. 3 A branch of the accruals literature provides evidence that managers take advantage of investor naivete ´about accruals to manage perceptions of auditors, analysts, and investors. See, e.g., Teoh et al. (1998a, b);Rangan (1998), Ali et al. (2000), Bradshaw et al. (2000), Xie (2001), and Teoh and Wong (2002). 4 For example, current-period operating accruals are negative predictors of stock returns for up to twoyears ahead (Sloan, 1996). Our hypothesis that investor misperceptions result from deviations betweenaccounting and cash profitability suggests that an index of misperceptions should reflect both workingcapital accruals and the deviation between investment and depreciation (see Eq. (2)). By incorporatingdepreciation but not investment, operating accruals do not fully capture the latter deviation. 5 A stock measure is also simpler, as it derives from the current year balance sheet, whereas a flowmeasure is calculated as a difference across years in balance sheet numbers. D. Hirshleifer et al. / Journal of Accounting and Economics 38 (2004) 297–331 300

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Jul 23, 2017
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