Ch. 4: Behavioral Corporate Finance 153
according to payout policy as they do inBaker and Wurgler (2004a). The tradeoff is
−fd(K,·)=(
e+1 −λ
λ)
δd(·),where the left-hand side is the tax cost of dividends, for example, and the right-hand
side is the market timing gain, if the firm is simultaneously issuing equity, plus the
catering gain, if the manager has short horizons. In principle, a similar tradeoff governs
the earnings management decision or corporate name changes; however, in the latter
case, the fundamental costs of catering would presumably be small.
2.2. Empirical challenges
The framework outlined above suggests a role for securities mispricing in investment,
financing, and other corporate decisions. The main challenge for empirical tests in this
area is measuring mispricing, which by its nature is hard to pin down. Researchers have
found several ways to operationalize empirical tests, but none of them is perfect.
Ex ante misvaluation. One option is to take anex antemeasure of mispricing, for
instance a scaled-price ratio in which a market value in the numerator is related to
some measure of fundamental value in the denominator. Perhaps the most common
choice is the market-to-book ratio: a high market-to-book suggests that the firm may
be overvalued. Consistent with this idea, and the presumption that mispricing corrects
in the long run, market-to-book is found to be inversely related to future stock returns
in the cross-section byFama and French (1992)and in the time-series byKothari and
Shanken (1997)andPontiff and Schall (1998). Also, extreme values of market-to-book
are connected to extreme investor expectations byLakonishok, Shleifer, and Vishny
(1994), La Porta (1996), andLa Porta et al. (1997).
One difficulty that arises with this approach is that the market-to-book ratio or another
ex antemeasure of mispricing may be correlated with an array of firm characteristics.
Book value is not a precise estimate of fundamental value, but rather a summary of past
accounting performance. Thus, firms with excellent growth prospects tend to have high
market-to-book ratios, and those with agency problems might have low ratios—and
perhaps these considerations, rather than mispricing, drive investment and financing
decisions.Dong et al. (2005)andAng and Cheng (2006)discount analyst earnings
forecasts to construct an arguably less problematic measure of fundamentals than book
value.
Another factor that limits this approach is that a preciseex antemeasure of mispricing
would represent a profitable trading rule. There must be limits to arbitrage that prevent
rational investors from fully exploiting such rules and trading away the information
they contain about mispricing. But on a more positive note, the same intuition suggests
that variables like market-to-book are likely to be a more reliable mispricing metric
in regions of the data where short-sales constraints and other (measurable) arbitrage
costs and risks are most severe. This observation has been exploited as an identification
strategy.