Some Investors automatically dismiss stocks that are highly priced relative to their earnings outlook, but new research finds an upside—at least to the overall economy—to overvaluation: It encourages companies to be inventive.
A study in the December edition of the Journal of Financial and Quantitative Analysis suggests that companies with overvalued stock not only are more inclined to pursue innovation, but also are more willing to take risks on ambitious, potentially groundbreaking projects.
Spending money on unproven technologies and research can be risky for companies for many reasons, so risk-averse managers tend to under-innovate, says Siew Hong Teoh, the Lee and Seymour Graff endowed professor at UCLA Anderson School of Management, one of the study’s researchers.
But she and her fellow researchers found that market overvaluation can change that dynamic, making managers more willing to take ambitious bets or even embrace what researchers call “moonshots”—projects that have big potential long-term payoffs but may be seen as long shots. Thus, there is some “social value” for everyone in overvalued stocks because they encourage this investment, Dr. Teoh says.
Dr. Teoh says that continuing research is examining what effect all of this increased innovation has on overvalued companies in terms of generating future sales and profits.
The typical metric investors use to measure overvaluation involves calculating the price-to-earnings ratio of a particular company and comparing it to others in similar categories. In this study, however, researchers used quarterly mutual-fund outflows as a proxy for equity misvaluation, an approach established and used by researchers in previous studies. With this approach, stocks that are sold less during periods of fund outflows are considered more overvalued.
To measure innovation, researchers analyzed public company research-and-development outlays and patent activity from 1981 through 2012. They found that companies deemed overvalued in a given year spent more on R&D the following year relative to average R&D spending, applied for and obtained more patents and were more likely to apply for particularly innovative patents. What’s more, other companies tended to cite these patents as the basis for their own inventions, the researchers found, suggesting a ripple effect.
“The patents that come out of these companies are more inventive, more original and are greater in scope,” Dr. Teoh says.
Overvaluation leads to more investment in innovation because managers don’t have to worry as much about potential failures tanking the stock in a too-damaging way, she says. It provides a buffer. On the other hand, if a stock is already undervalued, even a small amount of bad news could cause the stock price to spiral down to a territory where the manager’s job could be in danger, she says.
At the same time, overvalued companies can float new equity shares and get capital more cheaply because people place high valuation on the stock. Suppliers are likely to be more willing to sell to overvalued companies, anticipating their growth potential. And, she adds, potential employees are more likely to select innovative companies and take job offers at a lower salary because there is a buzz about the company.
“All of that positive sentiment encourages everyone to contribute to your company rather than a competitor or another industry altogether. It can be in effect, self-fulfilling,” Dr. Teoh says.
Ms. Winokur Munk is a writer in West Orange, N.J. She can be reached at reports@wsj.com.
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