Overvaluation, Financial Opacity and Crash Risk

Abstract

Equity is overvalued when its market value is far above its underlying value. Jensen (2005) proposes that overvaluation leads to value-destroying opportunistic earnings management. In this study I examine how equity overvaluation affects a firm’s financial opacity and its stock crash risk. I find that overvalued firms tend to use more earnings management (higher financial opacity) and they do so to conceal firm specific information from the investors, it is especially so for substantially overvalued firms. On the contrary, undervalued firms are willing to provide more firm-specific information to the market. Furthermore, I find that the reported ROEs of substantially overvalued firms are significantly higher than the unmanaged ROEs. But no significant difference of reported ROEs and unmanaged ROEs is detected among substantially undervalued firms. In addition, I show that overvalued firms have higher crash risk than otherwise identical but non-overvalued firms. At last, I find that a powerful CEO (proxy by CEO and chairman duality) can restrain an overvalued firm’s urge to manage earnings more aggressively.