1. Stock Mispricing and
Evidence from Pakistan
Presenting a research paper
was published in Journal of
Financial Reporting and
This study examines the impact of stock mispricing on corporate investment decisions by
taking the sample of Non-financial firms listed on the PSX during the period of
2. • We are participants of course “Investment analysis and portfolio
• We are here to present a subjected research paper under the
instructions of our honorable teacher Sir Dr. Shakeel.
Gro up members:
M uha mmad So ha il
Ha sna in
Zo ra in
• Stock mispricing is a phenomenon that can be encountered in rational
as well as irrational environments.
• However, with the numerous theoretical and empirical studies that
address mispricing in the stock market, the question of whether
information asymmetry or investor biases causes stock mispricing is
still under debate in the finance literature.
• Rather than trying to determine the cause of stock mispricing, this
study considers a more important aspect of stock mispricing, which is
the effect of stock mispricing on corporate investment.
• The purpose of this study is to analyze the effect of stock market
mispricing on corporate investment decisions. Particularly, this study
addresses the three possible explanations of the relation between
mispricing and corporate investments
1. The first theory states that the stock market affects investments
through its influence on the cost of external financing.
2. The second theory states that when managers make their investment
decisions, they are forced to cater to shareholders’ opinions in order
to protect their jobs.
3. The third theory states that managers use the stock market as a
source of information about the state of the economy, the condition
of the industry, and the value of the firm. Such information is
intended to help managers in making their investment decisions.
3 theories that can explain the relation between investments and stock
Stock mispricing is represented into two ways; the current price above its
fundamental value is called overvaluation and the price below its
fundamental value is called undervaluation.
Not everyone believes a stock can be mispriced, particularly those who are
proponents of the efficient markets hypothesis.
EMH Stock Mispricing
• The price-to-earnings ratio (P/E
ratio) measures the price of a
stock relative to annual earnings
per share (EPS) generated by a
• The price-to-book (P/B)
ratio: and it is also useful for
identifying the level of
speculation present in a stock’s
• Enterprise value (EV) to earnings
before interest, taxes,
depreciation and amortization
(EBITDA) is another popular
• The EV/EBITDA ratio can help
when evaluating firms that
operate in different industries.
How to Identify Mispriced Stocks
Intrinsic Value Technical Analysis
• Some investors ascribe to the
theories of Columbia Business
School’s Benjamin Graham and
David Dodd, who contend that
stocks have an intrinsic value
independent of the market
• Discounted cash flow (DCF) is
one of the most popular intrinsic
• Residual income valuation is
another popular method for
calculating intrinsic value.
• Some investors forgo analyzing
the specifics of a stock’s
underlying business, opting
instead to determine value by
analyzing the behaviors of
market participants. This
method is called technical
analysis, and many technical
investors assume market pricing
already reflects all available
information regarding a stock’s
fundamentals. Technical analysts
forecast future stock price
movements by forecasting
future decisions of buyers and
9. Literature Review
• There are some studies available on mispricing in the context of Pakistan like Haque and Naeem
• (2016), Javeria and Hassan (2015) and Qureshi et al. (2012). But this study is different from
• The study of Qureshi et al. (2015) found that institutional investors in Pakistan are prone to behavioral biases
and make biased investment decision and these are behavioral biases that create mispricing.
• Similarly, Javaira and Hassan (2015) found that during the liquidity crisis of 2005, the stock market showed
the herding behavior. Both the studies depict the investors‘ irrational decision making that raises question
like: “Is this irrational decision making causing mispricing?
• Haque and Naeem (2016) found the impact of stock mispricing on corporate investment. They measured
stock mispricing by using discretionary accruals. Their focus has been on the overvalued firms only and they
did not identify the effect of undervalued firm.
• Like other studies, for instance Gilchrist et al. (2005) and Baker et al. (2003), Haque and Naeem (2016) could
only manage to find the impact of the one-sided, overvaluation, effect of mispricing on investment.
• Stein (1996) found the relationship between mispricing and investment by using model consistent with
Morck et al. (1990). Their model fails to identify the managerial time horizon and financial constraint level.
• Stein (1996) also found that investment and stock mispricing sensitivity is high when the firms depend more
on equity. If the firm is in a position to use the retained earnings and raise debt, then the firm will be less
likely to respond to the changes in prices.
On the basis of given literature, we have concluded following
Hypothesis 1: Stock mispricing affects corporate investments
positively through corporate equity transactions that are driven
by market-timing strategies
Hypothesis 2: The more the firm depends on equity (financially
constrained,) the higher the sensitivity of corporate investments
to stock mispricing.
Population: All the firms listed on
Pakistan stock exchange. There are a total of
559 listed firms.
Sample: all the firms on PSX 100 index as
sample for this study, covering a time period
from 2008 to 2014. Financial firms are excluded
from study There are total of 80 non-financial
firms counted on PSX 100 index during the
Sectors: The sectors which are included in
final sample are; Oil & Gas, Electricity,
Chemical, Cement, Food, General Industries,
Automobile & parts, Pharmacy and Bio Tech.
There are total of 447 firm year observations
after excluding the extreme values.
Data Data Collection Method
This study uses annual reports,
published by firm, to collect relevant
data. These annual reports
are obtained from company’s official
websites. The data of share prices is
collected from business recorder and
the official website of PSX. Business
recorder is the first financial and
business daily news paper in
To measure the mispricing, this study decomposes the market to
book ratio into mispricing and growth components, and measures
corporate investment by capital expenditures.
• Findings of the study indicate that both the mispricing and growth
component of market affect the corporate investment decisions.
• Firms listed on PSX time the market by issuing overvalued equity but
they do not always issue the equity in response to overvaluation and
repurchases in case of undervaluation.
• Investment mispricing sensitivity is significantly higher in firms which
are more financially constrained.
• Cash flow investment sensitivity is also determined by considering
the existence of financing constraints. The most financially
unconstrained and constrained firms exhibit less cash flow investment
sensitivity while the less healthy and constrained firms show greater
• This study will help in promoting investment culture in Pakistan by
providing empirical evidence on the issue. Investors, in Pakistan, are
not aware of these issues and incur losses by making investment in
overvalued stocks. This has discouraged investors and has become a
serious hurdle in promotion of investment culture in Pakistan.
• We believe that these findings have interesting implication for further
research in the literature of corporate finance, and also help in
economic policy making.
• Firstly, policy makers should focus on creating awareness among
the investors so they can understand the psychological areas causing
the effect on the investment decisions and market prices.
• In this way, they can better understand the mispricing of securities
and form their decisions based on fundamentals and correct
information, which leads to increase the market efficiency and their
• Secondly, Authorities should make efforts to provide greater market
transparency because this mispricing arises only when the economic
agents do not know about the economic fundamentals.