When Markets Get It Wrong: How Mispriced Firms Really Use Their Cash

Why It Matters

Stock markets do not always price companies accurately. When firms are overvalued or undervalued, managers face strong incentives that can shape how they use internal cash. Understanding these decisions helps investors, regulators and boards spot distortions that may affect long-term value.

Key Takeaways

• Overvalued firms are more likely to invest aggressively and increase spending using internal cash flow.
• Undervalued firms tend to cut back on investment and conserve cash.
• Market mispricing can distort real corporate decisions, with lasting consequences for performance and shareholder value.
  

When Share Prices Send the Wrong Signals

Financial theory assumes that markets price firms efficiently. In reality, sentiment, speculation and information gaps often lead to misvaluation. Some firms trade above their fundamental value, while others remain persistently undervalued.

This research examines how such mispricing influences corporate behaviour, specifically, how firms deploy internal cash flow. Internal cash flow is critical because it funds day-to-day operations, investment, innovation and expansion. Unlike external financing, it does not rely on issuing new shares or debt. Managers therefore have significant discretion over how to use it.

The study asks a simple but powerful question: when markets get a firm’s value wrong, do managers change how they spend their cash?

Overvaluation Fuels Investment — But at What Cost?

The findings show a clear pattern. Firms that appear overvalued by the market tend to invest more aggressively. When internal cash flow increases, these firms channel a larger share of it into capital expenditure, acquisitions and expansion.

Why does this happen? When a company’s share price is high, managers may feel pressure to justify investor optimism. Strong market valuations also make it easier to raise additional funds if needed. In some cases, executives may interpret a high valuation as validation of growth opportunities, even when fundamentals are weaker than the market believes.

However, this dynamic can create risks. If investment decisions respond to inflated market signals rather than underlying productivity, firms may overinvest. Projects undertaken during periods of overvaluation may later underperform, eroding shareholder value when prices correct.

The research suggests that mispricing does not simply affect stock charts; it shapes real economic activity inside firms.

Undervaluation Leads to Caution and Constraint

The opposite pattern appears among undervalued firms. When markets price companies below their fundamental value, managers become more cautious in deploying internal cash flow.

These firms are more likely to scale back investment and preserve liquidity. Managers may fear that external financing would be too costly or dilutive at a low share price. As a result, they rely heavily on retained earnings and prioritise financial stability over expansion.

While prudence can protect firms during uncertain times, persistent undervaluation may also suppress growth. Companies with strong fundamentals but weak market perception may delay valuable investments, reduce research spending or miss strategic opportunities.

In this way, market mispricing can create a self-reinforcing cycle. Overvalued firms expand rapidly, sometimes excessively. Undervalued firms hold back, even when productive opportunities exist.

Mispricing Has Real Economic Effects

A key contribution of the study is its focus on internal cash flow sensitivity — how strongly corporate investment responds to changes in internally generated funds.

The research finds that this sensitivity varies systematically with market valuation. Overvalued firms show higher investment–cash flow sensitivity, meaning that additional cash strongly increases spending. Undervalued firms display lower sensitivity, indicating restraint.

This evidence challenges the idea that investment depends solely on fundamentals such as profitability or growth prospects. Instead, market perception plays a meaningful role in shaping corporate decisions.

The implications extend beyond individual firms. If many companies respond to mispricing in similar ways, market inefficiencies can amplify economic cycles, fuelling booms during optimistic periods and deepening slowdowns when sentiment turns negative.

Business Implications

For boards and executives, the findings underscore the importance of disciplined capital allocation. High valuations should not substitute for rigorous project evaluation. Leaders must separate market sentiment from operational reality and ensure that investment decisions rest on long-term fundamentals.

For investors, the study highlights how mispricing can influence managerial behaviour. Share prices do not merely reflect corporate actions; they help shape them. Monitoring investment patterns alongside valuation metrics can provide early warning signs of overexpansion or underinvestment.

For regulators and policymakers, the research suggests that sustained market distortions may have broader economic consequences. Transparent disclosure, robust governance and effective oversight remain essential to ensure that capital flows to its most productive uses.

Ultimately, the study reminds us that markets and firms interact in powerful ways. When prices diverge from fundamentals, corporate behaviour shifts, sometimes in ways that reinforce the original mispricing.

Authors & Sources

Authors: Xin (Simba) Chang (Nanyang Technological University), Wing Chun Kwok (The Hang Seng University of Hong Kong ), Tao Li (Central University of Finance and Economics), George Wong (The Hong Kong Polytechnic University), Jiaquan Yao (University of Science and Technology of China)

Original article: Journal of Business Finance & Accounting;  SSRN Working Paper Version

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