Behavioral theories suggest that investor misperceptions and market mispricing will be correlated across firms. We use equity and debt financing to identify common misval- uation across firms. A zero-investment portfolio (UMO, undervalued minus overvalued) built from repurchase and issue firms captures comovement in returns beyond that in some standard multifactor models, and substantially improves the Sharpe ratio of the tangency portfolio. Loadings on UMO incrementally predict the cross-section of returns on both portfolios and individual stocks, even among firms not recently involved in external fi- nancing activities. Further evidence suggests that UMO loadings proxy for the common component of a stock’s misvaluation.

We examine effects of capital structure management and misvaluation on the payment method in mergers and acquisitions. In a sample of 3,097 transactions, we find evidence both for leverage optimization and misvaluation as drivers for the decision to pay with cash or stock. Our evidence also shows that it is difficult to pay with overvalued stock unless justified by economic fundamentals. Few bidders try and often only succeed after going hostile. Paying with cash while capital structure optimization suggests stock payment is more common. These firms are reluctant to pay with undervalued stock and experience positive long-term excess returns.

This paper documents the relations between firms' pre-offer market valuations and takeover behavior, and evaluates their consistency with the Q theory and the misvaluation theory of takeovers. We employ two valuation measures: price/book ratios and ratios of price to residual income model value. Market valuations of bidders and targets influence the means of payment chosen, the mode of acquisition, the premia paid, target hostility to the offer, the likelihood of offer success, and bidder and target announcement period stock returns. The evidence is broadly consistent with both hypotheses. The evidence for the Q hypothesis is stronger in the pre-1990 period than in the 1990-2000 period, whereas the evidence for the misvaluation hypothesis is stronger in the 1990-2000 period than in the pre-1990 period.