2014. The Impact of Equity Misvaluation on Predictive Accuracy of Bankruptcy Mondels
This paper examines the impact of stock market misvaluation on corporate bankruptcy prediction. Prior research has documented that market-based variables enhance the accuracy of hazard models for bankruptcy prediction. However, when market prices deviate from fundamentals, the predictive accuracy of models using these market-based variables may be affected. We document three main sets of findings: (1) the difference in predictive accuracy between properly-valued and misvalued firms is greater for market-based hazard models than for accounting-based hazard models; (2) the forecasting accuracy of market-based hazard models applied to misvalued firms improves significantly if forecasting variable coefficients are allowed to vary in the presence of misvaluation; (3) the difference in predictive performance of accounting-based and market-based hazard models is greater for misvalued than for properly-valued firm-quarters. In additional tests, we find that the predictive accuracy of structural bankruptcy risk models is not affected by misvaluation to the same extent as reduced form hazard models. Our results suggest that users should modify reduced form hazard models used for bankruptcy prediction to account for misvaluation, and confirm the impact of misvaluation on the quality of market signals.
Wongsunwai, Wan and George Batta. Forthcoming. 2014. The Impact of Equity Misvaluation on Predictive Accuracy of Bankruptcy Mondels . Journal of Fixed Income.