Negative Tangible Equity
Around 40% of the S&P 500 firms reported negative tangible equity (NTE) in 2019, a significant increase from around 10% two decades ago. We find that debt-fueled NTE firms are associated with larger market capitalizations, more stock buybacks, and acquisitions of intangibles. Higher credit ratings and lower bond yields in the latest decade suggest that they are viewed as less risky by debtholders than in previous decades. Stock prices of NTE firms increased (decreased) immediately after the Federal Reserve’s monetary policy action decreased (increased) interest rates. In addition, stock returns of NTE firms outperformed by 1.2% to 1.5% in stock returns in the next four quarters after portfolio formation in 2011–2019, but this outperformance was not accompanied by higher earnings expectations. Our results contradict Graham and Dodd’s (1940) advice to avoid NTE firms but raise questions about their valuations should interest rates rise in the future.