Does Stock Market Misprice Growth in Long-term Net Operating Assets?

Fairfield et al. (2003) propose that the reasons why firms investing more in net operating assets at current year will experience lower one-year ahead ROA arise from both diminishing marginal returns on investment (Stigler, 1963) and conservative accounting (Penman, 2001). They also reveal that investors appear to equivalently overprice accruals and growth in long-term net operating assets. Their evidence shows that firms with a growth in long-term net operating assets would be, on average, less profitable in the following year.However, we argue that rational firms should invest in long-term net operating assets when the internal rates of returns of the new projects are higher than the required rate of returns. For firms with current ROA lower than the required rate of returns, their future ROA should be, on average, increasing if they increase investments. For firms with current ROA higher than the required rate of returns, the future ROA could be increasing or decreasing, since the result depends on the relative levels of the current ROA and the internal rate of returns of the new projects. Empirical evidence is more consistent with our rational investment argument.The evidence is also inconsistent with FWY's argument regarding conservative accounting bias. When firms increases operating asset, conservative accounting bias means that expenditures should be expensed when incurred, not to defer them into the future. This could result in a higher one-year-ahead ROA, unless these expenditures persist into the next year. Since most projects involve some form of start-up costs, we believe that, under possible conservative accounting, the accounting treatment for the second year of the asset life would be less conservative than that of the first year. So, the second year ROA will not be, on average, decreasing as FWY expected.