Valuation Driven Innovation

Abstract

This paper examines whether and how market valuation influences firm innovation, using an ex ante valuation measure that filters firm size and growth prospects from tangible investment. Specifically, by utilizing the National Bureau of Economic Research (NBER) patent database, I find that firms with high market valuations generate more innovative outputs, as measured by the number of patents and patent citations. Causality is established using mutual fund flows as an exogenous shock, demonstrating a strong effect of market valuation on firm innovation. Consistent with the idea that managers take advantage of irrationally low discount rates by issuing equity and investing the proceeds, these results are more pronounced among firms with high financial constraints and overvaluation. The sensitivity of innovative output to market valuation varies with equity market timing and sentiment, but is not affected by whether or not firms are issuing equity.