Earnings Smoothing and Investment Sensitivity to Stock Prices

Existing research suggests that market misvaluations affect corporate investment, often leading to suboptimal investment. I examine whether earnings smoothing reduces the impact of market misvaluations on corporate investment and in turn enhances investment efficiency. I find that earnings smoothing has a strong negative effect on the sensitivity of corporate investment to stock prices. Further analyses indicate that this negative effect is driven by both innate and discretionary components of earnings smoothing and is more pronounced for firms operating in more volatile business environments. I complement these findings by demonstrating that firms with smoother earnings have lower over- (under-)investment and higher future operating performance. Collectively, the evidence suggests that earnings smoothing improves corporate investment efficiency by reducing the impact of market misvaluations on investment.