Financial Management Association Roundtable on Stock Market Pricing and Value‐Based Management

A group of academics and practitioners addresses a number of questions about the workings of the stock market and its implications for corporate decision‐making. The discussion begins by asking what the market wants from companies: Is it mainly just steady increases in earnings per share, which are then “capitalized” by the market at the current industry P/E multiple to produce a higher stock price? Or does the market pay attention to the “quality,” or sustainability, of earnings? And are there more revealing measures of annual corporate performance than GAAP earnings—measures that would provide investors with a better sense of companies' future cash‐generating capacity and returns on capital? The consensus was that although many investors respond uncritically to earnings numbers, the most sophisticated and influential investors consider far more than current earnings when pricing stocks. And although the stock market is far from omniscient, the heightened scrutiny of companies resulting from the growth of hedge funds, private equity, and investor activism of all kinds appears to be making the market “more efficient” in building information into stock prices. The second part of the discussion explored the implications of this view of the market pricing process for corporate strategy and the evaluation of major investment opportunities. For example, do acquisitions have to be “EPS‐accretive” to be value‐adding, or is there a more reliable means of assessing an investment's value added than pro forma EPS effects? Does the DCF valuation method always offer a better guide to value than the method of comparables used by many Wall Street dealmakers? And under what circumstances are the relatively new real options valuation approaches likely to provide a significant advantage over conventional methods? The main message offered to corporate practitioners is to avoid letting cosmetic accounting effects get in the way of value‐adding investment and operating decisions. As the corporate record on acquisitions makes painfully clear, there is no guarantee that an accretive deal will turn out to be value‐increasing (in fact, the odds are that it will not). As for choosing a valuation method, there appears to be a time and place for each of the major methods—comparables, DCF, and real options—and the key to success is understanding which method is best suited to the circumstances.     

A Look Back at the Beginnings of EVA and Value‐Based Management

One of the pioneers of value‐based management discusses his life's work in converting principles of modern finance theory into performance evaluation and incentive compensation plans that have been adopted by many of the world's largest and most successful companies, including Coca‐Cola in the U.S., SABMiller in London, Siemens in Germany, and the Godrej Group in India. The issues covered include the significance of dividend payouts (are dividends really necessary to support a company's stock price and, if so, why?) as well as the question of optimal capital structure (whether and why debt might not be cheaper than equity). But the most important focus of the interview is corporate performance measurement and the use of executive pay to strengthen management incentives to increase efficiency and value. According to Stern, the widespread tendency of public companies to manage “for earnings”—or in accordance with what he refers to as “the accounting model of the firm”—often leads to value‐destroying decisions. As one example, the GAAP accounting principle that requires intangible investments like R&D and training to be written off in the year the expenses are incurred is likely to cause underinvestment in such intangibles. At the same time, the failure of conventional income statements to reflect the cost of equity almost certainly encourages corporate overinvestment. Stern's solution to this problem is an executive incentive compensation plan in which rewards are tied to increases in a measure of economic profit called economic value added, or EVA, which research has shown to have a significance relation to changes both in share value and the premium of market value over book value. Moreover, by combining such a plan with a “bonus bank” that pays out annual awards over a multi‐year period, boards can ensure that management will be rewarded not for good luck but rather for sustainable improvements in performance.     

An Information‐Based Theory of Time‐Varying Liquidity

We propose an information‐based theory to explain time variation in liquidity and link it to a variety of patterns in asset markets. In “normal times,” the market is fully liquid and gains from trade are realized immediately. However, the equilibrium also involves periods during which liquidity “dries up,” which leads to endogenous liquidation costs. Traders correctly anticipate such costs, which reduces their willingness to pay. This foresight leads to a novel feedback effect between prices and market liquidity, which are jointly determined in equilibrium. The model also predicts that contagious sell‐offs can occur after sufficiently bad news.     

Cross‐Firm Real Earnings Management

Our analysis is rooted in the notion that stockholders can learn about the fundamental value of any firm from observing the earnings reports of its rivals. We argue that such intraindustry information transfers, which have been broadly documented in the empirical literature, may motivate managers to alter stockholders’ beliefs about the value of their firm not only by manipulating their own earnings report but also by influencing the earnings reports of rival firms. Managers obviously do not have access to the accounting system of peer firms, but they can nevertheless influence the earnings reports of rival firms by distorting real transactions that relate to the product market competition. We demonstrate such managerial behavior, which we refer to as cross‐firm real earnings management, and explore its potential consequences and interrelation with the practice of accounting‐based earnings management within an industry setting with imperfect (nonproprietary) accounting information.     

Investment‐Based Corporate Bond Pricing

A standard assumption of structural models of default is that firms' assets evolve exogenously. In this paper, we examine the importance of accounting for investment options in models of credit risk. In the presence of financing and investment frictions, firm‐level variables that proxy for asset composition are significant determinants of credit spreads beyond leverage and asset volatility, because they capture the systematic risk of firms' assets. Cross‐sectional studies of credit spreads that fail to control for the interdependence of leverage and investment decisions are unlikely to be very informative. Such frictions also give rise to a realistic term structure of credit spreads in a production economy.     

Earnings Management and the Post‐earnings Announcement Drift

We posit that the post‐earnings announcement drift (PEAD) is related to earnings management. Accordingly, we find that firms with large negative (positive) changes in operating cash flows manage accruals upward (downward). Most importantly, we find that PEAD is concentrated largely among those firms that are most likely to have smoothed their reported earnings and is generally associated with discretionary accruals as opposed to nondiscretionary accruals. There is no evidence of a positive (negative) PEAD for those firms with large positive (negative) earnings changes that are least likely to have managed earnings downward (upward).     

Earnings Management During Antidumping Investigations in Europe: Sample‐Wide and Cross‐Sectional Evidence

This paper examines earnings management by EU firms that initiate an antidumping investigation. We first document economically and statistically significant income‐decreasing earnings management around the initiation of an antidumping investigation. We show that earnings management increases when accounting data directly affect the magnitude of the tariffs imposed in the trade investigation. We also find that earnings management decreases as the number of petitioning firms increases or as the distance between petitioning firms increases, suggesting free‐rider and coordination problems. We find that earnings management increases when the petition is directed at a country that imports more goods from the petitioning firm's home country, suggesting that retaliation threats affect incentives. We document that raising equity or debt financing moderates income‐decreasing earnings management, consistent with the idea that sample firms trade off capital market and regulatory considerations. Our results indicate that contemporary research methods can detect accruals‐based earnings management in settings in which the incentives for earnings management can be clearly identified.     

Information Acquisition in Rumor‐Based Bank Runs

We study information acquisition and dynamic withdrawal decisions when a spreading rumor exposes a solvent bank to a run. Uncertainty about the bank's liquidity and potential failure motivates depositors who hear the rumor to acquire additional noisy signals. Depositors with less informative signals may wait before gradually running on the bank, leading to an endogenous aggregate withdrawal speed and bank survival time. Private information acquisition about liquidity can subject solvent‐but‐illiquid banks to runs, and shorten the survival time of failing banks. Public provision of solvency information can mitigate runs by indirectly crowding‐out individual depositors' effort to acquire liquidity information.     

Private Interaction Between Firm Management and Sell‐Side Analysts

Although sell‐side analysts often privately interact with managers of publicly traded firms, the private nature of this contact has historically obscured direction examination. By examining a set of proprietary records compiled by a large‐cap NYSE‐traded firm, I offer insights into which analysts privately meet with management, when analysts privately interact with management, and why these interactions occur. I also compare private interaction to public interaction between analysts and managers on conference calls. The evidence suggests that private interaction with management is an important communication channel for analysts for reasons other than firm‐specific forecasting news.     

Understanding Post‐Euro Law‐of‐One‐Price Deviations

We put together a unique panel of thousands of good‐level prices before and after the euro to compare the determinants and understand the evolution of goods price dispersion across Europe over time. We find that tradeability and nontraded inputs play a significantly smaller role for cross‐country price dispersion after the adoption of the euro, and for Eurozone economies as compared to European Union ones. We then compare the distributions of law‐of‐one‐price (LOP) deviations over time to understand how the degree of integration across European economies changed after the euro. Our tests reveal that the distributions after the euro are typically significantly different from those before, consistent with a greater degree of integration. Utilizing our unique panel data set to trace the location of individual goods in the distribution of LOP deviations, we ask how the price advantage or disadvantage evident in these price distributions evolves over time, and whether goods characteristics play a role for the persistence of these LOP deviations. LOP deviations for these goods are highly correlated over 5‐ or 10‐ year horizons, and correlations remain significantly high over longer horizons. These correlations are greater for homogeneous as compared to differentiated goods and vary across countries. Finally, for most of these European economies and goods, price advantage is typically revealed to be more persistent than price disadvantage.     

A Dynamic Model of Characteristic‐Based Return Predictability

We present a dynamic model that links characteristic‐based return predictability to systematic factors that determine the evolution of firm fundamentals. In the model, an economy‐wide disruption process reallocates profits from existing businesses to new projects and thus generates a source of systematic risk for portfolios of firms sorted on value, profitability, and asset growth. If investors are overconfident about their ability to evaluate the disruption climate, these characteristic‐sorted portfolios exhibit persistent mispricing. The model generates predictions about the conditional predictability of characteristic‐sorted portfolio returns and illustrates how return persistence increases the likelihood of observing characteristic‐based anomalies.     

On the Life Cycle Dynamics of Venture‐Capital‐ and Non‐Venture‐Capital‐Financed Firms

We use data over 25 years to understand the life cycle dynamics of VC‐ and non‐VC‐financed firms. We find successful and failed VC‐financed firms achieve larger scale but are not more profitable at exit than matched non‐VC‐financed firms. Cumulative failure rates of VC‐financed firms are lower, with the difference driven largely by lower failure rates in the initial years after receiving VC. Our results are not driven by VCs disguising failures as acquisitions or by certain types of VCs. The performance difference between VC‐ and non‐VC‐financed firms narrows in the post‐internet bubble years, but does not disappear.     

UNIVERSITY OF GEORGIA ROUNDTABLE ON: Enterprise‐Wide Risk Management

For many years, MBA students were taught that there was no good reason for companies that hedge large currency or commodity price exposures to have lower costs of capital, or trade at higher P/E multiples, than comparable companies that choose not to hedge such financial price risks. Corporate stockholders, just by holding well‐diversified portfolios, were said to neutralize any effects of currency and commodity price risks on corporate values. And corporate efforts to manage such risks were accordingly viewed as redundant, a waste of corporate resources on a function already performed by investors at far lower cost. But as this discussion makes clear, both the theory and the corporate practice of risk management have moved well beyond this perfect markets framework. The academics and practitioners in this roundtable begin by suggesting that the most important reason to hedge financial risks—and risk management's largest potential contribution to firm value—is to ensure a company's ability to carry out its strategic plan and investment policy. As one widely cited example, Merck's use of FX options to hedge the currency risk associated with its overseas revenues is viewed as limiting management's temptation to cut R&D in response to large currency‐related shortfalls in reported earnings. Nevertheless, one of the clear messages of the roundtable is that effective risk management has little to do with earnings management per se, and that companies that view risk management as primarily a tool for smoothing reported earnings have lost sight of its real economic function: maintaining access to low‐cost capital to fund long‐run investment. And a number of the panelists pointed out that a well‐executed risk management policy can be used to increase corporate debt capacity and, in so doing, reduce the cost of capital. Moreover, in making decisions whether to retain or transfer risks, companies should generally be guided by the principle of comparative advantage. If an outside firm or investor is willing to bear a particular risk at a lower price than the cost to the firm of managing that risk internally, then it makes sense to lay off that risk. Along with the greater efficiency and return on capital promised by such an approach, several panelists also pointed to one less tangible benefit of an enterprise‐wide risk management program—a significant improvement in the internal corporate dialogue, leading to a better understanding of all the company's risks and how they are affected by the interactions among its business units.     

Price Discovery in Near‐ and Away‐from‐the‐Money Option Markets

This paper examines the relative price discovery roles of near‐ and away‐from‐the‐money option markets. The evidence shows that, when considering multiple options with different strike prices jointly, option markets have an average information share of 17.6%. However, no individual option market dominates in the price discovery process, higher and lower trading activity options (i.e., near‐ and away‐from‐the‐money options, respectively) each contribute approximately equally to this process. The main implications of these results are that (1) collectively, option markets process a substantial amount of new stock price‐related information, and (2) looking across strike prices, option markets appear to be informationally nonredundant.     

Why Is Long‐Horizon Equity Less Risky? A Duration‐Based Explanation of the Value Premium

We propose a dynamic risk‐based model that captures the value premium. Firms are modeled as long‐lived assets distinguished by the timing of cash flows. The stochastic discount factor is specified so that shocks to aggregate dividends are priced, but shocks to the discount rate are not. The model implies that growth firms covary more with the discount rate than do value firms, which covary more with cash flows. When calibrated to explain aggregate stock market behavior, the model accounts for the observed value premium, the high Sharpe ratios on value firms, and the poor performance of the CAPM.     

Broad‐Based Employee Stock Ownership: Motives and Outcomes

Firms initiating broad‐based employee share ownership plans often claim employee stock ownership plans (ESOPs) increase productivity by improving employee incentives. Do they? Small ESOPs comprising less than 5% of shares, granted by firms with moderate employee size, increase the economic pie, benefiting both employees and shareholders. The effects are weaker when there are too many employees to mitigate free‐riding. Although some large ESOPs increase productivity and employee compensation, the average impacts are small because they are often implemented for nonincentive purposes such as conserving cash by substituting wages with employee shares or forming a worker‐management alliance to thwart takeover bids.     

Financing Shipping Companies and Shipping Operations: A Risk‐Management Perspective

Shipping has always been a volatile and cyclical business. The extreme changes in revenues, operating cash flows, and asset values during the recent financial crises have upset the usual means of financing shipping companies. While bank debt will remain important in the future, the new regulatory environment has been forcing shipping banks to shift these risks from their balance sheets to capital markets through instruments such as loan securitization. As a result, the shipping industry will increasingly look to capital markets for external funds. And shipping banks are likely to change from being commercial bank lending institutions to becoming more like investment banks that arrange a variety of financing solutions, including high yield bonds or public equity. Risk management will be central to shipping companies in this new environment. Shipping companies can manage their own risks by modifying operations, employing freight and vessel price derivatives, or adjusting their capital structures. To arrive at the value‐maximizing combination of these three basic methods, they must decide which risks to bear, which to manage internally, and which to transfer to the capital markets. These decisions require shipping financial managers to assess the effect of each risk on firm value, understand how each contributes to total risk, and determine the most cost‐effective way to limit that risk to an acceptable level.     

Risk‐based explanation for the book‐to‐market effect

This paper proposes a risk‐based explanation for the book‐to‐market (B/M) effect. I decompose B/M into net operating asset‐to‐market (NOA/M) and net financing asset‐to‐market (NFA/M) components. Portfolio analysis shows that (i) positive B/M, NOA/M and NFA/M are positively related to future returns and (ii) negative B/M, NOA/M and NFA/M are negatively related to future returns. To the extent that positive B/M, NOA/M and NFA/M act as measures of asset risk and negative B/M, NOA/M and NFA/M act as inverse measures of borrowing risk, the nonlinear relations between B/M, NOA/M and NFA/M and future returns provide some evidence to support the risk‐based explanation for the book‐to‐market effect in stock returns.