Risk Interpretation of the CAPM's Beta: Evidence from a New Research Method

This study tests the validity of using the CAPM beta as a risk control in cross‐sectional accounting and finance research. We recognize that high‐risk stocks should experience either very good or very bad returns more frequently compared to low‐risk stocks, that is, high‐risk stocks should cluster in the tails of the cross‐sectional return distribution. Building on this intuition, we test the risk interpretation of the CAPM's beta by examining if high‐beta stocks are more likely than low‐beta stocks to experience either very high or very low returns. Our empirical results indicate that beta is a strong predictor of large positive and large negative returns, which confirms that beta is a valid empirical risk measure and that researchers should use beta as a risk control in empirical tests. Further, we show that because the relation between beta and returns is U‐shaped, that is, high betas predict both very high and very low returns, linear cross‐sectional regression models, for example, Fama–MacBeth regressions, will fail on average to reject the null hypothesis that beta does not capture risk. This result explains why previous studies find no significant cross‐sectional relation between beta and returns.     

Does liquidity risk explain low firm performance following seasoned equity offerings?

A seasoned equity offering (SEO) can improve a firm’s stock liquidity and lower its cost of capital. This paper examines whether SEO firms achieve a liquidity gain and the sources of this gain. It explores the role of liquidity risk in explaining SEO long-run performance. The evidence shows that SEO firms experience significant post-issue improvements in liquidity and reductions in liquidity risk. Size and book-to-market matching fails to control for these liquidity effects, generating the low long-term post-SEO performance documented in the literature. After adjusting for liquidity risk, SEO firms show normal long-term performance.     

Intended Use of Proceeds,Underwriter Quality and the Long‐run Performance of SEOs in the UK

We document that prospectus disclosure of (i) the motives for a seasoned equity offering, and (ii) the choice of underwriter explain the long‐run performance of equity issuers in the UK. Firms citing investment needs show no abnormal performance after the offering and have higher investment rates post‐issue compared to the period before the offering. Issuers that state general corporate purposes and recapitalisation motives underperform, have similar investment rates pre‐ and post‐issue, and their leverage tends to increase after the offering. Further, consistent with the certifying role of underwriters, equity issues underwritten by high‐quality brokers show no evidence of post‐issue abnormal returns, but offerings taken public by low‐quality underwriters exhibit negative abnormal performance. Together, our results document the significant role that prospectus information on the intended use of offering proceeds and on the underwriter play in predicting issuers post‐offering performance in the UK.     

Analyst revenue forecast reporting and the quality of revenues and expenses

We decompose earnings quality into revenue and expense quality and examine their associations with analyst propensity to supplement their earnings forecasts with revenue forecasts. Analysts report more revenue forecasts to I/B/E/S when expense quality is low to compensate for the low accuracy of their earnings estimates, which has a positive association with expense quality. Expense quality is unassociated with revenue forecast accuracy, thus revenue forecasts become increasingly useful for valuing firms when expense quality is low. Analysts report fewer revenue forecasts when revenue quality is low because both earnings and revenue forecast accuracy decline as revenue quality deteriorates. To control for endogeneity, we use firm‐fixed effects to control for unobserved time‐invariant heterogeneity across firms, instrumental variables regressions and regression in changes.     

Analyst Research Activity During the COVID-19 Pandemic

This paper documents that, in response to the COVID-19 pandemic, analysts increase their research activity and significantly revise their forecasts when compared to the pre-pandemic period. Uncertainty-adjusted forecast errors are either comparable or smaller during the pandemic compared to the pre-pandemic period. Investor attention and price reactions to analyst forecast revisions are higher during the pandemic and the effect is stronger in periods where investors actively search for information about firms. During the pandemic, investors value analyst price discovery role more than their role in interpreting public information. Jointly, the results suggest that analysts play an important information intermediation role during the COVID-19 pandemic.     

Do Analysts Disclose Cash Flow Forecasts with Earnings Estimates when Earnings Quality is Low?

Cash flows are incrementally useful to earnings in security valuation mainly when earnings quality is low. This suggests that when earnings quality decreases, analysts will be more likely to supplement their earnings forecasts with cash flow estimates. Contrary to this prediction, we find that analysts do not disclose cash flow forecasts when the quality of earnings is low. This is because cash flow forecast accuracy depends on the accuracy of the accrual estimates and the precision of accrual forecasts decreases for firms with low quality earnings. Consequently, as earnings quality decreases, cash flow forecasts become increasingly inaccurate compared to earnings estimates. Cash flow estimates that lack reliability are not useful to investors and, consequently, unlikely to be reported by analysts. This result provides an explanation for why analysts are less likely to report cash flow estimates when earnings quality is low.     

Strategic distortions in analyst forecasts in the presence of short-term institutional investors

We document that analysts cater to short-term investors by issuing optimistic target prices. Catering dominates among analysts at brokers without an investment banking arm as they face lower reputational cost. The market does not see through the analyst catering activity and their forecasts lead to temporary stock overpricing that short-term institutional investors exploit to offload their holdings to retail traders. We also report evidence consistent with catering brokers being rewarded with more future trades channelled through them. Our study identifies a new source of conflicts of interest in analyst research originating from the ownership composition of a stock.     

Information Quality and the Expected Rate of Return: A Structural Equation Modelling Approach

Asia-Pacific Financial Markets - We use structural equation modelling for a robust test of the role information quality plays in explaining the cost of equity capital (CoE). SEM allows us to...