Person:

Wang, Charles

This paper presents a methodology to study implied cost of capital's (ICC) measurement errors, which are relatively unstudied empirically despite ICCs' popularity as proxies of expected returns. By applying it to the popular implementation of ICCs of Gebhardt, Lee, and Swaminathan (2001) (GLS), I show that the methodology is useful for explaining the variation in GLS measurement errors. I document the first direct empirical evidence that ICC measurement errors can be persistent, can be associated with firms' risk or growth characteristics, and thus confound regression inferences on expected returns. I also show that GLS measurement errors and the spurious correlations they produce are driven not only by analysts' systematic forecast errors but also by functional form assumptions. This finding suggests that correcting for the former alone is unlikely to fully resolve these measurement-error issues. To make robust inferences on expected returns, ICC regressions should be complemented by realized-returns regressions.

We develop and implement a rigorous analytical framework for empirically evaluating the relative performance of firm-level expected-return proxies (ERPs). We show that superior proxies should closely track true expected returns both cross-sectionally and over time (that is, the proxies should exhibit lower measurement-error variances). We then compare five classes of ERPs nominated in recent studies to demonstrate how researchers can easily implement our two-dimensional evaluative framework. Our empirical analyses document a tradeoff between time-series and cross-sectional ERP performance, indicating the optimal choice of proxy may vary across research settings. Our results illustrate how researchers can use our framework to critically evaluate and compare a growing body of ERPs.

We compare the performance of a comprehensive set of alternative peer identification schemes used in economic benchmarking. Our results show the peer firms identified from aggregation of informed agents' revealed choices in Lee, Ma, and Wang (2014) perform best, followed by peers with the highest overlap in analyst coverage, in explaining cross-sectional variations in base firms' out-of-sample: (a) stock returns, (b) valuation multiples, (c) growth rates, (d) R&D expenditures, (e) leverage, and (f) profitability ratios. Conversely, peers firms identified by Google and Yahoo Finance, as well as product market competitors gleaned from 10-K dis-closures, turned in consistently worse performances. We contextualize these results in a simple model that predicts when information aggregation across heterogeneously informed individuals is likely to lead to improvements in dealing with the problem of economic benchmarking.

Golden parachutes (GPs) have attracted substantial attention from investors and public officials for more than two decades. We find that GPs are associated with higher expected acquisition premiums and that this association is at least partly due to the effect of GPs on executive incentives. However, we also find that firms that adopt GPs experience negative abnormal stock returns both during and subsequent to the period surrounding their adoption. This finding raises the possibility that even though GPs facilitate some value-increasing acquisitions, they do have, on average, an overall negative effect on shareholder wealth; this effect could be due to GPs weakening the force of the market for control and thereby increasing managerial slack, and/or to GPs making it attractive for executives to go along with some value-decreasing acquisitions that do not serve shareholders' long-term interests. Our findings have significant implications for ongoing debates on GPs and suggest the need for additional work identifying the types of GPs that drive the identified correlation between GPs and reduced shareholder value.

During the period 1991-1999, stock returns were correlated with the G-Index based on twenty-four governance provisions (Gompers, Ishii, and Metrick (2003)) and the E-Index based on the six provisions that matter most (Bebchuk, Cohen, and Ferrell (2009)). This correlation, however, did not persist during the subsequent period 2000-2008. We provide evidence that both the identified correlation and its subsequent disappearance were due to market participants’ gradually learning to appreciate the difference between firms scoring well and poorly on the governance indices. Consistent with the learning hypothesis, we find that:

(i) The disappearance of the governance-return correlation was associated with an increase in the attention to governance by a wide range of market participants; (ii) Until the beginning of the 2000s, but not subsequently, stock market reactions to earning announcements reflected the market’s being more positively surprised by the earning announcements of good-governance firms than by those of poor-governance firms; (iii) Stock analysts were also more positively surprised by the earning announcements of good-governance firms than by those of poor-governance firms until the beginning of the 2000s but not afterwards; (iv) While the G-Index and E-Index could no longer generate abnormal returns in the 2000s, their negative association with Tobin’s Q and operating performance persisted; and (v) The existence and subsequent disappearance of the governance-return correlation cannot be fully explained by additional common risk factors suggested in the literature for augmenting the Fame-French-Carhart four-factor model.

Relative TSR (rTSR) is increasingly used by market participants to judge and incentivize managerial performance. We evaluate the efficacy, reasons, and implications of firms' benchmarks in rTSR-based contracts. Although compensation consultants suggest that a primary objective of rTSR is to filter shocks unrelated to managerial performance, following the informativeness principle, we document that a significant subset of firms, who choose index-based benchmarks, do not adequately achieve this objective. Further, the index-benchmark selection is associated with governance-related frictions, and not driven by plausible alternative theories. Both structural calibration and reduced-form estimates reveal significant negative performance implications from sub-optimal peer-selection.

We provide a tractable model of firm-level expected holding period returns using two firm fundamentals—book-to-market ratio and ROE—and study the cross-sectional properties of the model-implied expected returns. We find that 1) firm-level expected returns and expected profitability are time-varying but highly persistent; 2) forecasts of holding period returns strongly predict the cross section of future returns up to three years ahead. We document a highly significant predictive pooled regression slope for future quarterly returns of 0.86, whereas the popular factor-based expected return models have either an insignificant or a significantly negative association with future returns. In supplemental analyses, we show that these forecasts are also informative of the time-series variation in aggregate conditions: 1) for a representative firm, the slope of the conditional expected return curve is more positive in good times, when expected short-run returns are relatively low; 2) the model-implied forecaster of aggregate returns exhibits modest predictive ability. Collectively, we provide a simple, theoretically motivated, and practically useful approach to estimating multi-period ahead-expected returns.

Under fairly general assumptions, expected stock returns are a linear combination of two accounting fundamentals―book to market and ROE. Empirical estimates based on this relation predict the cross section of out-of-sample returns in 26 of 29 international equity markets, with a highly significant average slope coefficient of 1.05. In sharp contrast, standard factor-model-based proxies fail to exhibit predictive power internationally. We show analytically and empirically that the importance of ROE in forecasting returns depends on the quality of accounting information. Overall, a tractable accounting-based valuation model provides a unifying framework for obtaining reliable proxies of expected returns worldwide.

The well-established negative correlation between staggered boards (SBs) and firm value could be due to SBs leading to lower value or a reflection of low-value firms' greater propensity to maintain SBs. We analyze the causal question using a natural experiment involving two Delaware court rulings―separated by several weeks and going in opposite directions―that affected the antitakeover force of SBs. We contribute to the long-standing debate on staggered boards by documenting empirical evidence consistent with the market viewing SBs as leading to lower firm value for the affected firms.

In the presence of managerial short-termism and asymmetric information about skill and effort provision, firms may opportunistically shift earnings from uncertain to more certain times. We document that firms report more negative discretionary accruals when financial markets are less certain about their future prospects. Stock-price responses to earnings surprises are moderated when firm-level uncertainty is high, consistent with performance being attributed more to luck rather than skill and effort, which can create incentives to shift earnings toward lower-uncertainty periods. We show that the resulting opportunistic earnings management is concentrated in CEOs, firms, and periods where such incentives are likely to be strongest: (1) where CEO wealth is sensitive to change in the share price, (2) where announced earnings are particularly likely to be an important source of information about managerial ability and effort, and (3) before implementation of Sarbanes-Oxley made opportunistic earnings management more challenging. Our evidence highlights a novel channel through which uncertainty affects managerial decision making in the presence of agency conflicts.