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The Popular Stock Metric That Can Lead Investors Astray

by Rachel Layne

Investors may rely too heavily on a financial measure that no longer reflects the economic fundamentals of modern business. What should investors do? Research by Charles C.Y. Wang and colleagues. Open for comment; 0 Comments.

Connecting Expected Stock Returns to Accounting Valuation Multiples: A Primer

by Akash Chattopadhyay, Matthew R. Lyle, and Charles C.Y. Wang

This paper introduces a framework to investors and researchers interested in accounting-based valuation. The framework connects expected stock returns to accounting valuation anchors. It can be generalized to evaluate an enterprise's expected returns, and can be adapted to correct for the use of stale accounting data.

Short-Termism, Shareholder Payouts, and Investment in the EU

by Jesse M. Fried and Charles C.Y. Wang

Shareholder-driven “short-termism,” as evidenced by increasing payouts to shareholders, is said to impede long-term investment in EU public firms. But a deep dive into the data reveals a different story.

The European Commission’s Sustainable Corporate Governance Report: A Critique

by Mark Roe, Holger Spamann, Jesse Fried, and Charles Wang

The European Commission commissioned a report on sustainable corporate governance that purports to find serious problems of corporate short-termism. The report is wholly flawed: it conflates time horizon problems with externality problems, mismeasures investment and its financing, and proposes ineffective, possibly harmful reforms.

Can Capitalism Be Fixed by Making Companies More Just?

Re: Ethan C. Rouen & Charles C.Y. Wang

JUST Capital seeks to make public companies more "just" by measuring and ranking their overall impact on society, based on priorities most important to average Americans. Ethan Rouen and Charles Wang explore whether JUST Capital's performance evaluation methodology can improve corporate behavior. Open for comment; 0 Comments.

Core Earnings? New Data and Evidence

by Ethan Rouen, Eric So, and Charles C.Y. Wang

Using a novel dataset of earnings-related disclosures embedded in the 10-Ks, this paper shows how detailed financial statement analysis can produce a measure of core earnings that is more persistent than traditional earnings measures and forecasts future performance. Analysts and market participants are slow to appreciate the importance of transitory earnings.

rTSR: When Do Relative Performance Metrics Capture Relative Performance?

by Paul Ma, Jee-Eun Shin, and Charles C. Y. Wang

Managers are increasingly evaluated based on relative performance metrics, particularly relative total shareholder returns (rTSR). This paper finds that the majority of firms that tie CEO performance-based contracts to rTSR do a remarkable job of filtering out the systematic risk in TSR. However, a significant portion of firms make relatively poor choices in the design and selection of rTSR, a result of weak governance and an overreliance on compensation consultants.

Expected Stock Returns Worldwide: A Log-Linear Present-Value Approach

by Akash Chattopadhyay, Matthew R. Lyle, and Charles C.Y. Wang

Over the last 20 years, shortcomings of classical asset-pricing models have motivated research in developing alternative methods for measuring ex ante expected stock returns. This study evaluates the main paradigms for deriving firm-level expected return proxies (ERPs) and proposes a new framework for estimating them.

Government Incentives and Financial Intermediaries: The Case of Chinese Sell-Side Analysts

by Sheng Cao, Xianjie He, Charles C.Y. Wang, and Huifang Yin

This study is the first to examine analysts’ incentives vis-à-vis the government in a context where government has the ability and motives to influence capital market institutions. The paper highlights the role of government incentives in analysts’ behavior and output.

First Look at Research and Ideas, August 8, 2017

Sean Silverthorne

Can Waze navigate its own growth challenges? ... Hospital management practices can help (and hurt) maternal outcomes ... Seeking prestige, Japanese companies perform better on the Nikkei 400 stock index.

Governance Through Shame and Aspiration: Index Creation and Corporate Behavior in Japan

by Akash Chattopadhyay, Matthew D. Shaffer, and Charles C.Y. Wang

By exploiting the unique features of Japan’s JPX-Nikkei 400 index, this paper examines how membership in a stock index serves as a source of prestige that can motivate managers and influence corporate governance norms. Findings are important for understanding non-pecuniary mechanisms to induce meaningful changes in corporate behavior.

Relative Performance Benchmarks: Do Boards Get It Right?

by Paul Ma, Jee Eun Shin, and Charles C.Y. Wang

Use of relative performance based (RPE) grants has been steadily increasing. Common wisdom is that such grants help induce costly effort from the CEO by shielding them from performance shocks that are outside of their control. This study raises questions about the use of index-based benchmarks in lieu of a narrower set of specific peers.

Economic Uncertainty and Earnings Management

by Luke C.D. Stein and Charles C.Y. Wang

This paper provides the first evidence on how market participants' uncertainty about firms' future prospects affects managerial decisions in financial reporting. Firms are more likely to manage earnings downward during times of elevated uncertainty, particularly when managers face greater incentives or enjoy greater ability to do so.

Accounting Data, Market Values, and the Cross Section of Expected Returns World

by Charles C.Y. Wang

Over the past 30 years, the central question in asset pricing is understanding what drives the variation in expected returns. Despite its importance, empirical research in this area has remained problematic because the key variable, expected returns, is not observable. This paper promotes an accounting-fundamentals-based approach to estimating expected returns. It contributes to the stream of empirical studies devoted to developing the estimation of, and understanding the behavior of, expected returns. It also provides a practical tool that can be used to analyze investment choices in international equity contexts. Closed for comment; 0 Comments.

The Search for Benchmarks: When Do Crowds Provide Wisdom?

by Charles M.C. Lee, Paul Ma & Charles C.Y. Wang

Finding appropriate economic benchmarks for individual firms is a fundamental issue. Firms, managers, investors, and researchers all need to identify fundamentally similar benchmarks for such tasks as performance evaluation, executive compensation, equity valuation, statistical arbitrage, and portfolio construction. While traditional benchmarking methods rely primarily on industry classification schemes, more recent approaches introduce new dimensions by utilizing novel data sources or fresh data analytic techniques. Some of these approaches suggest we may need to rethink the reliance on traditional industry classification for benchmarking purposes. In this paper, the authors conduct a comprehensive analysis of the state-of-the-art representatives of four broad categories of peer identification schemes nominated by either financial practitioners or recent academic studies as potential solutions to economic benchmarking. The study's results suggest that the class of bench-marking solutions that harnesses the collective wisdom of investors is a promising path for the future. This approach's effectiveness, however, depends on the sophistication of the individuals in the population (the inherent level of collective wisdom attainable through sampling) and the quality of the information environment surrounding the firm, as well as the size of the sample itself. Key concepts include: Traditional industry classifications are unlikely to capture nuanced or changing economics in firms in an increasingly service- and knowledge-based economy. Aggregated revealed-choice-based approaches have great potential in resolving long-standing benchmarking problems in accounting and finance. These approaches aggregate individual agents' choices to reveal the collective wisdom of investors with respect to the set of economically-related firms. Closed for comment; 0 Comments.

Measurement Errors of Expected Returns Proxies and the Implied Cost of Capital

by Charles C.Y. Wang

In accounting and finance the implied cost of equity capital (ICC)—defined as the internal rate of return that equates the current stock price to discounted expected future dividends—is an increasingly popular class of proxies for the expected rate of equity returns. Though ICCs are intuitively appealing and have the potential to help researchers better understand the cross-sectional variation in expected returns, much remain unknown about the sources of their measurement errors and how to correct for them; thus their use in regression settings should be interpreted with caution. This paper studies the measurement errors properties of GLS, a popular implementation of ICCs developed by Gebhardt, Lee, and Swaminathan (2001). The paper finds that ICCs can have persistent measurement errors that are associated with firms' risk or growth characteristics, and thus produce spurious results in regression settings. It also finds that ICC measurement errors are driven by not only analyst forecast biases but also functional form assumptions, suggesting that correcting for the former alone is unlikely to fully resolve these measurement-error issues. Together, these findings emphasize the importance of complementing ICC regressions with realized returns to establish robust inferences on expected returns. Key concepts include: The common justification for using ICCs for studying expected returns—that ICCs are far less "noisy" than realized returns—is insufficient without a better understanding of the biases embedded in ICC measurement errors. ICC measurement errors can be persistent, can be associated with firms' risk or growth characteristics, and thus confound regression inferences on expected returns. Due to the cross-sectional association between ICC measurement errors and firms' risk or growth characteristics, standard methods for addressing measurement errors, namely portfolio grouping and instrumental variables, may have limited effectiveness. To convincingly establish an association between expected returns and firm characteristics using ICCs, it is necessary for researchers to complement ICC regressions with regressions using realized returns. Closed for comment; 0 Comments.

Boardroom Centrality and Firm Performance

by David F. Larcker, Eric C. So & Charles C.Y. Wang

Economists and sociologists have long studied the influence of social networks on labor markets, political outcomes, and information diffusion. These networks serve as a conduit for interpersonal and inter-organizational support, influence, and information flow. This paper studies the boardroom network formed by shared directorates and examines the implications of having well-connected boards, finding that firms with the best-connected boards on average earn substantially higher future excess returns and other advantages. Key concepts include: Board of director networks provide economic benefits that are not immediately reflected in stock prices. Firms with better-connected boards experience significantly higher future excess returns and gains in profitability compared to those with less-connected boards. There is a statistically significant and positive relation between board connectedness and the extent to which the firm's realized earnings exceed the consensus analyst forecast. Network effects appear to be important not only in specific settings or decisions, but they have a more general impact on the economic performance of firms, particularly resource-needy firms. Closed for comment; 0 Comments.

Cost of Capital Dynamics Implied by Firm Fundamentals

by Matthew Lyle & Charles C.Y. Wang

Despite ample evidence that expected returns are time varying, there has been relatively little empirical research on estimating the dynamics of firm-level expected returns. Capturing the dynamics of firm-level expected returns is important, because it allows for a better understanding of firm risk over time and can inform investors in tailoring their portfolios to match their desired investment horizons. Findings show that cost of capital is time varying and highly persistent. The authors also demonstrate that the model produces empirical proxies of expected returns that can predict future stock returns up to three years into the future and sorts portfolio returns with near monotonicity. Aside from its practical contributions, this paper adds to a budding finance and accounting literature that studies the properties of expected return dynamics. Key concepts include: The model can forecast stock returns up to three years into the future and tracks economic conditions. From a practical standpoint, the approach has several advantages relative to the current methodologies for estimating expected returns. The model is easy to implement, requiring only realized returns, realized BM ratio, and realized ROE. The model also allows for discount rates to be dynamic and produce a full projection of future—time varying—cost of capital estimates. On average, the term structure of cost of capital, like the yield curve for bonds, is upward sloping. However, during times of high economic uncertainty, as in recessions and crisis periods, the term structure flattens and can be downward sloping. Closed for comment; 0 Comments.