Working Paper: CEPR ID: DP8539
Authors: Elias Albagli; Christian Hellwig; Aleh Tsyvinski
Abstract: We study the interplay of share prices and firm decisions when share prices aggregate and convey noisy information about fundamentals to investors and managers. First, we show that the informational feedback between the firm's share price and its investment decisions leads to a systematic premium in the firm's share price relative to expected dividends. Noisy information aggregation leads to excess price volatility, over-valuation of shares in response to good news, and undervaluation in response to bad news. By optimally increasing its exposure to fundamental risks when the market price conveys good news, the firm shifts its dividend risk to the upside, which amplifies the overvaluation and explains the premium. Second, we argue that explicitly linking managerial compensation to share prices gives managers an incentive to manipulate the firm's decisions to their own benefit. The managers take advantage of shareholders by taking excessive investment risks when the market is optimistic, and investing too little when the market is pessimistic. The amplified upside exposure is rewarded by the market through a higher share price, but is inefficient from the perspective of dividend value.
Keywords: information aggregation; managerial incentives; market efficiency
JEL Codes: D82; D84; G14; M52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Share Prices (P) (G19) | Expected Dividends (E[D]) (G35) |
| Expected Dividends (E[D]) (G35) | Share Prices (P) (G19) |
| Managerial Incentives (M52) | Investment Decisions (G11) |
| Investment Decisions (G11) | Share Prices (P) (G19) |
| Managerial Incentives (M52) | Expected Dividends (E[D]) (G35) |
| Share Prices (P) (G19) | Overvaluation during Good News (G14) |
| Share Prices (P) (G19) | Undervaluation during Bad News (G14) |