Allocating Capital
Corporate Discount Rates
Niels Joachim Gormsen & Kilian Huber
NBER Working Paper, June 2023
Abstract:
Standard theory implies that the discount rates used by firms in investment decisions (i.e., their required returns to capital) determine investment and transmit financial shocks to the real economy. However, there exists little evidence on how firms' discount rates change over time and affect investment. We construct a new global database based on manual entry from conference calls. We show that, on average, firms move their discount rates with the cost of capital, but the relation is far below the one- to-one mapping assumed by standard theory, with substantial heterogeneity across firms. This pattern leads to time-varying wedges between discount rates and the cost of capital. The average wedge has increased substantially over the last decades as the cost of capital has dropped. Future investment is negatively related to discount rates and discount rate wedges, but only weakly related to the cost of capital because of the limited transmission into discount rates. Moreover, the large and growing discount rate wedges can account for the puzzle of "missing investment" (relative to high asset prices) in recent decades. We find that beliefs about value creation combined with market power, along with fluctuations in risk, explain changes in discount rate wedges over time.
Where the Wild Things Are? The Governance of Private Companies
Gideon Parchomovsky & Asaf Eckstein
University of Pennsylvania Working Paper, March 2023
Abstract:
Private companies far outnumber public ones but receive scant scholarly, public, or regulatory attention and little is known about their governance. In this Article, we begin to fill the void by shedding light on the governance of the largest 200 private companies in the world -- some of which are as large as the top public companies. We embarked upon our study with two principal hypotheses. The first is that there exists a governance gap between private and public companies. According to this hypothesis, the governance structures in public companies are much closer to the ideal than the governance regimes found in private companies. The second hypothesis is that there exists a governance gap between the largest and the smallest private companies -- specifically, that the governance structures in largest private companies are better than those found in the smallest. We expected to see governance gaps because private companies are not subject to the same regulation as public ones, are free of the rules imposed by exchanges and the guidelines of institutional investors, and are also largely immune from public and media pressures. To test our two hypotheses, we hand-collected data about the following parameters that have attracted much attention in the corporate literature on public corporations and are considered the building blocks of good corporate governance: board composition with an emphasis on board diversity, separation of the roles of CEO and chairperson, CEO tenure, directors' tenure, director elections, directors independence, use of external gatekeepers, such as accounting firms and legal counsels, and the extent of their involvement. We then analyzed the data we collected and compared our findings to the existing data on public corporations. Surprisingly, our findings reveal that there is no significant governance gap between the 200 largest private companies and public corporations. There are some differences on various metrics between the private companies we studied and public corporations, but the disparities are mostly not substantial and do not give rise to serious concerns. On most good governance metrics, private companies do as well as the flagship corporations. Furthermore, we observed no critical difference in the governance of the largest and smallest private companies in our sample. Even though on some metrics the largest companies did better than the smallest ones, on our parameters we obtained the opposite result and for most variables there were no differences at all. On the whole, the smallest companies in our sample did as well as the largest ones. We proceed to discuss five theories that explain our unexpected results and explore the policy implications of our findings. Concretely, we examine the need to impose additional regulation on the largest private companies and weigh the option of adopting a model code for private companies that can inform the development of their future governance. We conclude that the governance in the 200 largest private companies does not establish a prima facie case for a regulatory intervention and that the best path forward is to continue to monitor and study the governance of the largest private companies to ensure that it remains in high standing.
The Irrelevance of Environmental, Social, and Governance Disclosure to Retail Investors
Austin Moss, James Naughton & Clare Wang
Management Science, forthcoming
Abstract:
Using an hourly data set on retail investor individual security positions from Robinhood Markets, we find no evidence that environmental, social, and governance (ESG) disclosures inform retail investors' buy and sell decisions. The response on ESG press release days by retail investors is indistinguishable from nonevent days. In contrast, these same investors make economically meaningful changes to their portfolios in response to non-ESG press releases, especially those that pertain to earnings announcements. We use stock return tests to show that there is economic content in ESG press releases, and we conduct subsample analyses showing that retail investors do not respond to the most salient and economically transparent ESG disclosures. Collectively, these tests suggest that a lack of economic content, a lack of visibility, and difficulty with investment integration are unlikely to explain our findings.
Strategic Upward Striving Toward $100 Million Revenue: Setting Goals to Attract External Attention
Daniel Dongil Keum & Stephen Ryan
Organization Science, forthcoming
Abstract:
We provide evidence that in certain contexts, firms set upward-striving goals and that this upward striving yields significant performance and visibility benefits. We develop a model of variable attention in which, as firms' performance levels approach cognitively salient round numbers, managers strategically shift their focus from easier-to-reach goals based on historical and social reference points to more challenging goals that provide external visibility and capital market benefits. As one specific yet important instance of an upward shift in attention, we document a significant increase in revenue growth rates as firms' annual revenue approaches $100 million. Firms achieving this goal obtain discontinuous increases in analyst and media coverage, investment by new institutional investors, and executive compensation. We find no evidence of decreased investment efficiency or profitability, suggesting that managers typically build slack into their goal levels. Our theory extends to goals based on other salient round numbers, such as revenue of $10 million, $500 million, and $1 billion. This study recasts behavioral theory of firm research in an open systems perspective, highlighting the externally directed aspects of firm goal setting.
In the CEO We Trust: Negative Effects of Trust between the Board and the CEO
Kee-Hong Bae et al.
Journal of Financial and Quantitative Analysis, forthcoming
Abstract:
In this study, we investigate whether and how trust between board members and the CEO (board-CEO trust) affects the performance of mergers and acquisitions. Contrary to conventional wisdom, we find that firms with higher levels of board-CEO trust exhibit poor M&A performance: High trust is associated with low acquisition announcement returns, long-term stock return performance, and post-deal operating performance. This negative effect of board-CEO trust is more pronounced among acquiring companies prone to agency problems. Our results suggest that, in the institutional setting of a board of directors, high trust can be too much of a good thing.
Investing in Misallocation
Mete Kilic & Selale Tuzel
University of Southern California Working Paper, May 2023
Abstract:
We document that 20% of Compustat firms have above-median investment rates despite having below-median marginal product of capital (MPK), seemingly "misallocating" productive resources. These firms are typically younger and significantly more likely to experience a substantial upward jump in their sales and MPK in the following years. They account for a significant share of innovative activity and their investments predict future aggregate productivity in the economy, creating value in ways not captured by their MPK. We propose and estimate a simple endogenous firm growth model that captures the key features of the cross-section of firms and allows for counterfactual analysis. Hypothetical firm investment policies that ignore the potential for future jumps reduce MPK and investment dispersion but also lower aggregate productivity.
The role of CEO accounts and perceived integrity in analysts' forecasts
Daniel Skarlicki et al.
Organizational Behavior and Human Decision Processes, May 2023
Abstract:
Although holding oneself accountable is deemed important for effective leadership, CEOs tend to demonstrate a self-serving tendency when reporting their company's performance to the financial community. Leaders do so by providing internal accounts for favorable performance and external accounts for unfavorable performance. The effects of this strategy on the financial community's judgments of a company's value, however, is frequently mixed. Guided by the actor-observer perspective, we propose that observers (i.e., analysts) are likely to provide higher forecasts for firms whose CEOs attribute unfavorable organizational outcomes to internal factors and favorable outcomes to external factors. Integrating this conceptual perspective with attribution theory, we predicted that CEO accounts will have a stronger influence on analysts' forecasts when the company performs unfavorably versus favorably. Results of archival data analysis (N = 35,676 quarterly earnings conference calls) generally supported our hypothesis, and were then replicated in a pre-registered follow-up field experiment (Study 2; N = 307), showing that analysts' perceptions of the leader's integrity mediated the effects of CEO accounts on analysts' evaluation of the company. The mediating role of leader integrity was only significant when the company performed unfavorably (versus favorably). The present research adds to theory on causal accounts and perceived leader integrity, while offering guidance on how leaders' accounts can relate to observers' evaluations of those leaders and their companies.
ES Risks and Shareholder Voice
Yazhou Ellen He, Bige Kahraman & Michelle Lowry
Review of Financial Studies, forthcoming
Abstract:
We examine whether shareholder votes in environmental and social (ES) proposals are informative about firms' ES risks. ES proposals are unique in that they nearly always fail. We examine whether mutual funds' support for these failed proposals contains information about the ES risks that firms face. Higher support in failed ES proposals predicts subsequent ES incidents and the effects of these incidents on shareholder value. Examining the detailed records of fund votes, we find that agency frictions between a group of shareholders contribute to proposal failure.