Firm Investment And Price Informativeness
Board of Governors of the Federal Reserve System
October 30, 2015
I investigate how the informational content of stock prices is affected by firm characteristics reflected in their capital investment decisions. Firms can base their investment decisions on private signals and stock price information. I show that the informational content of a firm’s stock price increases in the weight attached to private information. Intuitively, by relying more heavily on private signals, firms can incentivize informed traders to trade more aggressively on their own private information. Then, the equilibrium stock price reflects relatively more novel information and less noise, such that price informativeness increases and firms can learn more additional information from the financial market. The model makes several empirical predictions: i) individual stock prices should be more informative than aggregate prices, ii) firms with better managers should have more informative prices, and iii) a higher degree of stock-based compensation reduces the informational content of prices.
Firm Investment And Price Informativeness – Introduction
Market efficiency is an important concept in financial economics. It measures how much information about the future payoff is reflected in an asset’s stock price.1 Improving the informational content of stock prices is generally seen as a desirable goal because it allows real decision makers (such as firms) to invest more efficiently. The idea that there exists such a “feedback effect” has received theoretical and empirical support from the existing literature.2 What is less understood, is the firm-specific factors, besides signal precisions or the amount of noise trading, that determine the informational content of individual and aggregate stock prices.
In this paper, I analyze whether the structure of a firm’s investment decision has an impact on the informational content of stock prices. In my model, firms have access to several sources of information (“signals”) about future productivity. Firm investment is then characterized by the weights a firm assigns ex ante to the different pieces of information. On the one hand, there are private signals that are only available to a specific firm. Outsiders, such as traders in a financial market or other firms, cannot observe these pieces of information. On the other hand, firms have access to informative stock prices that reflect the aggregate demand for the different assets. A key question for firms is then how to weight these different signals when making an investment decision. Clearly, if one of these signals is less precise than the other one, we would expect that a firm should rely more on the one containing more information. The main insight of this paper, is to show that the informational content of stock prices is actually a function of the weights a firm attaches to the different signals. For example, I show that if a firm increases its weight attached to private information, the aggregate demand by informed traders becomes more sensitive to information and the informational content of the stock price increases.
In the baseline model, a large number of firms decides on capital investment. This investment decision together with a cross-sectionally correlated productivity shock determines the firms’ terminal value which is paid out as a liquidating dividend. Claims to these payoffs are traded in a secondary financial market by two groups of agents: informed traders and noise traders. The former possess valuable information about certain aspects of future firm productivity, whereas the latter trade for reasons orthogonal to future productivity. As a result, the equilibrium stock price eventually reflects information about future productivity together with noise. Therefore, each firm’s stock price serves as an endogenous noisy signal which establishes the existence of a “feedback effect” from the financial market to the real economy. A crucial assumption is that firms are imperfectly informed about some aspects of future firm productivity. They receive perfect information about some dimensions of it, whereas they receive noisy, private signals about other aspects. In equilibrium, they can then learn some additional information about the latter from the financial market.
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