Columbia Law School
What Can We Learn from Stock Prices ? Cash Flow, Risk and Shareholder Welfare
Price is expected cash flows discounted at the risk-free rate and a discount for risk exposure. Price-equivalency does not always imply welfare-equivalency: shareholders are not necessarily indifferent between a price increase of $1 from higher cash flows and the same $1 increase from lower risk exposure. Even in complete markets, if managers enjoy private benefits of control, the social planner may prefer lower risk exposure to a price-equivalent increase in firm value from greater investor protection.
This has implications for event studies, the tradeoff between principal costs and agency costs, and the link between macroeconomic risk and corporate governance.
Prices convey information. Hayek (1945) put it this way: prices “coordinate the separate actions of different people in the same way as subjective values help the individual to coordinate the parts of his plan.” Stock prices, in particular, matter a great deal in corporate and securities law. Event studies, which measure statistically significant changes in stock prices, are widely used by investors and courts to infer the effect of an event on the value of a firm (Bhaghat & Romano, 2002b).
This article asks a basic question: what can we learn from stock prices? It is a tautology to say that price reflects value: after all, buyers will not pay more for an asset than what that asset is worth to them. But value does not imply cash flow: a buyer may happily pay $1 for an asset which never pays off $1. That is because assets which pay off when investors need money are more valuable to those investors than assets which pay off they are wealthy. Stock prices reflect not only the expected future cash flows of a firm but also the extent to which those cash flows serve as a kind of implicit insurance for investors, paying off precisely when they need money. Put differently, investors especially value cash flows that “smooth consumption” by making hard times less painful.