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Leverage, Volatile Future Earnings Growth and Expected Stock Returns

Author
Alcock, Jamie; Steiner, Eva; Tan, Kelvin Jui Keng
Abstract
We provide theory and evidence to complement Choi's [RFS, 2013] important new insights on the returns to equity in `value' firms. We show that higher future earnings growth ameliorates the value-reducing effect of leverage and, because the market for earnings is incomplete, reduces the earnings-risk sensitivity of the default option. Ceteris paribus, a levered firm with low (high) earnings growth is more sensitive to the first (second) of these effects thus generating higher (lower) expected returns. We demonstrate this by modeling equity as an Asian-style call option on net earnings and find significant empirical support for our hypotheses.
Date Issued
2014-08-07Subject
corporate leverage; default risk; earnings risk; earnings growth; value vs growth; stochastic earnings valuation model
Rights
Required Publisher Statement: Copyright held by the authors.
Type
preprint