Leverage, Volatile Future Earnings Growth and Expected Stock Returns

47 Pages Posted: 8 Aug 2014 Last revised: 15 Aug 2014

See all articles by Jamie Alcock

Jamie Alcock

The University of Sydney Business School; Centre for International Finance and Regulation (CIFR)

Eva Steiner

Cornell SC Johnson College of Business

Kelvin Jui Keng Tan

University of Queensland - Business School; Financial Research Network (FIRN)

Date Written: August 7, 2014

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 modelling equity as an Asian-style call option on net earnings and find significant empirical support for our hypotheses.

Keywords: corporate leverage, default risk, earnings risk, earnings growth, value vs growth, stochastic earnings valuation model.

JEL Classification: G12, G14

Suggested Citation

Alcock, Jamie and Steiner, Eva Maria and Tan, Kelvin Jui Keng, Leverage, Volatile Future Earnings Growth and Expected Stock Returns (August 7, 2014). Available at SSRN: https://ssrn.com/abstract=2477343 or http://dx.doi.org/10.2139/ssrn.2477343

Jamie Alcock (Contact Author)

The University of Sydney Business School ( email )

Cnr. of Codrington and Rose Streets
Sydney, NSW 2006
Australia

Centre for International Finance and Regulation (CIFR) ( email )

Level 7, UNSW CBD Campus
1 O'Connell Street
Sydney, NSW 2000
Australia

Eva Maria Steiner

Cornell SC Johnson College of Business ( email )

465B Statler Hall
Ithaca, NY 14853
United States

HOME PAGE: http://https://sha.cornell.edu/faculty-research/faculty/ems457/

Kelvin Jui Keng Tan

University of Queensland - Business School ( email )

Brisbane, Queensland 4072
Australia

Financial Research Network (FIRN) ( email )

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

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