Leverage, Volatile Future Earnings Growth and Expected Stock Returns
47 Pages Posted: 8 Aug 2014 Last revised: 15 Aug 2014
Date Written: August 7, 2014
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: Suggested Citation