Year Effects on Stock Returns, Earnings, and Capital Expense
Journal of International Finance and Economics, Vol. 8, No. 3, pp. 77-92, 2008
Posted: 5 Dec 2009
Date Written: 2008
In this study business cycle effects are taken into consideration in investigating the relationship between stock returns, earnings and capital expense in different countries. In countries where corporate governance rules and mechanisms are well-established, managers are closely monitored. Therefore, the earnings that the firm generates are used for good investment projects leading to positive stock returns. If the financial markets in these countries are also well-established and efficient, the reaction of stock returns to good investment projects should also be fast, in fact contemporaneous. The increase in stock returns increases the discount rate that investors use in valuation of firms. The high discount rate should lead to negative future stock returns, all else equal in efficient financial markets. Capital expense by the management should produce similar results as those of earnings but to a lesser extent because earnings are the first resort of funding in investment decisions. On the other hand, for countries where corporate governance mechanisms are not well established and where financial markets are not very efficient, earnings or capital expense may not be used for the best interests of shareholders, and stock price reaction to earnings will neither be necessarily positive nor contemporaneous. The results show that in common law countries earnings and capital expense produce positive contemporaneous returns. In civil law countries that is not necessarily the case. The results are more pronounced in developed countries. The analysis uses fixed effects regression models and therefore, takes into account the fact that the world economy has gone through different phases during 1990s and 2000s. Year dummies are introduced to counter the business cycle influence.
Keywords: Corporate Governance, Earnings, Capital Expense, Business Cycle, Fixed Effects, Efficiency
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