Elsevier

Journal of Corporate Finance

Volume 46, October 2017, Pages 34-50
Journal of Corporate Finance

What do stock price levels tell us about the firms?

https://doi.org/10.1016/j.jcorpfin.2017.06.013Get rights and content

Highlights

  • We hypothesize that high stock price levels impede informed trading on the stocks and reduce price informativeness.

  • The relative trading of options over stock, O/S, increases with stock price levels.

  • The high price effect on O/S is stronger for firms that have more difficulty in attracting small investors.

  • Price informativeness about future earnings and investment sensitivity to stock price are lower for high-price firms.

  • Firms can use stock splits to improve informed trading and enhance price informativeness.

Abstract

We hypothesize that high stock price levels impede informed trading on the stocks and reduce price informativeness. This is because uninformed trading is needed to facilitate informed trading, and high stock prices may impose budget constraints on uninformed investors. Indeed, we find, for high-price firms, (i) options to stock trading volume (O/S), an informed trading measure in options market, is higher, (ii) price informativeness about future earnings is lower, and (iii) investment sensitivity to price is lower. We also find these patterns reverse after stock splits, suggesting that firms can use splits to improve informed trading and enhance price informativeness.

Introduction

Weld et al. (2009) review potential explanations on the phenomenon that the average nominal price for stocks has been largely at $35 since Great Depression. They argue that none of the existing theories including signaling and optimal trading range are able to explain why firms split their stocks to manage their stock price levels. Similarly, Easley et al. (2001, p. 25) point out “why a split per se is necessary is unclear… empirical research has documented a wide range of negative effects such as increased volatility, larger proportional spreads, and larger transaction costs following the splits. On balance, it remains a puzzle why companies ever split their shares.” The fact that the market reacts positively to split announcements seems to suggest that the benefits of lowering stock price levels to split firms should outweigh the associated negative effects.

Yet, there are many firms that keep their stock prices at relatively high levels, like Berkshire Hathaway-A at $248,440 and Priceline at $1877 per share.1 These high-price firms could go for a stock split but choose not to.2 This raises several intriguing questions: What do stock price levels tell us about the firms? Why do less known firms tend to choose lower stock price levels? If there are some benefits of doing a stock split, why do high-price firms choose not to take it?

The purpose of our study is to shed light on these questions. Based on market microstructure theories that will be discussed in next section, we hypothesize that high stock price levels impede informed trading on the stocks and reduce price informativeness. This is because high stock prices may impose budget constraints on uninformed investors and limit their risk sharing capacity, while uninformed trading is needed to facilitate informed trading (Kyle, 1985, Glosten and Milgrom, 1985).3 When stock prices are less informative, informed traders are more likely to capitalize on the information not yet reflected into stock prices.

We conduct three main tests to provide supportive evidence to our hypothesis. First, the literature has shown that the informed traders tend to use options to exploit the trading opportunities due to the high embedded leverage in options and potential short-sale constraints in stock.4 Hence, our hypothesis predicts that when their stock prices are less informative, the options of higher-price stocks would be more attractive to traders, causing the relative trading of options over stock (i.e., O/S ratio in Roll et al.'s (2010)) to increase with stock price levels.

Our hypothesis also predicts that, controlling for the determinants identified by Roll et al. (2010), O/S should be positively related to the stock price level and this positive relation should be stronger for firms that have more difficulty to attract small investors, who are more likely to be uninformed. To proxy for the ease in attracting small investors, we use dollar ownership per shareholder, i.e., market value of equity divided by the number of shareholders. If a firm can easily attract small investors, it would have many small investors as shareholders and the dollar ownership per shareholder would be relatively small.

The second test utilizes the future earnings response coefficient (FERC) from the return-earnings model to measure the informativeness of current stock prices for future earnings (e.g., Collins et al., 1994, Lundholm and Myers, 2002, Gelb and Zarowin, 2002). Presumably, stock prices would be more informative if there is more informed trading or if stock returns contain more firm-specific information. FERC would capture the intuition that more informative stock prices contain more information about future earnings. If our hypothesis holds, we would expect a lower FERC for high-price stocks.

The last test of our hypothesis is to examine whether managers of high-price firms learn less from the stock market as the prices contain less information. Prior studies suggest that price informativeness improves resource allocations and is valuable to firms (e.g., Khanna et al., 1994, Subrahmanyam and Titman, 2001, Chen et al., 2007). Hence, when stock prices are more informative and contain information that managers otherwise would not know, their real decisions should be more influenced by stock prices. Specifically, we test whether corporate investment sensitivity to stock price is inversely related to stock price levels.

Using Fama-Macbeth regression analysis on a comprehensive sample of 5527 firms with listed options from 1996 to 2016, we find that O/S is positively related to stock price levels after controlling for other known determinants of O/S. Our findings indicate that, holding other things constant, high stock price levels have drawbacks to attract both uninformed and informed trading to the stocks, and stock price levels matter in price informativeness and in where informed traders choose to trade. In addition, our subsample analysis shows a non-linear relation between O/S and stock price, which is primarily driven by firms with stock prices in the top quartile. We also find that the high price effect on O/S is stronger for firms that have more difficulty in attracting small investors to provide liquidity in the stock market.

We further show that price informativeness about future earnings is inversely related to stock price levels. In particular, while stock returns in a given year are positively related to future earnings in the next three years, the relations are weaker for high-price firms as revealed by the interaction of Ln(Price) and future earnings being significantly negative in the regressions. Moreover, our subsample analysis indicates that stock price informativeness is significantly lower for high-price firms without listed options compared to comparable firms (that have similar stock price, size, and book-to-market ratio) with listed options. The results provide supportive evidence that stock prices are less informative for higher-price stocks due to a drop of informed trading on the stocks.

Finally, we find that corporate investment sensitivity to stock price is lower for firms with higher stock price levels. The evidence suggests that when making investment decisions, managers of higher-price firms put less weight on their stock prices. One implication of this finding is that when firms need less feedback from stock prices, they keep their stock prices at higher levels, which also allow them to avoid the negative effects of lowering stock price levels that Easley et al. (2001) mention. Since high-price firms rely less on the inputs from the market, we conjecture that their managers perhaps rely more on “their own ideas” in running their firms.

If our hypothesis that high stock price levels impede informed trading on the stocks is valid, a stock split, which has been shown to attract more uninformed trading to the stock, should be able to lessen the constraints on informed trading and enhance price informativeness.5 Thus, stock splits allow us to further test our hypothesis by examining changes in price informativeness following split-induced changes in stock price levels.

To do so, we collect 1836 stock splits undertaken by firms with listed options during the period 1996–2016. Indeed, the average O/S of the split firms gradually increases during the pre-split 12 months, reaches the peak in the month immediately before the split announcement, and then declines significantly after the ex-date of the split. We further show that changes in O/S from before to after stock splits are positively related to the corresponding changes in stock price levels, and this effect is more pronounced for firms that had more difficulty to attract small investors before stock splits. The results are largely consistent with our hypothesis that the pre-split high stock price levels make split firms' options more appealing to informed traders, and as stock splits attract more uninformed trading to improve informed trading on the stock, informed traders find the equity market an attractive trading venue again.

One may argue that if some traders are merely aware of the forthcoming split events, which on average receive positive market reactions, they could still profit by trading options regardless of reasons behind splits.6 To address this concern and to better understand the information content of pre-split O/S, we link pre-split O/S to split announcement returns and post-split firm performance. Our empirical results show that the higher the pre-split O/S, the higher the split announcement returns.7 Also, firms with higher pre-split O/S are associated with larger earnings surprises over the first four quarters after stock splits. These results are consistent with the notion that pre-split O/S reflects informed traders' preference of options over stock. The results also suggest that the informed have information about the firms' future prospects and that they are not merely reacting to forthcoming split announcements.

The fact that the information content of pre-split O/S was not fully impounded into stock price until the firms announce to undertake stock splits suggests that the price discovery function in the equity market was impaired by high stock price levels prior to stock splits and there is a need to improve informed trading. By lowering stock price levels to attract more liquidity trading, stock splits could improve informed trading on the stocks and restore the price discovery function. We find that post-split stock prices are indeed more informative about future earnings than pre-split stock prices. The results provide supportive evidence to our hypothesis that nominal stock price level has a real effect on the price informativeness.

The remainder of the paper is organized as follows. Section 2 reviews the literature and develops our hypothesis. Section 3 describes the data and provides summary statistics. Section 4 discusses empirical results for our hypothesis. Section 5 presents additional tests using the setting of stock splits. Section 6 offers our concluding remarks.

Section snippets

The literature on nominal stock prices

A firm's stock price level to a large extent reflects how it “cuts its pie.” For example, given a $1 billion dollar firm, its stock price level could be $200 a share if the firm has 5 million shares outstanding or $20 if its outstanding shares are increased to 50 million. Do stock price levels matter? If they do, where do they matter? A large body of literature has examined these issues. Weld et al. (2009) point out that “It is surprising that firms actively maintained constant nominal price

Data and summary statistics

Our sample construction begins with all firms with listed options from OptionMetrics database during the period from Jan 1, 1996 to Apr 30, 2016. We require firms to be listed on the NYSE, AMEX and Nasdaq with ordinary common shares (i.e., CRSP share code 10 or 11). We further require firms to have non-missing values for the variables in our empirical tests. After this filtering process, our comprehensive sample of options consists of 7,322,980 firm-day observations for 5527 firms during the

Stock price levels, price informativeness and investment sensitivity

In this section, we first examine the relation between O/S and stock price levels. We then investigate the relation between price informativeness and stock price levels. Finally, we explore how investment sensitivity changes with stock price levels.

Stock splits and improving informed trading

To further test our hypothesis, in this section, we examine whether stock splits would be able to improve informed trading and enhance informational efficiency of stock prices. We use a sample of split firms with listed options and explore how stock splits affect stock price informativeness, options trading relative to stock, and the information content of O/S.

Conclusion

In this paper, we address the questions of why stock price levels matter and why firms undertake stock splits to lower their stock price levels. Specifically, we propose that since uninformed trading is needed for market making, and high stock price levels may impose budget constraints on uninformed traders (who have limited risk sharing capacity) to enter the market, informed trading on the stocks could be impeded by high stock price levels. Consequently, high stock price levels could reduce

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    We are grateful to Gurdip Bakshi, Hendrik Bessembinder, Utpal Bhattacharya, Mark Grinblatt, Jiekun Huang, Jingzhi Huang, Neil Pearson, Tie Su, Avanidhar Subrahmanyam, and participants at the Sixth Chulalongkorn Accounting and Finance Symposium, Hong Kong Baptist University, Hong Kong Polytechnic University, Louisiana State University, Shanghai University of Finance and Economics, and University of Hong Kong for helpful comments. Konan Chan acknowledges the financial support from National Science Council, Taiwan (NSC 101-2410-H-004-085). Any remaining errors are ours.

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