Publication Date: August 2011
We study the interplay of share prices and ﬁrm decisions when share prices aggregate and convey noisy information about fundamentals to investors and managers. First, we show that the informational feedback between the ﬁrm’s share price and its investment decisions leads to a systematic premium in the ﬁrm’s share price relative to expected dividends. Noisy information aggregation leads to excess price volatility, over-valuation of shares in response to good news, and undervaluation in response to bad news. By optimally increasing its exposure to fundamental risks when the market price conveys good news, the ﬁrm shifts its dividend risk to the upside, which ampliﬁes the overvaluation and explains the premium. Second, we argue that explicitly linking managerial compensation to share prices gives managers an incentive to manipulate the ﬁrm’s decisions to their own beneﬁt. The managers take advantage of shareholders by taking excessive investment risks when the market is optimistic, and investing too little when the market is pessimistic. The ampliﬁed upside exposure is rewarded by the market through a higher share price, but is ineﬀicient from the perspective of dividend value.