Valuation and Communication : Two Conflicting Roles of Stock Price

In an environment where capital market participants collectively possess superior information about a decision faced by a firm manager, we use an experimental market to analyze the effectiveness with which the market communicates this information to the manager through stock price. We do so in a setting in which an inherent conflict exists between pricing that communicates information to the manager and pricing that accurately values the firm given the manager's optimal response to the communicated information. Despite this conflict, we find that when the manager initially selects a low-value project, the stock price from the capital market is lower than the price that accurately values the firm given the manager's optimal response to this price. Because managers often respond to this lower stock price by switching to a higher value project, firms with the lowest initial stock price generate the greatest future returns. Consistent with behavioral theory, we further highlight that imposing a small cost on the manager for switching projects decreases the communicative effectiveness of price leading to lower future returns in response to a low stock price. Collectively, our results potentially contribute to a better understanding of the seemingly anomalous book-to-market effect and results from the executive compensation literature