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Factors of Moving Stock Prices and Corporate Governance - Coursework Example

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This work called "Factors of Moving Stock Prices and Corporate Governance" demonstrates a particular corporation the financial performance. The author outline factors that move stock prices, corporate governance and investor relations. From this work, it is clear how to follow specific rules with all peculiarities s of leading business.   …
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Factors of Moving Stock Prices and Corporate Governance
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Factors that move stock prices, corporate governance and investor relations I. Factors that move stock prices Stock prices have been traditionally related with corporate governance and investor relations. Especially for investors, stock prices are the key element for their decision regarding the investment on a particular corporation. More specifically, the trends of the stock prices in accordance with the dividends paid on a specific company are the main issues that are examined by any potential investor on the above company. Furthermore, this relationship between the dividends and the stock prices as fundamental factors for the investment decision has been examined by Balke et al. (2006, 55) who found that ‘before 1981, much of the finance literature viewed the present value of dividends to be the principal determinant of the level of stock prices’. For this reason the above researcher refer to the work of LeRoy et al. (1981) and Shiller (1981) who supported that ‘under the assumption of a constant discount factor, stock prices were too volatile to be consistent with movements in future dividends: this conclusion, known as the excess volatility hypothesis, argues that stock prices exhibit too much volatility to be justified by fundamental variables’ (Balke et al., 2006, 55). It should be noticed here that there are also other factors that can influence the share price and as a result the investment decision on a particular corporation. Real estate is considered to be one of the most important factors of this kind. Towards this direction, Quan et al. (1999, 183) stated that ‘a number of authors have argued that commercial real estate offers diversification benefits to institutional investors because of its low correlation with commonly used stock price indexes; for example, using annual U.S. data from 1947 to 1982, Ibbotson et al. (1984) found real estates correlation with SP stocks to be -.06, whereas Hartzell (1986), using quarterly data from 1977 to 1986, estimated the correlation to be -.25’. Regarding the above findings, Quan et al. (1999) admitted that ‘the low correlation between real estate and stock price indexes is somewhat surprising, given that both are affected by the level of economic activity and interest rates; however, other factors can reduce the correlation between the two time series; for example, stock prices may increase because of increased investment opportunities in an economys corporate sector; changes in the cost of labor could also induce a negative relation between stock prices and commercial real estate values: for example, foreign competition may lead to decreases in domestic wage rates, which in turn lead to increased corporate profits and higher stock prices’ (Quan et al., 1999, 183). There is no comparison however between the above factors as of their level of influence on the stock prices and accordingly on the decision of investors to proceed to a particular investment plan on a specific company. All the above factors could be possibly used however for relevant evaluations in the future. A similar study is that of Timmermann (2001, 299) who found that ‘structural breaks in the dividend process, if present, can affect stock prices in two important ways: First, like any shock to the endowment process, breaks will affect future dividends; the main difference between breaks and ordinary shocks to dividends is that the former are low-frequency events that lead to rare level shifts in dividends that remain in effect for a long time; this is the "persistence" effect of breaks; On the other hand, breaks give rise to an information effect that concerns how much information investors have and how they revise their expectations about future dividends following a structural break; under full information, investors instantaneously observe the new parameters of the dividend process after each break’. The influence of structural breaks on the share price as described above can however have many other forms. It depends on the needs of the market in a particular period of time that will formulate the appropriate forms in order to help the local or the national economy to recover. In the above context, unexpected turbulences in the financial market should be also regarded as having a major influence on share prices. On the other hand, regarding specifically the influence of breaks to the firm’s investors it should be stated that since breaks can influence the share price they have a significant influence also on the investor’s decision to proceed to a proposed investment on a particular corporation. Such an interaction however is rather difficult to be measured with accuracy. Trying to resolve the above problem Bulke et al. (2006, 55) based their study on the hypothesis that ‘there is a fundamental problem in identifying the sources of stock price movements: the problem lies in the fact that stock prices (or, more specifically, price-dividend ratios) are very persistent but real dividend growth and excess returns are not’. Regarding the above issue the study of the above researchers proved that ‘the decompositions of stock price movements are very sensitive to what assumptions are made about the presence of permanent changes in either real dividend growth or excess stock returns; when real dividend growth was allowed to have a permanent component but excess stock returns only to have a transitory component, real dividend growth was found to explain much more of the movement in stock prices than did excess stock returns while when this assumption was reversed, the relative contributions of excess stock returns and real dividend growth were also reversed’ (Balke et al., 2006, 55). In other words, the relationship between dividend growth and share prices is close and direct. This can be possibly explained by the fact that the rate of dividend growth has been traditionally considered as a fundamental indicator for the estimation of the share price in accordance with the general financial conditions of the particular market. Regarding specifically for the influence of the dividend growth on investor relations, as already explained above, it will be significant as the dividends paid on an annual basis (or in the interim periods) from a specific corporation are crucial factors for the preference showed by the investors regarding the above corporation. From another point of view, Mahdavim (1991, 41) supported that there is a close relationship between stock prices and real economy and this relationship could be presented in practice using the following equation where ‘a simple stock pricing model in which the price of corporate equities or stocks ([P.sub.s]) is related to the present discounted value of future real after-tax earnings: Formally, [P.sub.s] = [E.sub.x]/(r - [g.sub.x]) where [E.sub.x] is the expected level of real after-tax earnings in the current period, r is the real interest rate used for discounting future earnings and [g.sub.x] is the expected rate of growth of real after-tax corporate earnings; accordingly, for a given value of r, [P.sub.s] directly varies with both [E.sub.x] and [g.sub.x]; the last two variables, in turn, are affected by the state of the overall economy as represented by GNP’. The results of the application of the above equation by Mahdavim (1991) proved that stock prices interact with the GNP, i.e. share prices influence GNP and vice verca and this finding involves in all financial markets around the world. For this reason, Mahdavim (1991, 41) refer also to the study of Peek et al. (1988, 43) who supported that ‘if the path of corporate earnings move in tandem with aggregate economic activity, a forecast of the path of earnings will be observationally equivalent to a forecast of the path of the real economy’. On the other hand, Kopcke (1992, 26) found that ‘most descriptions of stock prices share a common pedigree: the value of common stocks essentially rests on the prospective earnings of the assets backing these shares; although stocks appear to be valued for both their dividend payments and their resale values, from the fundamental point of view the resale value of stocks must reflect the prospective value of subsequent dividends’. The above assumption is similar with the one of Mahdavim (1991) presented above. More specifically, while Mahdavim has referred to the real economy in general, Kopcke (1992) uses as a base for his study the value of stocks as it can be evaluated through their stream of dividends. This assumption is quite similar with the one of Balke et al. (2006) also presented above who used as a basis for his study the dividend growth. Regarding specifically the relationship between the value of stocks and the share price Kopcke (1992, 26) stated that ‘the fundamental value of stocks depends on their stream of dividends, which, in turn, depends on prospective earnings. Share prices tend to rise when dividends increase or when prospective earnings promise a greater capacity for paying dividends in the future’. From the investor’s aspect, real economy cannot be underestimated as it has a proven influence not only on share prices but on any element of the financial market. From another point of view, Kelly (1997) examined the relationship between the noise traders and the share prices and came to the conclusion that the actions of the former in many cases influence the development of the latter. More specifically, the above researcher came to the conclusion that ‘market participation by smart money and noise traders should be negatively correlated, and neither should be related to market participation by passive investors; secondly, high market participation by noise traders (who buy high and sell low) should be a negative predictor of future stock returns, while participation by smart money should be a positive one, whereas the participation of passive investors should have no predictive power either way’ (Kelly, 1997, 351). However, it is noticed that the above study is based on the hypothesis that an individual has few chances to be a noise trader. Noise traders should be considered as differentiated from firm’s investors who usually search for opportunities for long term investments and not for occasional placements of money. In a similar study, Mccormac (1991, 42) examined the work of Friedman (1988) who ‘investigates the relationship between money and the level of stock market prices using United States data from 1961 to 1986’. In accordance with the findings of the above study ‘the real quantity of money demanded relative to income is related positively to the deflated price of equities (lagged three quarters) and related negatively to the contemporaneous real stock price while the positive relationship is considered as a wealth effect and the negative relation as a substitution effect, with the wealth effect being somewhat stronger’ (Mccormac, 1991, 42). This study leads to the same results with the study of Mahdavim (1991) which has already developed above where it is stated that there is a close relationship between share prices and real economy. As for the investor relations, it should be expected that these are going to be affected by the levels of share prices (as parts of the real economy environment) especially regarding long term investment decisions. From another point of view, Hettihewa et al. (2006, 687) refer to the work Poterba (2001) who ‘studied the asset market meltdown hypothesis and predicted that there may be a decline in the stock prices; he examined the effect of demographic variables on asset prices and returns, and found a weak effect on asset prices and a strong effect on stock prices’. Under these terms, the study of Abel (2001) is also considered as valuable as it leads to the assumption that ‘the continued high demand for assets by retired baby boomers does not attenuate the fall in the price of capital while the price of capital cannot be predicted by focuses on demand and ignoring supply’ (Hettihewa et al., 2006, 687). However, both the above studies are criticized by Hettihewa to the extension that they do not refer to all the existed macroeconomic variables that can influence stock prices. Generally, stock market performance has been considered as having by itself an influence on share prices. More specifically, Mahdavim (1991, 41) states that ‘an examination of historical data yields mixed results with respect to the stock market performance as a predictor of future economic growth’. However, the above researcher notices that they have been cases where the stock market ‘generated false signals’ which is an event that can lead to severe turbulences of the local (or the international) financial market. On the other hand, stock market and particularly share prices are crucial elements for the formulation of a specific investment decision and from this point of view they can influence firm’s relations with its investors. Of course, periods of financial turbulences should be normally expected within any financial market and even regarding profitable corporations, however on a long term basis such turbulences are not justified and it is in this case that they can cause severe damages to the firm’s relations with its investors. Using all the above material the investor relations professionals can alternate the share prices in accordance with the targets set by the corporation’s governors. In other words, real economy, real estate indexes and dividend payout ratio are going to be used by the above professionals for the formulation of a particular scheme regarding the most appropriate share price either for the current or the future financial years. This scheme is going afterwards to influence the corporate governance and the investor relations either on a short term or a long term basis. II. Corporate Governance In order to understand the nature of corporate governance and its influence on the business performance we should primarily refer to the sectors that constitute a business entity. In this context, Fisch (2004, 39) supported that ‘historically, the regulation of business has been split between corporate law and securities law; corporate law is contractual, enabling, and administered by the states; securities law is national, mandatory, and administered by the Securities and Exchange Commission and the self-regulatory organizations’. The reference to the above frameworks by Fisch is made because corporate rules and securities rules are both valuable for the operation of any corporation around the world. It is expected under these terms that all rules related with the corporate activities (including the corporate governance) are partially connected with the rules that regulate securities and their derivatives. In this context, Song (2003, 257) notices that ‘in the summer of 2002, Congress passed the Sarbanes-Oxley Act in response to a barrage of corporate governance crises and flagging investor confidence in the securities markets’. The above legislative text includes all necessary provisions for the regulation of corporate governance as part of the corporate operation in general. Under these terms, Paredes (2004, 1063) stated that ‘corporate law is one small part of a complex U.S. corporate governance system comprising a wide array of complementary institutions, incentive structures, constraints, and practices that work together to create a whole that is greater than the sum of its parts’. However, the evaluation of corporate governance as part of corporate activities is rather difficult to be completed mostly because of the existence of several factors that can influence the operation of a specific corporation in a particular commercial market. In any case, it has been proved by the above findings that corporate governance has a close relationship with law which mainly provides the necessary ‘theoretical tools’ for the protection of the former. On the other hand, the study of Kay et al. (1995) proves that the rules that have recently implemented regarding the corporate governance (with a reference specifically to the Sarbanes-Oxley Act of 2002) have not achieved the targets set by the relevant legislative bodies. In fact, previous legal rules may have been more effective regarding a series of issues related with the corporate governance. As an example Kay et al. (1995, 84) refer to the Companies Acts of 1844 and 1856 mentioned that these Acts were primarily ‘established the limited liability corporation, and many contemporary commentators expected an explosion of fraud and irresponsibility but they were proved to be wrong; there were inevitable scandals and crashes, but the majority of corporations - which still controlled only a modest proportion of economic activity - were run with prudence and integrity’. From another point of view, O’Sullivan (2001, 4) tried to explore the relationship between corporate governance and innovation and found that ‘to date, research on the relationship between the process of innovation and corporate governance has been limited because the leading perspectives advanced in the contemporary debates on corporate governance—the shareholder and stakeholder theories—have largely ignored the requirements that the developmental, organizational, and strategic characteristics of resource allocation place on the governance of corporations if they are to be innovative’. The above study refers to another aspect of corporate governance, the ‘managerial’ one and it is useful in order to understand the cooperation of the particular parts of corporate governance when designing and applying a specific business activity. III. Investor Relations Department and Professionals The communication between the corporation and its investors is usually conducted through people that have been appointed especially for this purpose. These ‘specialists’ have as a main mission to ensure the immediate and accurate transmission to the company’s investors of any piece of information that is valuable for them in accordance with their interests in the particular corporation. In this context, Botan (1997, 188) has noticed that ‘strategic communication campaigns are conducted under many labels including public relations, community relations, constituent relations, crisis management, health promotion, issues management, investor relations, membership relations, outreach, public affairs, public health, public information, risk communication, strategic advertising, strategic marketing, and the like’. In other words, the department of the corporation that deals with all issues that refer to its investors is in practice a ‘public relations’ department and all employees working there have to possess all relevant attributes in order to meet the advanced requirements of the particular department. On the other hand, Martin et al. (1996, 174) noticed that ‘communication with a corporations financial stakeholders is heavily regulated by federal statutory law (Securities Act of 1993, securities Exchange Act of 1934 and the Investment Advisers Act of 1940) which establishes only the minimum amount of information a company must make public; by itself, complying with that minimum does not definitively establish the effectiveness of a companys financial communications, but because the management of such communication is vital for the existence of a public company, CEOs often retain primary responsibility for this activity, sharing it only with those executives most likely to understand its complexity’. The above views only refer however to the obligations of the professionals working in the Investor Relations Department to provide accurate information to the firm’s investors. Apart from their legal duties, professionals working in the Investor Relations Department have to follow specific guidelines and meet the requirements set by the organization before been appointed to the particular position. More specifically, Brown (1992, 43) noticed that a person working in the Investor Relations Department ‘must have a thorough understanding of the company and its financial statements, as well as access to senior management; he or she must be able to perform the delicate task of providing information to analysts and investors without crossing the line of differential disclosure; This person cannot be purely a cheerleader, nor a sugar-coater; the goal is to present a fair picture of current conditions’ (Brown, 1992, 43). Towards this direction, Martin et al. (1996, 173) conducted ‘an exploratory study of chief executive officers (CEOs) in Florida nonbanking public companies’ and found that ‘top executives do not perceive investor relations to be part of the public relations function while a mail survey (31% response rate) revealed these CEOs favor financial affairs executives and departments to supervise and conduct investor relations, and they perceive both the investor relations and public relations functions to be more technically than managerially oriented’. In other words, although public relations are incorporated in the duties of a CEO, in many cases, they are not used as a communication tool even if this activity is imposed by the firm’s principles. The reference to the CEO instead of the professional of Investors Relations Department is being made in order to explain the alternatives used by a corporation in case that there is no such a department included in the corporate entity but the communication with the investors is taking place directly through the firm’s CEO or the ‘head managers’ of the other sectors of the corporation. Particularly for the head of the Investor Relations, it is mentioned that ‘there is no one spot in the organization from which the head of investor relations should come; for example, at Wachovia Corp. and Mellon Bank Corp. the heads of investor relations are individuals located in the finance part of the organization; both are excellent. Bank of America Corp. has one individual whose sole responsibility is investor relations and he is the best in the business’ (Brown, 1992, 43). In other words, the professionals appointed in the Investor Relations Department can origin from a series of backgrounds or commercial sectors. Their experience and their ability to be adapted to the needs and the demands of the corporation are the only factors that count. IV. Conclusion The presentation of the above issues proves that within a particular corporation the financial performance (as explained through the share price as an indicative element of the corporate performance) is closely connected with the corporate governance. This assumption can be justified by the fact that they are the decisions made by the company’s governors that can lead to high share prices and vice versa, i.e. low share price can result to the differentiation of the strategies followed by the firm’s governors either on a long term or a short term basis. Moreover, it has been proved that both the above ‘elements’ of business activity, i.e. share price and corporate governance are related with the firm’s investors. More specifically, they are the latter that have the power and the responsibility to decide on the strategies proposed by the corporate governors (through their voting) while they can also influence the share price (if they decide to alternate their position in a specific corporation, through buying or selling their shares). In fact, it should be mentioned that share price can be possibly regarded as more related with investors than with corporate governance. On the other hand, the corporate governance has to follow specific rules that are imposed both by the law and by the corporation. The impact of the application of these rules for the corporation’s performance is high. More specifically, it has been proved that when these rules are violated, severe consequences may be resulted for the entire firm’s stakeholders but mainly for its investors. The case of Enron proved the validity of the above assumption. Although the company had a high share price and its relationship with its investors were satisfactory, its performance has been based on false financial indicators violating the rules related with the commercial ethics and principles. Professionals of investor relations department should also follow the rules and the ethics set by the law and the corporation. More specifically, their evaluations regarding the appropriate level of the share price as resulted from the study of all firm’s financial indexes, should respond to actual data and not formulated in accordance with the needs of the business at a particular point of time. However, professionals in Investor Relations Department often use methods that differentiate from the ones proposed by the legal rules which regulate the financial transactions. This is not done always on purpose. In many cases, data and information that influence the stock price can be misinterpreted and as a result the guidelines offered to the firm’s potential investors (also to its governors) do not correspond to the reality. For this reason selection and training of professionals in Investor Relations Department should be made very carefully trying to identify any possible elements that could influence his/ her performance in a particular corporation. References Abel, A.B. (2001) Will bequests attenuate the predicted meltdown in stock prices when baby-boomers retire? Review of Economics and Statistics, 83(4): 589-595 Balke, N., Wohar, M. (2006). What Drives Stock Prices? Identifying the Determinants of Stock Price Movements. Southern Economic Journal, 73(1): 55-67 Botan, C. (1997). Ethics in Strategic Communication Campaigns: The Case for a New Approach to Public Relations. The Journal of Business Communication, 34(2): 188-193 Brown, T. (1992). Straight Talk from Wall Street. ABA Banking Journal, 84(1): 43-44 Fisch, J. E. (2004). The New Federal Regulation of Corporate Governance. Harvard Journal of Law & Public Policy, 28(1): 39-46 Friedman, M. (1988). Money and the Stock Market. Journal of Political Economy, 96(2): 221-245 Hartzell, D. (1986). Real Estate in the Portfolio.The Institutional Investor: Focus on Investment Management. Ballinger: Cambridge, MA Hettihewa, S., Huynh, W., Mallik, G. (2006). The Impact of Macroeconomic Variables, Demographic Structure and Compulsory Superannuation on Share Prices: The Case of Australia. Journal of International Business Studies, 37(5): 687-698 Ibbotson, R., Siegel, L. (1984). Real Estate Returns: A Comparison with Other Investments. AREUEA Journal, 12: 219-241 Kay, J., Silberston, A. (1995). Corporate Governance. National Institute Economic Review, 153: 84-97 Kopcke, R. (1992). Profits and Stock Prices: The Importance of Being Earnest. New England Economic Review, 26-34 Kurtz, J. M., Sleeper, B. J. (1992). Fraud Liability for Outsider Trading: SEC Rule 14e-3 in Limbo. American Business Law Journal, 29(4): 691-730 LeRoy, S. F., Porter, R. (1981). The present value relation: Tests based on variance bounds. Econometrica, 49:555-77 Mahdavim, S., Sohrabian, A. (1991). The Link between the Rate of Growth of Stock Prices and the Rate of Growth of GNP in the United States: A Causality Test. American Economist, 35(2): 41-55 Martin, H., Petersen, B. (1996). CEO Perceptions of Investor Relations as a Public Relations Function: An Exploratory Study. Journal of Public Relations Research, 8(3): 173-209 Mccormac, D. (1991). Money and the Level of Stock Market Prices: Evidence from Japan. Quarterly Journal of Business and Economics, 30(4): 42-55 O’Sullivan, M. (2001). Contests for Corporate Control: Corporate Governance and Economic Performance in the United States and Germany. Oxford: Oxford University Press Paredes, T. A. (2004). A Systems Approach to Corporate Governance Reform: Why Importing U.S. Corporate Law Isnt the Answer. William and Mary Law Review, 45(3): 1055-1105 Peek, J., Rosengren, E. (1988). The Stock Market and Economic Activity. New England Economic Review, May/June 1988: 39-50 Poterba, J.M. (2001) Demographic structure and asset returns. Review of Economics and Statistics, 83(4): 555-584 Quan, D., Titman, S. (1999). Do Real Estate Prices and Stock Prices Move Together? An International Analysis. Real Estate Economics, 27(2): 183-195 Shiller, R. J. (1981). Do stock prices move too much to be justified by subsequent changes in dividends? American Economic Review 71:421-36 Song, D. (2003). The Laws of Securities Lawyering after Sarbanes-Oxley. Duke Law Journal, 53(1): 257-280 Timmermann, A. (2001). Structural Breaks, Incomplete Information and Stock Prices. Journal of Business & Economic Statistics, 19(3): 299-304 Read More
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