One of the great debates in finance is whether the source of the value premium is risk-based or behavioral-based. Many academics believe the value premium is actually an anomaly (in contradiction to the efficient markets hypothesis) and the result of persistent pricing errors made by investors.
Adherents to the “behavioral school” of finance, for instance, argue that investors naively extrapolate past growth when evaluating a company and therefore overreact to that information, resulting in an environment where growth firms are persistently overpriced and value firms are persistently underpriced.
Behavioralists also find that investors confuse the familiar with the safe. Because they tend to be more familiar with popular growth stocks, those stocks tend to be overvalued.
Many academic papers provide support for a risk-based explanation for the value premium. For example, research has found that value stocks are typically characterized by high volatility of earnings and dividends, high leverage, significant irreversible capital, and have returns more procyclical than the returns to growth stocks—they are more susceptible to distress risk in bad economic times. And assets that tend to do poorly in bad times should command a risk premium.
While the debate between the behavioral-based and risk-based schools persists, given the weight of the evidence on both sides, it’s almost certainly true that both the mispricing and risk explanations play a role in the premium.
Equity Value As Call Option
John Birge of the University of Chicago’s Booth School of Business and Yi Zhang of the Illinois Institute of Technology contribute to the literature regarding the value premium with their October 2017 study, “Default Risk Premia and a Non-Linear Asset Pricing Model.”
They begin by explaining: “The value of an equity investment can be framed as an embedded call option on a ﬁrm’s assets. The embedded call option creates a non-linear relationship between stock returns and underlying risk factors; however, such option value is often underestimated or overlooked in most assets pricing studies.”
They write that, while defaults are relatively rare—around 2% in any year—they can increase quickly and with little warning. When default does occur, debt holders can take control of the company and equity holders usually lose all their value. Given both the signiﬁcance and unpredictability of the loss, investors require return premiums on equities with greater default risk as compensation.
Birge and Zhang add another risk to the picture—managerial behavior may change when the company is exposed to high default risk, creating conﬂicts of interest. This situation develops—from the view of firm shareholders—as essentially having a call option on the value of the ﬁrm’s assets, with the strike price equal to the ﬁrm’s total obligations.
When the ﬁrm is exposed to high default risk, with an asset value close to or even below the ﬁrm’s total obligations, equity holders have potential upside beneﬁts but little downside risk because the call option gives them rights, but not obligations, to keep the remaining asset value. In effect, the asset becomes like a lottery ticket, a type of investment preferred by many individuals.
Birge and Zhang also note that another conflict, referred to as debt overhang, arises. When a ﬁrm faces high default risk, managers have little incentive for making new investments, even those with potentially high ROE. The reason is that the beneﬁts from new investments may only go to existing debt holders. In fact, research has shown that firms in distress tend to reduce investment signiﬁcantly, and also reduce investments in longer-term assets.