The max EPS Paradigm For Corporate Finance [Paper] (with Itzhak Ben-David)
There are three classic problems in corporate finance: capital structure, real investment, and payout policy. The three papers below characterize the max EPS solution to each one. The max EPS approach delivers an optimal leverage ratio even in the absence of frictions, an investment rule based on comparing yields rather than using a risk-adjusted discount rate, and a payout policy where accretive buybacks are preferred to neutral dividends. Our max EPS model draws a bright line between growth and value. Growth stocks have earnings yields below the riskfree rate; value stocks have earnings yields above it. This single comparison leads the two kinds of firms to pursue different constellations of EPS-maximizing policies. This review article ties together these results to form a new max EPS paradigm for corporate-finance research.

EPS-Maximizing Capital Structure [Paper, Appendix] (with Itzhak Ben-David)
A simple EPS-maximizing model delivers a rich set of capital-structure implications. The earnings cost of equity is a firm’s earnings yield. The earnings cost of debt is the interest expense on the next dollar borrowed. EPS maximizers lever up when shareholders want more earnings for the marginal dollar of capital than creditors. There is an EPS-maximizing leverage before adding frictions. Value stocks have earnings yields above the prevailing Treasury rate. They see riskfree debt as cheap compared to equity, lever up, and repurchase shares. Growth stocks have earnings yields below the Treasury rate. These firms see equity as cheaper, remain unlevered, and hold cash. Data support these predictions.

Accretive Investment [Paper, Appendix] (with Itzhak Ben-David)
EPS maximizers invest in accretive projects that generate enough income next year to pay for their own short-term funding using the firm’s cheapest available source of capital (equity, debt, or cash). This is the max EPS analog to the positive-NPV rule. On a per-dollar basis, accretive projects have income yields above the firm’s financing yield. An IRR is a multiperiod generalization of the project’s income yield. A payback period is the project’s income yield expressed as a multiple. Growth stocks have earnings yields below the riskfree rate. These firms view equity financing as cheap and fund new projects by issuing shares even when cash is present. Value stocks have earnings yields above the riskfree rate. These firms borrow enough to make external financing (both equity and debt) look expensive compared to cash, giving them high investment-cash flow sensitivities. We find empirical support for our model’s predictions.

max EPS Payout Policy [Paper] (with Itzhak Ben-David)
Holding cash has a cost. For an EPS-maximizing CEO, that cost equals her firm’s earnings yield (EY). EPS maximizers retain cash when they can get an even higher yield by investing the money. Otherwise, they return cash to shareholders. This is the EPS-maximizing payout policy. Growth stocks (EY < rf) never return cash because they can clear their low earnings-yield hurdle by investing cash in riskfree bonds. Value stocks (EY > rf) face a higher hurdle, which makes cash their cheapest source of capital but also raises the opportunity cost of retention. Value stocks return cash when they cannot invest in enough accretive projects to make up for the higher cost. Dividends and repurchases both deliver the same shareholder value, but only repurchases can be accretive. So EPS-maximizing CEOs prefer to distribute cash via repurchases.

Crimes Against Campbell-Shiller [Paper, Appendix] (with Itzhak Ben-David)
The Campbell-Shiller log-linear approximation is widely viewed as a model-free accounting identity that always holds: in sample, in expectation, and under arbitrary subjective beliefs. None of these claims is true. The formula is far from automatic even in realized data. Many companies do not pay dividends, making the calculation ill-defined. For dividend payers, the results are not always what they seem. The formula registers buybacks and new issuance as phantom cash-flow shocks. Taking expectations comes with its own complications. Researchers see the forward-looking version of Campbell-Shiller as a dynamic Gordon model, but this interpretation requires investors to consistently think in present-value terms and to know the cap rate with basis-point precision. Both are strong assumptions that do not always hold in the data. Finally, the formula generically fails under arbitrary subjective beliefs. The exceptions represent knife-edge cases where forecast errors obey a precise adding-up condition. Insisting that Campbell-Shiller always holds makes it harder to learn about the true pricing model in the many cases where it does not.

Expected EPS x Trailing PE: Pricing Without Discounting [Paper] (with Itzhak Ben-David)
Analysts explain how they calculate their price targets in the text of each report. We read what they write and find that most do not apply present-value logic. They typically multiply a company’s expected EPS (earnings per share) times its *trailing* PE (price-to-earnings) ratio. This has important implications for asset-pricing research even if analysts are not the marginal investor. All of asset-pricing theory currently starts by assuming that price equals expected discounted payoff. The one group of market participants who tells us their subjective payoff expectations does not generally use a discount rate to price them.

The Peoples’ Equity Risk Premium [Coming Soon] (with Itzhak Ben-David)
Many people calculate the equity risk premium (ERP) as an excess earnings yield, not an excess return. e.g., see here, here, here, here,… This approach doesn’t reflect present-value logic. Instead, the peoples’ ERP comes from thinking like an EPS-maximizing CEO. If stocks are expensive, equity financing must be cheap. High stock prices imply that shareholders are willing to provide a lot of equity capital in exchange for each $1 of a firm’s expected earnings. This funding-cost logic explains why popular accounts of the ERP tend to revolve around corporate policies (equity issuance, buy backs, etc) rather than discount rates. The Fed Model comes from misinterpreting the funding-cost logic behind the peoples’ ERP as a present-value statement.

Proving You Can Pick Stocks Without Revealing How [Paper, Appendix]
It might seem like, if you don’t have enough money to trade on your own behalf, then you must reveal some information about how you pick stocks in order to prove that you can do it. And that would be bad news. Every piece of additional information that you reveal makes it a little bit easier reverse engineer your approach. Luckily for you, that conventional wisdom is wrong. In this paper, I show how you can construct a zero-cost zero-knowledge proof that you know about a profitable new way to pick stocks.

Model Identification vs. Market Efficiency [Paper]
When otherwise intelligent investors fail to correct an error, a researcher learns something about what these investors did not know. The investors must not have known about anything which would have allowed them to spot their mistake. If they had, they would have stopped making it. I show how a researcher can use this insight to identify how investors price assets by defining a special kind of error, called a “random anchoring error”, which investors will only fail to correct if they are not aware of any omitted variables. Random anchoring errors are instruments for identifying how mostly rational investors price assets.

White Papers

Survey Curious? Start-Up Guide and Best Practices for Running Surveys and Experiments Online [Paper] (with Abigail Bergman, Samuel Hartzmark, and Abigail Sussman)
You’re a financial economist who wants to run an online survey or experiment. But you don’t know where to get started. This paper provides the basic information you need to get started. We not only describe how to create a useful survey/experiment but also give click-by-click instructions for posting it online.