"Advertising and Systematic Risk of the Firm"

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Advertising and Systemic Risk of the Firm

Presenter: MinChung KimLeigh McAlisterRaji Srinivasan

April 8, 2006

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• “Speak language of finance” to gain support for marketing initiatives

• Objective: Relationship between advertising investment and firm value

- Finance tells us: Systemic risk is negatively associated with the financial value of firm.

- We show: Level of adv expenditure is negatively associated with systemic risk ‘beta’

Variation of adv expenditure is positively associated with systemic risk ‘beta’,

controlling for factors that accounting and finance believe to be related to systemic risk ‘beta’.

Outline______________________________________________________________________________________________________________________________________________

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Why “Systemic Risk”, ?______________________________________________________________________________________________________________________________________________

β

β

• = extent that firm’s stock co-varies with stock market

= risk that cannot be “diversified away”

• is directly related to a firm’s cost of capital.

• Higher has lower bond/stock ratings.

• Leading investment companies apply in their valuation schemes.

β

β

β

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:ˆ

:

:

i

M

it

itMiiit

β

R

R

RR

t

tεβα ++=

Firm i’s stock price more volatile than market (β i > 1)Firm i’s stock price less volatile than market (β i < 1)

“How one estimates the beta?”______________________________________________________________________________________________________________________________________________

Returns from stock i

Returns from market portfolio

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• Seminal Research: Beaver, Kettler, and Scholes (1970)

• Two research streams about the β

1. Prediction of future β (Elgers 1980, Eskew 1979, Ismail and Kim 1989)

2. Controlling accounting variables shown to be related to beta, explanation of the relationship between β and:

- Dividend policy (Bildersee 1975)

- Financial structure (Hill and Stone 1980)

- Earnings cash flow and cash flow (Mandelker and Rhee 1984)

- International diversification of stock investments (Goldberg and Heflin 1995)

Accounting research to study β ______________________________________________________________________________________________________________________________________________

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• Marketing efforts increase shareholders’ value by creating intangible market-based assets. (Day and Fahey 1988, Srivastava et al. 1998,1999)

- Market-based assets increase the level and speed of cash flows.

- Market-based assets decrease the volatility of cash flows.

How advertising reduces systemic risk____________________________________________________________________________________________________________________________________________________________

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Outline of the Market-based Asset Theory________________________________________________________________________________________________________________________________________________________________

Reduced volatility &vulnerability of CF

Increased future CF

Market Based Asset(Brand, Customer and Channel)

Marketing Activities

Financial Performance(Discounted Future Cash Flow)

Market based risk (Beta)Variation of ADV spending

Level of ADV spending

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H1: Higher levels of advertising associated with lower levels of .______________________________________________________________________________________________________________________________________________

• The effect of the level of advertising expenditure on Beta

- Higher advertising => less vulnerable to competition and demand uncertainty (Mela,Gupta, and Lehmann 1997).

- Higher advertising => stronger brands and customer relationship (Kamakura et al. 2003).

- Higher advertising => lower uncertainties of the new product’s performance (Lariviere and Padmanabhan 1997).

β

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H2: More variable advertising associated with higher levels of . ______________________________________________________________________________________________________________________________________________

• The effect of the variation of advertising expenditure on Beta

- Erdem and Swait (1998) and Keller (1998) : ADV cutback increases consumer’s uncertainty about product quality, thereby increases risk.

- Park and Zaltman (1987): consistent marketing mix is essential for successful implementation of marketing strategy.

- Aaker (1996) and Keller (1998): Although some change and improvisation is essential, consistency in marketing mix over time is critical to maintaining brand equity.

β

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• All firms listed on NYSE between 1979 and 2001• This study: 19 5-year moving window panels• Each five-year moving window includes

– the firms if • 50 of the 60 monthly stock price observations

(CRSP) available to estimate consistent firm’s beta• All 5 years of advertising data available for firm

– the firms having annual COMPUSTAT necessary to collect the control variables

• 1061 publicly listed firms (5317 obs) selected

Data ______________________________________________________________________________________________________________________________________________

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• Variables used to explain beta in Accounting and Finance

– Dividend Payout– Asset Growth Rate– Leverage– Liquidity– Asset Size– Earnings Variability

• Additional control variables

– Firm age (measured by IPO year)– Competitive intensity (Herfindahl’s concentration index)– Level and variability of R&D expenditure

• Our focal predictor variables

– Mean(adv/sales) – SD(adv/sales) / mean(adv/sales)

Variables in our model ______________________________________________________________________________________________________________________________________________

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i = 1,…., N; t = 1,…., Ti (<19), where

< 1 and is i.i.d with mean 0 and variance

: Firm specific fixed parameters that may be correlated with the covariates .

Fixed Effects Model accounting for autocorrelation ______________________________________________________________________________________________________________________________________________________________________________

itiitit XY ενβα +++=

ittiit ηρεε += −1,

ρ itη ησ 2

iν

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Fit statistics (Fixed effect model)______________________________________________________________________________________________________________________________________________

• The estimation of the fixed effect model: - Time specific dummies captures time specific effects in the

model.- Unavoidable serial correlation of the errors is captured in the AR(1) specification.- Fit stats

13422.1710200.27Schwarz Bayesian Information

(SBC)

-560.8-429.05Log-likelihood

9.742 (23, 5400) 6.852 (29, 4227)F

0.040.05R-square

0.610.6ρ (AR)

(Column 2)(Column 1)

Baseline model with variables from the BKS study

Proposed model #

Variables

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Estimation Results ______________________________________________________________________________________________________________________________________________

- -0.36 (0.32)Competitive intensity

- 0.01 (0.01)Firm age

- 0.08 (0.04)**Variability of R&D expenditure

- 0.20 (0.13)Level of R&D expenditure

-0.00 (0.00) -0.03 (0.02)Earnings variability (EV)

0.12 (0.02)*** 0.15 (0.03)***Asset size (AS)

0.00 (0.01) 0.01 (0.01)Liquidity (LIQ)

0.01 (0.01) 0.03 (0.09)Leverage (LEV)

0.27 (0.07)*** 0.27 (0.08)***Asset growth rate (G)

0.00 (0.00) 0.00 (0.00)Dividend payout (DP)

- 0.16 (0.04)***Variability of adv expenditure (H2)

- -1.29 (0.43)***Level of advertising expenditure (H1)

0.10 (0.03)*** 0.15 (0.05)***Intercept

Base model with BKS variablesProposed model Variables

( ) is Standard Errors ; ***, **, * are significant level 0.01, 0.05, 0.10 respectively

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Theoretical Implications______________________________________________________________________________________________________________________________________________

1. First study to relate advertising and systemic risk, controlling accounting measures shown to be related to beta.

3. Extends prior research to consider process relating marketing to firm value.

5. Demonstrates the importance of consistency in marketing activities on firms’ financial performance

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Managerial Implications______________________________________________________________________________________________________________________________________________

1. Marketing executives can demonstrate the financial accountability.

3. Dual benefits of consistent advertising expenditure: Firms should be cautious to cut back adv. expenditure.

5. May surprise senior management: advertising is not discretionary

7. Initiate overdue discussion among senior management on crucial ‘financial’ role of marketing.

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Limitation and Future Research______________________________________________________________________________________________________________________________________________

• Not account for differences in the implementation of advertising programs.

• Need to develop research methods and model building (in-depth interviews, surveys, field studies)

• Consider the impact of other elements of marketing mix on β.

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closing price at end of month t adjusted for capital change (e.g. stock splits and stock dividends)

“How one estimates the beta?” ______________________________________________________________________________________________________________________________________________

:

:

ln1

it

it

it

itit

it

D

P

P

PDR

+=

−

cash dividend payable on common stock i in month t

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Fisher’s link relative, a market price index of all firms on the NYSE at the end of month t, adjusted for dividends and all capital change

:

ln1

t

t

t

Mt

L

L

LR

=

−

“How one estimates the beta?”______________________________________________________________________________________________________________________________________________

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Increased future CF


Distribution Strategy

Financial firm value(Tobin’s Q)

Previous research relating marketing to firm value______________________________________________________________________________________________________________________________________________________________________________

- Distribution Strategy => Intangible value (Tobin’s Q) (Srinivasan 2006)

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Increased future CF


Branding Strategy

Financial firm value(Tobin’s Q)


- Branding Strategy => Intangible value (Tobin’s Q) (Rao et al. 2004)

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Stock returns


Emphasis on ADV

Financial Performance


- Emphasis on ADV out of R&D => Stock returns (Mizik and Jacobson 2003)

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Stock returns


Level of ADV

Financial Performance


- Level of advertising => Cost of capital (Singh et al. 2005)

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Data ______________________________________________________________________________________________________________________________________________

a6/s6s6a611984

a5/s5s5a511983

a4/s4s4a411982

a3/s3s3a311981

a2/s2s2a211980

adv/salessalesadvfirmyear

MW2

Beta(1) for MW1 – a set of mean(ADV/Sales), sd(ADV/Sales), accounting variables

a5/s5s5a511983

a4/s4s4a411982

a3/s3s3a311981

a2/s2s2a211980

a1/s1s1a111979

adv/salessalesadvfirmyear

MW1

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• Singh et al. 2005 developed a model relating the firm’s advertising expenditure to cost of capital.

– Firm characteristics are not controlled.– Annual measure of systemic risk with weekly stock prices– Pooled OLS regression

– The model used best performing firms as their sample.

– The model did not look at the effect of variability of advertising expenditure on systemic risk.

– ADV not scaled by sales

Problems with Singh et al. (2005, JAMS)______________________________________________________________________________________________________________________________________________

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"Advertising and Systematic Risk of the Firm"