However less informed investors understand their

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consistent with their risk preferences. However, less informed investors understand their informational disadvantage and demand a higher rate of return. This information asymmetry across investors is a source of risk that should be reflected in market price (Easley and O’Hara 2004 ). We refer to this predicted negative relation between stock price and dispersion of beliefs as the cost of capital hypothesis . In contrast, other theories based on market frictions and the option value of equity suggest a positive relation between dispersion of beliefs and stock prices. Miller ( 1977 ) proposes a theory wherein the presence of short sales constraints, divergence of opinion will result in a firm’s stock price being determined by only the most optimistic investors. Thus, to the extent that dispersion of beliefs increases, stock prices will deviate further from their fundamental values and become more overpriced. We refer to this as the market friction hypothesis . Another alternative view expressed by Fischer and Verrecchia ( 1997 ), among others, is that equity is a call option on the firm’s assets, and the value of a call option is increasing in the volatility of the underlying asset when the equity holder faces limited liability. Thus, high divergence of opinion results in a higher frequency of large positive possible future outcomes, and the call option component of the stock is relatively more valuable. This argument, which we refer to as the equity call option hypothesis , also predicts a positive relation between dispersion of investor beliefs and stock prices. Given the existing theories, the effect of dispersion of investor beliefs on stock prices is ambiguous, which reinforces the need for more research on the links between accounting information, investor uncertainty, and firm value, while controlling for the amounts and timing of cash flows. We employ an event-study research design and choose earnings announcements as a potentially powerful setting to distinguish between the competing theories. Public disclosure via earnings announcements is likely to significantly affect dispersion of investor beliefs by 1 In a review of capital markets research, Kothari ( 2001 ) indicates that this literature includes over 1,000 published articles in leading academic journals over the past three decades. 2 L. Rees, W. Thomas 123
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revealing information that was held privately by some investors prior to the announcement. Earnings announcements does not always result in a decrease in dispersion because public disclosure of accounting data could be interpreted differently by investors (e.g., Harris and Raviv 1993 ; Kim and Verrecchia 1994 ; Krinsky and Lee 1996 ; Kim et al. 1997 ; Kim and Verrecchia 1997 ). For our sample, we find an increase (decrease) in analyst forecast dispersion around earnings announcements for 37.9% (48.7) of the observations.
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