Transparency, Liquidity, and Valuation

Reductions in the liquidity and valuation of securities traded in global capital markets during the recent financial crisis have demonstrated the importance of understanding more fully the drivers of a firm’s stock market liquidity and associated linkages to valuation. In the paper, Transparency, Liquidity, and Valuation: International Evidence on When Transparency Matters Most, forthcoming in the Journal of Accounting Research,” we examine whether reduced transparency is associated with increased transaction costs and lower liquidity in a firm’s shares and, therefore, increased cost of capital and reduced valuation. We also investigate the extent to which the relation between transparency and liquidity is influenced by institutional and firm-level factors and by time series variation in uncertainty.

Our sample includes 97,799 firm-year observations across 46 countries over the period 1994–2007. In our first set of tests, we relate transparency to transaction costs and stock market liquidity. To measure transparency, we employ several firm-choice variables from prior cross-country research including earnings management (Fan and Wong (2002) and Leuz, Nanda, and Wysocki (2003)), auditor quality (Fan and Wong (2005)), and adoption of global accounting standards (Daske, Hail, Leuz and Verdi (2008, 2009)). We also employ two transparency variables that capture external information gathering by intermediaries: the number of analysts who cover a firm and the accuracy of analyst forecasts.

To capture transaction costs and liquidity, we use two measures that are readily available for large samples of firms across many countries and that have been shown to correlate well with actual transaction costs for trading in a firm’s shares: (1) the proportion of zero-return trading days over the fiscal year, and (2) the median bid-ask spread over the fiscal year. Bid-ask spreads speak more directly to transaction costs, while zero-return days measure liquidity more directly and are available for a wider sample of firms.

Our evidence suggests that increased transparency, as reflected in reduced earnings management, higher quality auditing, a serious commitment to international accounting standards, increased analyst following, and smaller analyst forecast errors, is associated with lower bid-ask spreads and greater liquidity. The relation is particularly pronounced in environments in which there is likely to be more inherent uncertainty (weak country-level institutions, time periods of increased country-level volatility, and when ownership is concentrated), suggesting that firm-level transparency is most important in the presence of other informational issues. Our results also provide evidence that liquidity represents an important channel through which transparency becomes associated with a lower cost of capital and higher valuation. Taken together, our results suggest that a focus on the transparency provided to those who invest in a firm’s securities could be a fruitful component of an effort to more fully understand the increases in illiquidity and decreases in valuation for many assets worldwide associated with the recent financial crisis.

Our results are subject to several caveats. First, we focus on only one potential consequence of increased transparency, improved liquidity. Of course, increased transparency entails other costs and benefits. As a consequence, our results do not imply that managers would be better off by increasing transparency, only that benefits may accrue through reduced transaction costs and increased liquidity. It is possible that other costs associated with increased transparency more than offset the liquidity benefits. There is room for future research examining more specifically the tradeoffs in establishing an optimal transparency level.

Second, it is difficult to ascertain causality. Our analyses are based on associations, and we cannot be certain to what extent the relations are causal. While we attempt to control for a wide range of potentially-important factors and to account for possible endogeneity, conclusions should be drawn with caution. There is substantial scope for additional research identifying more specifically the channels through which transparency may affect liquidity. Overall, though, we view our paper as providing interesting initial evidence on the potentially important effects of transparency on liquidity and valuation in a global setting.

The full paper is available for download here.