[Paper Review] With a Grain of Salt: Uncertain Veracity of External News and Firm Disclosures

Jonathan Libgober, Beatrice Michaeli+1 more|arXiv (Cornell University)|Apr 18, 2023

Auditing, Earnings Management, GovernanceBusiness, Management and Accounting3 citations

TL;DR

This paper examines how uncertain veracity of external news affects investor beliefs, market prices, and corporate disclosures. Despite news veracity being independent of firm private information, favorable news is perceived with skepticism—'with a grain of salt'—which amplifies beliefs that nondisclosing managers are concealing bad news, leading to non-monotonic stock price reactions and potential declines after disclosures.

ABSTRACT

We examine how uncertain veracity of external news influences investor beliefs, market prices and corporate disclosures. Despite assuming independence between the news' veracity and the firm's endowment with private information, we find that favorable news is taken ``with a grain of salt'' in equilibrium -- more precisely, perceived as less likely veracious -- which reinforces investor beliefs that nondisclosing managers are hiding disadvantageous information. Hence more favorable external news could paradoxically lead to lower market valuation. That is, amid management silence, stock prices may be non-monotonic in the positivity of external news. In line with mounting empirical evidence, our analysis implies asymmetric price reactions to news and price declines following firm disclosures. We further predict that external news that is more likely veracious may increase or decrease the probability of disclosure and link these effects to empirically observable characteristics.

Motivation & Objective

• To analyze how investors' skepticism toward external news with uncertain veracity influences market pricing and corporate disclosure decisions.
• To investigate the equilibrium dynamics where favorable news is distrusted even when independent of firm-specific private information.
• To explore how the perceived reliability of external news affects the probability of managerial disclosure and market reactions.
• To reconcile theoretical predictions with empirical evidence of asymmetric price reactions and post-disclosure declines.
• To identify observable firm characteristics linked to the impact of external news on disclosure incentives.

Proposed method

• Develops a theoretical signaling model in which managers possess private information about firm fundamentals and choose whether to disclose it.
• Incorporates external news with uncertain veracity as a public signal, independent of the firm's private information.
• Models investor beliefs as updating on both the external news and the absence of disclosure, leading to belief formation under ambiguity.
• Analyzes equilibrium outcomes where favorable news is perceived as less credible due to the strategic inference that nondisccribing managers may be hiding bad news.
• Uses comparative statics to examine how changes in news veracity reliability affect disclosure incentives and market valuation.
• Derives conditions under which more favorable news can paradoxically reduce firm valuation due to increased skepticism and adverse selection concerns.

Experimental results

Research questions

• RQ1 How does the uncertain veracity of external news affect investor beliefs about the likelihood of adverse information being hidden by nondisclosing managers?
• RQ2 Under what conditions does favorable external news lead to lower market valuation despite its positive content?
• RQ3 How does the perceived reliability of external news influence the probability of managerial disclosure in equilibrium?
• RQ4 What are the implications of external news skepticism for the asymmetry of price reactions to good versus bad news?
• RQ5 Which observable firm characteristics are linked to the sensitivity of disclosure decisions to the veracity of external news?

Key findings

• Favorable external news is perceived with skepticism—'with a grain of salt'—even when independent of firm private information, due to strategic inference about nondisclosure.
• This skepticism reinforces the belief that managers who do not disclose are concealing bad news, leading to a paradoxical decline in stock prices with more favorable news.
• Market valuations can be non-monotonic in the positivity of external news, with peak valuation occurring at intermediate news sentiment.
• External news that is more likely to be veracious may either increase or decrease the probability of disclosure, depending on firm-specific characteristics.
• The model predicts price declines following firm disclosures, consistent with empirical evidence of post-announcement drift.
• The impact of news veracity on disclosure is heterogeneous and linked to observable firm-level traits, such as information sensitivity or market attention.