Ram T. S. Ramakrishnan

Information Reliability and a Theory of Financial Intermediation

This paper is an analysis of when it will be beneficial for agents engaged in the production of information to form coalitions. The model is cast in a financial market framework, thus leading to an identification of conditions sufficient for the existence of financial intermediaries. Intermediation is shown to improve welfare if informational asymmetries are present, and the information generated to rectify these asymmetries is potentially unreliable. The usual appeal to transactions costs to explain intermediation is not needed.

Valuation of Permanent, Transitory, and Price-Irrelevant Components of Reported Earnings

Both the economic nature of events and extant accounting rules cause reported earnings to have different components, each with different valuation implications. The price-earnings link is described better by separating components of unexpected earnings and multiplying each by a different response coefficient, rather than applying a single earnings response coefficient (ERC) to aggregate unexpected earnings. Using a simple model that assumes three types of innovations to reported earnings (permanent, transitory, and price-irrelevant), we develop systematic links among current earnings components, future earnings, and stock prices. Empirical tests of the models predictions confirm the validity of our characterization of the price-earnings link. Attempts to understand better the effects of growth and (beta) risk result in little improvement.

What Matters from the Past: Market Value, Book Value, or Earnings? Earnings Valuation and Sufficient Statistics for Prior Information:

A number of recent analytical and empirical papers seek to identify the variables that best explain stock prices. We derive the relation between prices and earnings for three one-parameter “excess earnings” evolution processes that describe three different ways in which current period shocks to earnings persist in future. In each case, we show that price is a weighted average of capitalized current earnings and a sufficient statistic for all past information. The sufficient statistics are three amounts from last year: book value, market value, and capitalized earnings. Using time-series data over the 1969-1988 period for a sample of 511 firms, we estimate firm-specific excess earnings regressions and price regressions for the three cases. Although the book value model provides the best fit for a majority of firms for the excess earnings regressions, the market value model is far superior for the price regressions. We argue that this latter result is due to prior period price (included in the market value model alone), reflecting other information that is not explicitly modeled here. Despite this bias in favor of the market value model for the price regressions, we find a positive cross-sectional association between the relative explanatory power of the three models in the excess earnings regressions and the corresponding relative explanatory power in the price regressions. That is, if a firms excess earnings series is best described by a particular model, its price series is also likely to be best described by the valuation relation derived from the same model.

A decision-theory model of motivation and its usefulness in the diagnosis of management control systems

Abstract In this paper rational decision theory is used to formulate a model of motivation in a managerial context. The model is shown to behave reasonably well in empirical tests, but no better than a directly-assessed measure of motivation, which is easier to use in field research. Despite this, use of the model may be justified by the diagnostic insight to the management control system which can be obtained from the data used for its estimation. This is illustrated by an analysis of the variations in strength of factors contributing to motivation across managers in different functions. Patterns in these variations suggest systematic differences in the design of management control systems across functions.