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1 August 2013 CFA Institute Journal Review

Advertising Intensity, Investor Recognition, and Implied Cost of Capital (Digest Summary)

  1. Richard D. Long

In studying the capital market implications of advertising expenditures, the authors find that higher advertising intensity in a firm, as measured by the ratio of advertising expenditures to total firm assets, leads to better investor recognition. Improved recognition, in turn, leads to the firm experiencing increased liquidity and a lower cost of capital.

What’s Inside?

The authors study the relationship between a firm’s implied cost of capital and investor recognition, as measured by firm-level advertising intensity. Merton (Journal of Finance 1987) concluded that as more investors are aware of a firm, the firm’s liquidity improves, which eventually decreases the cost of capital. The authors study whether the implied cost of capital decreases when firm advertising intensity increases.

Investors usually prefer to buy the securities of firms with which they are familiar. Typically, these firms are large, exchange-listed firms with ample liquidity. The authors’ findings indicate that companies with higher advertising intensity ratios tend to have lower average costs of capital. Thus, they believe advertising can be effective in increasing firm recognition and in ultimately decreasing the estimated cost of capital.

How Is This Research Useful to Practitioners?

The authors add to the growing research regarding the effects of a firm’s visibility on investor behavior. Their findings demonstrate that advertising expenditures increase investor recognition and ultimately lead to a lower estimated cost of capital. These conclusions are useful to companies that are seeking increased investor recognition and to investors who are searching for lesser-known companies with relatively high levels of advertising intensity.

How Did the Authors Conduct This Research?

The study’s dataset includes companies with advertising expenditure data on Compustat for the period from 1975 to 2001; 1,556 firms are studied over the period, resulting in 9,103 total firm-years for the study. Advertising intensity is measured by calculating the ratio of advertising expenditures to total firm assets. Firms are ranked by the level of advertising intensity and divided into quintile portfolios.

The estimated one-year-ahead cost of capital is calculated using target prices and dividend forecasts provided by Value Line reports. The authors believe this measure is less biased than other estimates of the cost of capital, and it allows a larger sample of firms to be studied.

The authors regress each portfolio’s mean advertising intensity ratio against the average estimated year-ahead cost of capital. They control for firm size by dividing the sample into five portfolios ranked by equity market value and then breaking those portfolios down further by advertising intensity. They conclude that in both large firms and small firms, portfolios with higher advertising intensity have a lower estimated cost of capital.

Using an alternative estimate of the year-ahead cost of capital, the authors repeat the regression. They estimate the cost of capital using analyst earnings forecasts based on the I/B/E/S report and control for forecast error. The results of this regression are consistent with those of the initial test; portfolios with higher average advertising intensity have a lower estimated cost of capital.

Abstractor’s Viewpoint

The authors add to the research regarding company recognition and investor behavior, and their findings could lead investors and companies to consider how advertising can increase the value of a firm. But I agree with the authors that further research should be performed on the potential problems with their methods of estimating the implied cost of capital.

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