Abstract
For a sample comprising 36,105 U.S. firm-year observations from 1985 to 2008, we find that firms located in more religious counties enjoy cheaper equity financing costs. This result is robust to a battery of sensitivity tests, including alternative assumptions and model specifications, additional controls for noise in analyst forecasts, and various approaches to addressing endogeneity. In another set of tests, we find that the equity pricing role that religion plays comes predominantly from Mainline Protestants. We also document that the effect of religiosity on firms’ cost of equity capital is larger for firms (periods) lacking alternative monitoring (regulation) mechanisms as measured by lower institutional ownership (the pre-SOX era), implying that religion plays a corporate governance role. Finally, we find that the importance of religion to equity pricing is concentrated in firms that suffer lower visibility, which tend to be more sensitive to local social and economic factors. By examining the links between religiosity and valuation at the firm level, we provide strong, robust evidence supporting the perspective that religion facilitates economic development.
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Notes
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Morse (1964), Andreski (1969), and Harrison (1985), among others, document a negative relation between Catholicism and economic progress. In the same vein, La Porta et al. (1999) and Stulz and Williamson (2003) report that Catholic countries have significantly weaker corporate governance and weaker protection of creditor rights than Protestant countries. In cross-country research, Grier (1997) provides evidence that the growth rate of Protestantism rises with real GDP growth, although the author fails to find any empirical support for Weber’s (1905) assertion that Protestantism accounts for all the differential development and growth between Catholic and Protestant countries.
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Religion is shown to affect, among other things, individuals’ wages (Chiswick 1983), level of education (Chiswick 1985; Gruber 2005), tendency toward suicide (Pescosolido and Georgianna 1989), drug and alcohol use (Cochran and Akers 1989), health (Ellison 1991), criminal behavior (Evans et al. 1995), risk aversion (Miller and Hoffmann 1995; Halek and Eisenhauer 2001), and social ethics (Arruñada 2010). See Iannaccone (1998) for a review of this literature.
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See Vitell (2009) for a recent review of the empirical literature.
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This prediction finds further support from recent evidence that the influence of local religious norms on financial institutions is more pronounced in smaller organizations (Kumar et al. 2011).
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Several studies report that, to improve their visibility, firms hire investor relations (IR) firms to elicit more extensive analyst and media coverage as well as larger equity stakes held by institutional investors (e.g., Lang and Lundholm 1996; Brennan and Tamarowski 2000; Bushee and Noe 2000; Hong and Huang 2005; Bushee and Miller 2011).
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All evidence on our predictions is almost identical when we synchronize the data by retaining only firms with December fiscal year-ends. Given that we estimate the cost of equity capital at the same date for all firms, this ensures that variation in the release of their financial statements does not drive our results. Fama and French (1992) find that the vast majority of firms comply with SEC rules by filing their financial statements within 90 days of fiscal year-end.
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In an unreported test, we run our regressions using only the years for which we have direct survey data on religiosity (1990 and 2000). Though the sample size is much smaller, the significant results suggest that our linear interpolation and extrapolation does not create systematic noise in the sample.
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Some stress that studies failing to provide evidence that religiosity affects ethical behavior using one-dimensional measures of religiosity reinforce the importance of relying on multi-dimensional proxies. However, in using such a one-dimensional proxy, we provide evidence that is statistically strong and robust as well as economically material that firms in more religious counties attract cheaper equity financing.
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Throughout the article, we use the terms cost of equity capital, implied cost of equity, and equity risk premium synonymously.
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By taking the average across four models, we help dispel concern that our main evidence stems from the unique characteristics of any single model. However, we continue to find evidence that firms located in more religious counties enjoy cheaper equity financing costs when re-estimating our regressions using each individual model, the median, or the first principal component of the four (e.g., Chen et al. 2009). Indeed, recent evidence reinforces the importance of not specifying a single implied cost of capital estimate when examining the determinants of equity pricing (e.g., Botosan and Plumlee 2005; Guay et al. 2011; Dhaliwal et al. 2006; Francis et al. 2008).
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It follows that the delegated monitoring by regulatory authorities that utilities experience reduces their asset substitution (Jensen and Meckling 1976) and under-investment (Myers 1977) problems, which, in turn, may shape the link between religion and equity pricing. In unreported sensitivity tests, none of our core inferences are sensitive to excluding utilities (SIC codes 4900-4999) from the analysis. More generally, none of our inferences are materially sensitive to recursively removing firms from each of the 48 Fama and French (1997) industries from the samples, or replacing the industry dummies with the 1-year lagged average industry risk premium after Gebhardt et al. (2001) and Dhaliwal et al. (2005).
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Despite that this naturally admits data attrition, our core evidence is materially insensitive to re-estimating the regressions on a balanced panel to dispel any concern that our inferences spuriously reflect shifts in the sample composition over time.
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Our tabulations diverge from Grullon et al. (2010) in that we report summary statistics for our estimation sample, while they report summary statistics at the county level for the survey years.
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If we restrict our sample to the years before 2002 (the year in which the Sarbanes–Oxley Act was passed), then ADH comes through at the 1% level.
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We define the mining industry to broadly encompass the following activities: precious metals, non-metallic and industrial metal mining, coal, and petroleum and natural gas.
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We follow Gaspar et al. 2005 in classifying and calculating long-term and short-term institutional ownership.
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We define firm age as the number of years since the firm first appeared in the CRSP database.
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ILLIQ is defined as the average over the fiscal year of the square root of the daily absolute stock return over the corresponding daily dollar volume. However, in untabulated results, we find that our conclusions hold when we replace ILLIQ with the average effective bid-ask spread (Roll 1984) over the fiscal year.
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Acknowledgments
The authors would like to thank Najah Attig, Narjess Boubakri, Lamia Chourou, Art Durnev, David Godsell, Lew Johnson, Cherie Metcalf, Lynnette Purda, Walid Saffar, Fatma Sonmez, and seminar participants at the Queen’s University for constructive comments. The authors also appreciate generous financial support from Canada’s Social Sciences and Humanities Research Council.
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Appendices
The description of the models and notations used in the appendix follow El Ghoul et al. (2011).
Appendix 1: Models of Cost of Equity Capital
The description of the models and notations used in the appendix follow El Ghoul et al. (2011).
In this appendix, we describe the cost of equity models used in this article. We start by defining variables and specifying assumptions common to all models. We then successively cover each model and its assumptions.
Common Variables and Assumptions
P t = stock price in June of year t
DPS 0 = actual dividend per share in year t − 1
EPS 0 = actual earnings per share in year t − 1
LTG = long-term growth forecast in June of year t
FEPS t+τ = forecasted earnings per share for year t + τ recorded in June of year t
B t = book value per share at the beginning of year t
r f = yield on a 10-year Treasury note in June of year t
As explained in the text, we require firms to have positive 1-year-ahead (FEPS t+1) and 2-year-ahead (FEPS t+2) earnings forecasts as well as a long-term growth forecast (LTG). Yet, the two models call for the use of earnings forecasts beyond year 2. If a forecast is not available in I/B/E/S, then we impute it from the previous year forecast and the long-term growth forecast as FEPS t+τ = FEPS t+τ−1(1 + LTG).
Model 1: Ohlson and Juettner-Nauroth (2005)
The model is a generalization of the Gordon constant growth model. It allows share price to be expressed in terms of 1-year-ahead earnings forecast, near-term, and perpetual growth forecasts. The explicit forecast horizon is set to 1 year, after which forecasted earnings grow at a near-term rate that decays to a perpetual rate. We follow Gode and Mohanram (2003) implementation of the model. The near-term earnings growth is the average of (i) the percentage difference between 2-year-ahead and 1-year-ahead earnings forecasts, and (ii) the I/B/E/S long-term growth forecast. The perpetual growth rate is the expected inflation rate. Dividend per share is assumed to be constant. The model requires positive 1-year-ahead and 2-year-ahead earnings forecasts. The valuation equation is given by
where \( A = 1/2\left[ {\left( {\gamma - 1} \right) + \left( {DPS_{t + 1} } \right)/P_{t} } \right] \), DPS t+1 = DPS 0, g 2 = (STG + LTG)/2, STG = (FEPS t+2 − FEPS t+1)/FEPS t+1, and (γ − 1) = r f − 0.03.
Model 2: Easton (2004)
This model is a generalization of the Price-Earnings-Growth (PEG) model and is based on Ohlson and Juettner-Nauroth (2005). It allows share price to be expressed in terms of 1-year-ahead expected dividend per share, and 1-year-ahead and 2-year-ahead earnings forecasts. The explicit forecast horizon is set to 2 years, after which forecasted abnormal earnings grow in perpetuity at a constant rate. The model requires positive 1-year-ahead and 2-year-ahead earnings forecasts as well as positive change in earnings forecast. The valuation equation is given by
where DPS t+1 = DPS 0.
Model 3: Claus and Thomas (2001)
This model assumes clean surplus accounting (Ohlson 1995), allowing share price to be expressed in terms of forecasted residual earnings and book values. The explicit forecast horizon is set to 5 years, beyond which forecasted residual earnings grow at the expected inflation rate. Dividend payout is assumed to be constant at 50%. The valuation equation is given by
where ae t+τ = FEPS t+τ − k CT B t+τ−1, B t+τ = B t+τ−1 + FEPS t+τ (1 − DPR t+τ ), DPR t+τ = 0.5, and g = r f − 0.03.
Model 4: Gebhardt, Lee, and Swaminathan (2001)
This model also assumes clean surplus accounting, allowing share price to be expressed in terms of forecasted returns on equity (ROE) and book values. The explicit forecast horizon is set to 3 years, beyond which forecasted ROE decays to the median industry ROE by the 12th year, and remains constant thereafter. Dividend payout is assumed to be constant. The valuation equation is given by
where FROE t+τ = forecasted return on equity for year t + τ, B t+τ = B t+τ−1 + FEPS t+τ (1 − DPR t+τ ), and DPR t+τ = expected dividend payout ratio in year t + τ.
For the first 3 years, FROE t+τ is set equal to FEPS t+τ /B t+τ−1. Beyond the third year, FROE fades linearly to industry median ROE by the 12th year. Industries are defined according to Fama and French’s (1997) 48 industry classification, and the median industry ROE is calculated over the previous 10 years excluding loss firms.
The expected dividend payout ratio DPR t+τ is set equal to DPS 0/EPS 0. If EPS 0 is negative, then it is replaced by the value implied by a 6% return on assets (the long-run return on assets in the U.S.). We winsorize payout ratios at zero and one.
Alternative Models
We also consider alternative models of the cost of equity. These are used in Table 8.
Gordon Infinite Horizon model
This model assumes that dividends grow in perpetuity at a constant rate, g. Assuming that g = LTG, the valuation equation is given by
Gordon Finite Horizon Model
This model assumes that dividends grow over an explicit forecasting horizon set to 4 years, beyond which the firm’s return on equity reverts to the expected cost of equity capital. The valuation equations are given by
where DPS t+τ = DPS 0(1 + LTG)τ and \( NEPS_{t + 1} = \frac{{FEPS_{t + 3} }}{{\left( {1 + LTG} \right)^{2} }}. \)
Price-Earnings-Growth (PEG) Ratio
This is a special case of the Easton (2004) model assuming no dividend payments. There are two versions of the model. One is based on short-term earnings forecasts and the other on long-term earnings forecasts. The valuation equations are given by
Earnings-Price (EP) Ratio
This is a special case of the Easton (2004) model assuming that abnormal earnings growth is set to zero.
Appendix 2
See Table 12.
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El Ghoul, S., Guedhami, O., Ni, Y. et al. Does Religion Matter to Equity Pricing?. J Bus Ethics 111, 491–518 (2012). https://doi.org/10.1007/s10551-012-1213-x
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DOI: https://doi.org/10.1007/s10551-012-1213-x