Asymmetric Valuation of Sustained Growth by Debt- and Equity-Holders

Viewing equity as a call option on the firm's assets with a strike price equal to contractual debt obligations yields an asymmetric prediction on how debt and equity markets view sustained growth. Debt holders are expected to benefit from sustained growth when the default risk is high, while equity holders value such growth when risk is low. Using Altman's Z-score and debt ratings as alternative proxies for the default risk, we document a negative association between bond yield spreads and sustained growth in earnings for firms with high risk only. In sharp contrast, using earnings multiples from returns-earnings regressions as a proxy for equity market rewards, we find earnings multiples are larger when earnings growth is sustained for the low risk sample only. Decomposing earnings growth into revenue and non-revenue growth, we find that the debt market rewards for firms with revenue growth are confined to the high risk sample only, while non-revenue growth firms are not rewarded for either sample. Equity investors value revenue-led earnings growth for low and high risk samples while non-revenue growth is rewarded for the low risk sample only. Our study adds to our understanding of how changes in firm value from sustained earnings and revenue growth are divided between key providers of capital and how default risk plays an instrumental role in this valuation process.