Event studies are methods used to measure the impact of a particular event or a series of events on the market value of a stock or company. The concept behind this is to try to understand whether sudden and abnormal stock returns can be attributed to market information pertaining to an event. Often events such as mergers and acquisitions, new product launches, expansion into new markets, earnings announcements and public offerings can have a major impact on the stock price as well as the valuation of a firm. Various software programmes can be used to measure this impact, but most often event studies are conducted in Excel and Stata. Students will benefit from learning the methodology of event studies as it will open a new area of possibilities for conducting research, writing a dissertation or developing a proposal. In this guide, we will look at event studies and try to establish their uses in finance dissertations.
- Event study was invented by Eugene Fama and his team in 1969. Event studies can have a wide magnitude, simply because events can themselves be of different types. For instance, the announcement of acquiring a company which has solid fundamentals can lead to value creation for a firm. On the other hand, regulatory shocks can lead to value erosion if they have a direct bearing on the operations of an organisation. Stock markets can react differently to different events, and hence it is important to ascertain whether an event will have a positive or a negative impact on a company. The study of these events can help investors generate abnormal returns. However, it is important to isolate the effects of particular events on stock from other factors that may influence prices. For this reason, benchmarks for normal returns are used in event studies, and these normal returns are often estimated with an assumption that financial markets should be efficient.
- So, event studies are based on the efficient market hypothesis. According to the theory, in an efficient capital market, all the new and relevant information is immediately reflected in the respective asset prices. Although this theory is not universally applicable, there are many instances in which it holds true. An event study implies a step by step analysis of the impact that a particular announcement has on a company’s valuation. In normal conditions, without the influence of the analysed event, it is assumed that expected returns on a stock would be determined by the risk-free rate, systematic risk of the stock and risk premium required by investors. These conditions are measured by the capital asset pricing model (CAPM).
- There can primarily be three types of announcements which can constitute event studies. These include corporate announcements, macroeconomic announcements, as well as regulatory events. As the name suggests, corporate announcements could include bankruptcies, asset sales, M&As, credit rating downgrades, earnings announcements and announcements of dividends. These events usually have a major impact on the stock prices simply because they are directly interlinked with the company. On the other hand, macroeconomic announcements can include central bank announcements of changes in interest rates, an announcement of inflation projections and economic growth projections. Even though macroeconomic events to have systemic effects and influence the whole equity market, some companies may be more sensitive to particular macroeconomic news than others, and for this reason, the event study methodology can be implemented. Finally, regulatory announcements such as policy changes and new laws announcement can also impact the stock prices of companies, and therefore can be measured using the method of event studies.
- A critical issue in event studies is choosing the right event window during which the analysed announcements are assumed to produce the strongest effect on share prices. According to the efficient market hypothesis, announcements instantaneously affect and adjust stock prices. Hence, even within event windows, no statistically significant abnormal returns would be expected. However, in reality, there could be rumours before official announcements and some investors may act on such rumours. Moreover, investors may react at different times due to differences in speed of information processing and reaction. In order to account for all these factors, event windows usually capture a short period before the announcement to account for rumours and an asymmetrical period after the announcement.
- It is important to note that estimating abnormal returns using the event study method for a single company does not add much value because there is no way to check if these abnormal returns are not attained by accident. In order to make event studies stronger and statistically meaningful, a large number of similar or related cases are analysed. Then, abnormal returns are cumulated and averages are calculated. The presence of a high number of observations allows for conducting tests of significance of the estimated abnormal returns. T-statistic is often used to evaluate whether the calculated abnormal returns are on average different from zero. So, researchers that use event studies are concerned not only with the positive or negative effects of specific events but also with the generalisation of the results and measuring the statistical significance of abnormal returns.
To sum up, an event study is a broad field of research which can be used to measure the impact of major announcements on the valuation of a firm and its share price. It has a wide range of applications for analysts as well as students who are looking to prepare a dissertation in the field of finance.