We propose a theory of asset prices that emphasizes heterogeneous information as the main element determining prices of diﬀerent securities. Our main analytical innovation is in formulating a model of noisy information aggregation through asset prices, which is parsimonious and tractable, yet flexible in the speciﬁcation of cash flow risks. We show that the noisy aggregation of heterogeneous investor beliefs drives a systematic wedge between the impact of fundamentals on an asset price, and the corresponding impact on cash flow expectations. The key intuition behind the wedge is that the identity of the marginal trader has to shift for diﬀerent realization of the underlying shocks to satisfy the market-clearing condition. This identity shift ampliﬁes the impact of price on the marginal trader’s expectations. We derive tight characterization for both the conditional and the unconditional expected wedges. Our ﬁrst main theorem shows how the sign of the expected wedge (that is, the diﬀerence between the expected price and the dividends) depends on the shape of the dividend payoﬀ function and on the degree of informational frictions. Our second main theorem provides conditions under which the variability of prices exceeds the variability for realized dividends. We conclude with two applications of our theory. First, we highlight how heterogeneous information can lead to systematic departures from the Modigliani-Miller theorem. Second, in a dynamic extension of our model we provide conditions under which bubbles arise.
We study the interplay of share prices and ﬁrm decisions when share prices aggregate and convey noisy information about fundamentals to investors and managers. First, we show that the informational feedback between the ﬁrm’s share price and its investment decisions leads to a systematic premium in the ﬁrm’s share price relative to expected dividends. Noisy information aggregation leads to excess price volatility, over-valuation of shares in response to good news, and undervaluation in response to bad news. By optimally increasing its exposure to fundamental risks when the market price conveys good news, the ﬁrm shifts its dividend risk to the upside, which ampliﬁes the overvaluation and explains the premium. Second, we argue that explicitly linking managerial compensation to share prices gives managers an incentive to manipulate the ﬁrm’s decisions to their own beneﬁt. The managers take advantage of shareholders by taking excessive investment risks when the market is optimistic, and investing too little when the market is pessimistic. The ampliﬁed upside exposure is rewarded by the market through a higher share price, but is ineﬀicient from the perspective of dividend value.