Understanding the Effect of Advertising on Stock Returns and Firm Value: Theory and Evidence from a Structural Model

This paper brings structural modeling to the literature on financial research in marketing. I propose a dynamic investment-based model to understand the impact of advertising expenditures on stock returns and firm value. In addition, by interpreting advertising expenditures as an investment in brand capital, the approach in this paper provides a novel way to measure brand equity grounded in economic theory. Using the Euler equations from the firm's maximization problem, I derive closed-form expressions for the firm's equilibrium stock returns and market value, which depend on observable firm characteristics. I test the model's predictions by the generalized method of moments and data from a large cross section of publicly traded firms. The model is able to match simultaneously the pattern of average stock returns and firm values of portfolios sorted on advertising expenditures that standard asset pricing models cannot. The estimation results also show that brand equity accounts for a substantial fraction of firm market value about 23%, and that this value varies substantially across industries. Implications of the findings for research at the intersection of marketing and finance are discussed. This paper was accepted by Wei Xiong, finance.