The diversification discount: cash flows versus returns

We test whether the impact of financial constraints on firm value is observable in stock returns. We form portfolios of firms based on observable characteristics related to financial constraints, and test for common variation in stock returns. Financially constrained firm stock returns move together over time, suggesting that constrained firms are subject to common shocks. Constrained firms have low average stock returns in our 1968-1997 sample of growing manufacturing firms. We find no evidence that the relative performance of constrained firms reflects monetary policy, credit conditions, or business cycles.