If you practice securities litigation, you know the drill: When a stock’s value drops significantly after disclosure of adverse information, calculating damages typically focuses on the price decline itself, adjusted for market movements. In a new paper, I suggest this traditional approach may be missing a crucial component of shareholder harm – and potentially leave money on the table.

The Traditional Framework and Its Limitations

Securities class actions under Rule 10b-5 operate on the “fraud on the market” theory. The premise is straightforward: Material misstatements or omissions artificially inflate a stock’s price, causing investors to purchase shares at inflated values. When the truth emerges and the stock price corrects, those investors suffer damages equal to the inflated amount.

The conventional wisdom focuses on realized losses – the actual decline in stock price when the fraud is revealed. But my research challenges a fundamental assumption underlying this approach: that only realized risks matter for calculating investor harm.

Consider this hypothetical. If Boeing management knew about quality-control risks that could lead to catastrophic failures but failed to disclose them, shareholders were harmed even if the door plug incident never occurred. The undisclosed risk itself – whether or not it materializes – affects the true value of the investment. This insight opens the door to a more sophisticated understanding of securities fraud damages.

Understanding the Discount Rate

In my paper, I return to first principles of finance, specifically the constant growth valuation model: V = CF/(K-g), where V is value, CF is cash flow, K is the investor’s required rate of return (discount rate), and g is the growth rate.

When a stock price drops dramatically, the mathematics tell us that one or more of three things must have happened: Expected cash flows decreased, the growth rate declined, or K (the discount rate) increased. Traditional damages analyses focus almost exclusively on the cash flow component. This is incomplete.

The discount rate K represents investors’ perception of forward-looking risk. It’s not directly observable but can be calculated algebraically from the other variables in the valuation equation. By examining how K changes following major price shocks, we can quantify the risk component of shareholder harm separate from the earnings impact.

Risk Increases Are Real and Substantial

I analyzed over 2 million firm-month observations from 1990-2023, examining stocks whose price dropped 25% or more in a single day. The following findings are striking:

Discount rates increase significantly after major price drops. Depending on the measurement approach, K rises by 130 to 330 basis points following a significant price shock. For context, if a stock had a discount rate of 8% before the event, the rate might jump to 9.7-11.3% afterward. This represents a substantial increase in perceived risk that persists even after controlling for volatility, market movements, and other factors.

The effect is monotonic with severity. Stocks experiencing “big drops” (40%+ declines) show even larger increases in K compared with stocks having 25-40% drops, confirming that the market systematically reprices risk based on the magnitude of adverse events.

The risk increase persists. These aren’t just short-term market overreactions. The elevated discount rates remain significant even after controlling for prior volatility and implementing firm fixed effects in the regression models.

Debunking the “Disconnection” Myth

One of the most important practical findings for litigators involves stock beta – the measure of how much a stock moves with the overall market. Prior research, notably Dyl (1999), suggested that after a major idiosyncratic event, a stock becomes “disconnected” from the market, with beta approaching zero. This theory has been used to argue against market-based damages adjustments in securities cases.

My research definitively refutes this assumption. Not only does beta remain non-zero after major price shocks, it actually increases slightly. Over the 12 months following a major price drop, average beta rises from 0.656 to 0.768. The stock doesn’t become an island – if anything, it becomes more exposed to systematic market risk, perhaps because weakened companies have less financial flexibility to weather macroeconomic storms.

This finding has immediate practical implications. It supports the use of market-model damages calculations that adjust for overall market movements during the damages period. Arguments that a stock’s losses should be measured purely on an individual basis, without market adjustment, lack empirical support.

Short-Term Pain, Long-Term Recovery

Perhaps the most intriguing finding emerges when examining actual earnings trajectories. In the 12 months following a major price drop, operating income does fall sharply – by roughly 60% compared with pre-shock levels. This seems to justify the price decline.

But look further out: By 48 months after the shock, earnings have not only recovered but actually exceed pre-shock levels. EPS, operating income, and other financial metrics all show this pattern. The long-term earnings damage is minimal or nonexistent.

What does this mean? It suggests that the price drop is driven primarily by the risk repricing (increased K) rather than permanent earnings impairment. Investors aren’t just reacting to lower expected cash flows – they’re demanding a higher return for the increased uncertainty they now perceive in the company.

Implications for Securities Litigation Practice

This research has several important applications for securities litigation practitioners:

1. Broader Grounds for Damages

The traditional framework limits recoverable damages to the inflation in stock price caused by misstatements or omissions. But if undisclosed risks harm shareholders even when those risks don’t materialize, the universe of actionable conduct expands. A company that fails to disclose material risks may be liable even if the feared event never occurs – the risk itself inflates the stock by making it appear safer than it truly is.

This could prompt securities claims against companies that successfully manage or avoid worst-case scenarios but failed to disclose those risks to investors. The harm isn’t just in losses realized; it’s in risks concealed.

2. Enhanced Damages Calculations

My methodology offers a way to break stock price declines into two components: the earnings impact and the risk impact. In cases where the stock doesn’t fully recover, traditional approaches may attribute the entire permanent decline to lost earnings. But if a significant portion reflects elevated risk perception, damages calculations should account for both components.

Consider a scenario where a stock’s price drops from $100 to $60 following disclosure of fraud. Traditional analysis might focus on the $40 drop. But suppose more careful analysis shows that $15 of that decline represents increased K (risk repricing) while $25 represents reduced expected earnings. If earnings partially recover but the risk premium persists, the damages picture becomes more complex – and potentially more favorable to plaintiffs.

3. Defense Against Market-Efficiency Challenges

Defendants often argue that markets efficiently incorporate new information, suggesting that any price recovery after the initial drop demonstrates that losses were exaggerated. McDonald’s research offers a counterargument: Even if earnings recover, shareholders continue to bear harm through permanently elevated risk premiums. The stock may climb back from $60 to $80, but it’s now trading at a lower multiple of earnings due to higher perceived risk.

4. Sophisticated Expert Testimony

This research provides a roadmap for expert witnesses to offer more sophisticated damages analyses. Rather than rely solely on event studies and market models, experts can now quantify the risk component of losses using established finance theory and empirical evidence of how K changes following adverse events.

The methodology is academically rigorous – published research using standard financial databases (CRSP, Compustat, FactSet) and conventional econometric techniques. This gives it credibility that pure consulting opinions may lack.

A More Complete Theory of Harm

What makes my  research compelling is that it doesn’t just propose a theoretical refinement – it provides empirical evidence that markets actually behave this way. Discount rates do increase after major adverse events. Beta does remain significant. And long-term earnings often recover even when stock prices don’t fully rebound.

For securities litigators, this research offers both a sword and a shield. Plaintiffs can use it to argue for more complete damages calculations that account for persistent risk increases. Defendants can use the earnings recovery findings to argue that long-term harm was limited. Expert witnesses on both sides will need to grapple with these concepts.

The broader implication may be philosophical: Securities fraud damages should compensate investors not just for realized losses but for bearing risks they didn’t agree to bear. When a company conceals material information, it tricks investors into holding a riskier investment than they intended. Even if that risk never materializes into actual losses, the deception itself constitutes harm.

This aligns with the fundamental purpose of securities laws: ensuring that investors can make informed decisions based on accurate information. A company that hides risks – whether or not those risks result in harm – violates that principle and should be held accountable for the full scope of investor harm, including the risk repricing that occurs when the truth emerges.

Conclusion

When evaluating damages, attorneys should look beyond the price chart. Ask how the discount rate changed. Examine whether beta remained significant. Consider whether long-term earnings recovered. Understanding the risk component of price declines – separate from the earnings component – provides a more complete picture of shareholder harm and a more rigorous foundation for damages claims.

Michael McDonald is an associate professor of finance at Fairfield University. This post is based on his recent paper, “Drivers of Investor Required Rates of Return Following Stock Price Drops: Implications for Securities Class Action Litigation,” available here.