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Paradoxical transparency? Capital market responses to exploration and exploitation disclosure

Journal: Research Policy

Date: 2022

Author: Lane Matthews, Mariano Heyden, Dan Zhou

Abstract:
We draw on information risk theory and paradox theory to examine the additive and combined effects of disclosing exploration and exploitation information on cost of equity capital. We build on theory that presupposes that the information disclosed by a firm about its innovation activities will reduce information risk of investors. However, we contend that disclosure of exploration and exploitation innovation activities could convey potentially paradoxical expectations about a firm's future value. Based on longitudinal data of the UK FTSE 350 firms from 2011–2016, we show that firms tend to disclose more information related to exploration than exploitation. However, the bulk of market benefits are driven by exploitation rather than exploration disclosures—except for R&D-active firms that are rewarded for exploration disclosure. We also find that the combined disclosure is negatively associated with cost of equity capital, with the sub-population of R&D-active firms particularly accruing synergies from combined disclosure of both exploration and exploitation. These findings suggest that the market differentiates between exploration and exploitation information in addressing information risk, more so than previously assumed. We discuss implications for information-type-dependency in information-risk theory, the outward projection of internal paradoxes, capital market valuations of disclosure by R&D-active firms, opportunity-seeking by large publicly listed corporations, and policy implications.

Link: Google Scholar

Background and Context

Innovation Disclosure

The study examines how firms' disclosure about exploration and exploitation innovation activities affects their cost of equity capital.

Research Data

Researchers analyzed annual reports from UK FTSE 350 firms (2011-2016) using computer-aided textual analysis to measure innovation disclosures.

Theoretical Foundation

The research draws on information risk theory and paradox theory to investigate how investors respond to potentially paradoxical innovation information.

Exploration vs. Exploitation: Different Innovation Strategies

EXPLORATION Radical Change Risk-Taking Long-Term Focus Uncertain Returns EXPLOITATION Incremental Improvement Efficiency Short-Term Focus Predictable Returns
  • Exploration focuses on discovering radically new innovations with uncertain outcomes and longer time horizons.
  • Exploitation prioritizes refining existing capabilities through incremental improvements with more predictable returns.
  • These contrasting innovation approaches create potentially paradoxical information for investors to evaluate.

Firms Disclose More Exploration Than Exploitation Information

  • Firms consistently disclose significantly more exploration information (2.4%) than exploitation information (1.5%) in their annual reports.
  • This pattern holds true across both R&D-active and non-R&D firms with statistically significant differences.
  • R&D-active firms show slightly higher disclosure rates for both types of innovation activities.

The Transparency Paradox: Firms Disclose More of What Markets Reward Less

What Firms Disclose More Exploration (2.4%) What Markets Reward More Exploitation (-1.19%)
  • The study reveals a paradox: firms emphasize exploration in disclosures despite exploitation being more rewarded.
  • Exploitation disclosure significantly reduces cost of equity capital (-1.19%), while exploration disclosure shows no significant effect.
  • This counterintuitive finding suggests a misalignment between corporate disclosure strategy and capital market preferences.

R&D-Active Firms Show Different Benefits from Innovation Disclosure

  • R&D-active firms uniquely benefit from exploration disclosure (-1.459%), unlike non-R&D firms (0.037%, not significant).
  • Exploitation disclosure benefits both firm types, but with stronger effects for non-R&D firms.
  • Combined disclosure shows dramatically stronger benefits for R&D-active firms, suggesting synergistic effects.

Combined Disclosure Creates Synergistic Benefits for R&D-Active Firms

Exploration -1.459% Exploitation -1.021% Combined -2.572%
  • The combined effect (-2.572%) is greater than the sum of individual effects for R&D-active firms.
  • This synergistic relationship suggests R&D-active firms benefit from balanced disclosure of both innovation types.
  • Investors appear to recognize potential synergies between exploration and exploitation for R&D-intensive companies.

Contribution and Implications

  • Information risk is type-dependent, with markets differentiating between exploration and exploitation when pricing securities.
  • The paradox perspective on ambidexterity gains a market-based complement, showing how outsiders value seemingly contradictory activities.
  • R&D-active firms should balance disclosures to benefit from synergistic effects that reduce their cost of capital.
  • Large publicly listed firms should align their transparency strategies with their innovation profiles to optimize financing.
  • Regulators should consider innovation-specific disclosure frameworks to enhance capital market efficiency and support innovation.

Data Sources

  • Visualization 2 is based on data from Table 3 showing mean disclosure percentages of exploration and exploitation.
  • Visualization 3 data points are drawn from the regression coefficients in Table 5 Model 4.
  • Visualization 4 uses regression coefficients from Table 6 Models 6-9 comparing R&D-active and non-R&D firms.
  • Visualization 5 highlights the synergistic effects based on coefficient data from Table 6 Model 7.