Lecture Lecture 99Capital Markets ResearchCapital Markets Research

(cont.)(cont.)

Lecture OverviewLecture Overview Review

Two broad types of capital markets research Information content of earnings Ball and Brown’s Results

Other research examining the ‘information content’ of financial reporting decisions

Value Relevance Research Stocks and flows of wealth Research examining the ‘value relevance’ of

financial reporting decisions

Review - Introduction Review - Introduction to capital markets to capital markets researchresearch

Financialreporting

Share prices / returnsSemi – strong form

market efficiencyis assumed

Review - Two broad Review - Two broad types of capital markets types of capital markets researchresearch

Information content research Capital market reactions (share price changes /

returns) to company announcements Indicates new information in market

Value relevance research Share prices and returns used as ‘benchmarks’ Assumes investors know information before

financial statements are issues Financial reporting ‘reflects’ known information

Review – informationReview – informationcontent of earningscontent of earnings

A relation exists between share price and expected future earnings

Price as a function of Price as a function of earningsearnings

ti

t

ti kEP )1/(1

P = PV (CF)

CF = dividends

Dividends arepaid out ofearnings

Review – informationReview – informationcontent of earningscontent of earnings

A relation exists between share price and expected future earnings

Revisions of expectations about future earnings will be reflected in share price

Only the unexpected component of current earnings announcements represent ‘new’ information

Abnormal returns rather than share prices are generally used to assess whether company disclosures (including historical earnings) contain ‘information content’

The Market ModelThe Market Model(separates out market wide (separates out market wide effects)effects)

Raw return on day t

Constantaverage

daily return

Return due tomarket moves

Return dueto firm moves= + +

Rit = i + bi(Rmt) + it

Actual returns = Normal returns + Abnormal returns

Review – Ball and Review – Ball and Brown’s ResearchBrown’s Research

Tested whether accounting earnings, calculated using historical cost accounting principles, provides useful information to investors

Conclude that:1. The information contained in the annual

report is used in investment decision making2. Investors obtain much of the information

they need from sources other than the annual report prior to its release

Results from other Results from other ‘information content’ ‘information content’

researchresearch

3. The information content 3. The information content of earnings of earnings announcements depends announcements depends on the extent of on the extent of alternative sources of alternative sources of informationinformationInformation content of earnings varies between countries due to differences in (Brown, 1970):extent of alternative sources of info.

frequency of reportingaverage size of companies

4. Impact depends on 4. Impact depends on whether unexpected whether unexpected

earnings are earnings are permanent or permanent or

temporarytemporaryEarnings response coefficient (ERC) captures magnitude of relation between unexpected earnings and abnormal returnsOnly a 0.1 - 0.15% abnormal return associated with 1% unexpected change in earnings, on average (Beaver, Lambert and Morse, 1980)

Varies from firm to firm depending on ‘permanency’ or ‘persistence’ of unexpected earnings (Easton and Zmijewski, 1989)

Permanent and Permanent and Temporary EarningsTemporary Earnings

Earnings persistence - how much of any unexpected earnings will be permanent?

Permanent increases are expected to result in increased dividends

Temporary increases are discounted or ignored

Unusually large accruals should be discounted (less persistent)

5. ‘Persistence’ related to 5. ‘Persistence’ related to relative magnitude of cash relative magnitude of cash and accruals components and accruals components of earningsof earnings The accruals process involves adjusting the

timing of cash flows - subjective and open to manipulation

Firms with high accruals relative to cash flows are unlikely to have persistently high earnings - due to reversals of accruals over time

Prices act as if investors fail to identify differences between cash flows and accruals - market fixates on earnings (Sloan, 1996)

6. Earnings 6. Earnings announcements of other announcements of other firms in same industry firms in same industry have information have information contentcontent Earnings announcements result in abnormal

returns for the company and for other companies in the same industry (Foster, 1981)

Reduces uncertainty of earnings for similar companies who announce earnings later

Consider timing of announcements - Biggest price reaction to first firm in an industry to announce and smallest for last to announce (Clinch and Sinclair, 1987)

Information TransferInformation Transfer

The responsiveness of firm’s returns to other firm’s information announcements; especially within an industry

Reaction related to whether reflects change in conditions for entire

industry reflects changes in market share within

industry

7. Earnings forecasts 7. Earnings forecasts have information have information contentcontent

Relates to both management and analyst forecasts

Reflects revisions to expected future earnings

Information transfer associated with earnings forecasts as well as earnings announcements (Baginski, 1987)

8. Voluntary disclosure 8. Voluntary disclosure of information has of information has benefitsbenefits

More informative disclosures attract analyst following and result in more accurate analyst earnings forecasts - reduced information asymmetry (Lang and Lundholm, 1996)

More informative disclosures associated with lower cost of capital (Botosan, 1997)

9. Recognition is 9. Recognition is perceived differently perceived differently to disclosureto disclosure

Market ignores disclosed relative to recognized asset writedowns (Aboody, 1996)

Market discounts disclosed relative to recognized asset revaluations (Cotter and Zimmer, 2000) Why? - disclosed information indicates

less reliability / certainty - related to asset type

10. Size effect10. Size effect

Earnings announcements have a greater share price impact for smaller firms (higher ERC) due to greater information asymmetries for smaller firms (Grant, 1980)

Less information content for larger firms due to expectations about future earnings being more accurate (less NEW information in current earnings)

Summary - Information Summary - Information AsymmetryAsymmetry

Greater for smaller firms (greater problems of adverse selection) Less alternative sources of information Lower/non-existent analyst following Annual reports have more information content

Earnings forecasts and other voluntary disclosures reduce info. asymmetry

Announcements by similar firms reduce information asymmetries.

Summary - Information Summary - Information content of earningscontent of earnings

Unexpected earnings are related to abnormal returns (have info. content)

The magnitude of this relation (ERC) varies between firms firm size (information asymmetry) persistence (permanent or temporary)

Earnings of similar firms have info. Content Investors obtain much of the information they

need from other sources

Value Relevance ResearchValue Relevance Research

The intuitionThe intuition

Share prices anticipate earnings information obtained from alternate sources

Current earnings ‘reflect’ share prices and returns

Prices and returns are used as ‘benchmarks’ for assessing alternate financial reporting choices prices capture firm value returns capture firm performance

Changes versus levels Changes versus levels in earningsin earnings

The information content approach relates changes in earnings (unexpected earnings) to market returns

The value relevance approach relates levels of earnings (total current earnings) to market returns

Empirical evidence and theory shows that both changes and levels of earnings are associated with market returns

Stocks and Flows of Stocks and Flows of WealthWealth

Stocks and FlowsStocks and Flows

Market value and book value of a company can be considered as ‘stocks’ of wealth

Market returns and earnings can be considered as ‘flows’ or changes in wealth between two points in time

If market value is related to book value, total market returns should be related to total earnings over a period

Stocks and Flows - Stocks and Flows - Book ValueBook Value

Stock at 30/6/01 = Book value of ordinary shareholders’equity

Stock at 30/6/02 =Book value of ordinary shareholders’equity

Flow =earnings - dividendsfor year ended 30/6/02(change in book value)

Stocks and Flows - Stocks and Flows - Market ValueMarket Value

Stock at 30/6/01 = Price per share xnumber of ordinary sharesoutstanding

Stock at 30/6/02 = Price per share xnumber of ordinary shares outstanding

Flow =change in market value

Flows - Book and MarketFlows - Book and Market Book = earnings - dividends Market = change in () market value Equating the flows:

Error is due to: market inefficiency limitations of the accounting system

Earnings - dividends = market value + errorEarnings = market value + dividends + errorEarnings = returns + error

Limitations of the Limitations of the Accounting SystemAccounting System

1. Not all assets are recognised in the accounts, for example Human resources Customer satisfaction levels Internally generated goodwill

2. Some assets are recognised at less than their full value, for example Fixed assets that have not been revalued Inventory

Summary - Value Summary - Value relevance approachrelevance approach

The value relevance approach relates total earnings to returns (flows)

Used to assess the ‘value relevance’ of financial information

Used to compare the ‘value relevance’ of alternative accounting / disclosure methods

Research Results (cont.):Research Results (cont.):Research examining the Research examining the

‘value relevance’ of financial ‘value relevance’ of financial reporting decisionsreporting decisions

11. Share prices ‘lead’ or 11. Share prices ‘lead’ or ‘anticipate’ accounting ‘anticipate’ accounting

earningsearnings Prices in year t are related to

earnings in year t+1 (Beaver, Lambert and Morse, 1980)

Share price movements provide an indication of future movements in accounting earnings, especially for larger firms (Collins, Kothari and Rayburn, 1987)

12. Earnings are a better 12. Earnings are a better measure of firm measure of firm performance than cash performance than cash flowsflows

Accrual earnings have fewer timing and matching problems than cash flows

Returns are used as a benchmark measure of firm performance

Earnings are more closely associated with returns than cash flows (Dechow, 1994)

13. Current (fair) values 13. Current (fair) values better ‘reflect’ firm better ‘reflect’ firm value than historical value than historical costscosts

Relates to: Fair values of financial instruments

(Barth, Beaver and Landsman, 1996) Revaluations of non-current assets

(Easton, Eddey and Harris, 1993) However, revaluations do not have

‘information content’ (Brown and Finn, 1980)

For TutorialsFor Tutorials

Required reading Text chapter 10

Self assessment questions Remainder of questions from

module 6 Answers in tutorials