Lecture 9 Capital Markets Research (cont.)

1. Lecture 9Capital Markets Research(cont.)

2. Lecture 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

3. Review - Introduction to capital markets research Financial reporting Share prices / returns Semi – strong form market efficiency is assumed

4. Review - Two broad types of capital markets research • 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

5. Review – informationcontent of earnings • A relation exists between share price and expected future earnings

6. Price as a function of earnings P = PV (CF) CF = dividends Dividends are paid out of earnings

7. Review – informationcontent 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’

8. The Market Model(separates out market wide effects) Rit = i + bi(Rmt) + it Raw return on day t Constant average daily return Return due to market moves Return due to firm moves + + = Actual returns = Normal returns + Abnormal returns

9. Review – Ball and Brown’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 making 2. Investors obtain much of the information they need from sources other than the annual report prior to its release

10. Results from other ‘information content’ research

11. 3. The information content of earnings announcements depends on the extent of alternative sources of information Information content of earnings varies between countries due to differences in (Brown, 1970): extent of alternative sources of info. frequency of reporting average size of companies

12. 4. Impact depends on whether unexpected earnings are permanent or temporary Earnings response coefficient (ERC) captures magnitude of relation between unexpected earnings and abnormal returns Only 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)

13. Permanent and Temporary 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)

14. 5. ‘Persistence’ related to relative magnitude of cash and accruals components of 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)

15. 6. Earnings announcements of other firms in same industry have information content • 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)

16. Information 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

17. 7. Earnings forecasts have information content • 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)

18. 8. Voluntary disclosure of information has benefits • 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)

19. 9. Recognition is perceived differently to 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

20. 10. 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)

21. Summary - Information Asymmetry • 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.

22. Summary - Information content 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

23. Value Relevance Research

24. The 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

25. Changes versus levels in 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

26. Stocks and Flows of Wealth

27. Stocks 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

28. Stocks and Flows - Book 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 - dividends for year ended 30/6/02 (change in book value)

29. Stocks and Flows - Market Value Stock at 30/6/01 = Price per share x number of ordinary shares outstanding Stock at 30/6/02 = Price per share x number of ordinary shares outstanding Flow = change in market value

30. Flows - 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 + error Earnings =  market value + dividends + error Earnings = returns + error

31. Limitations of the Accounting 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

32. Summary - Value relevance 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

33. Research Results (cont.):Research examining the ‘value relevance’ of financial reporting decisions

34. 11. Share prices ‘lead’ or ‘anticipate’ accounting earnings • 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)

35. 12. Earnings are a better measure of firm performance than cash flows • 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)

36. 13. Current (fair) values better ‘reflect’ firm value than historical costs • 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)

37. For Tutorials • Required reading • Text chapter 10 • Self assessment questions • Remainder of questions from module 6 • Answers in tutorials