Measuring Earning Power

1. Measuring Earning Power Chapter 24 Chapter 24: The Issuer's Earning Power

2. Background • Miller & Modigliani’s dividend irrelevance theorem • Dividend policy of normal firm has no impact on firm’s stock price • This chapter shows how a change in firm’s cash dividend payments can cause short-term stock price fluctuations • Without violating M&M’s theory • Also shows how firm’s EPS are important in valuing stock Chapter 24: The Issuer's Earning Power

3. Informational Content of Cash Dividends • Board of Directors base cash dividend payments upon the following • Long-run targeted dividend payout ratio • Smoothing of cash dividend payments so they follow long-run trend in corporate earnings • Short-term changes in earnings usually have little impact on cash dividend payments • Reluctance to change (especially decrease) cash dividend payments • Prefer small infrequent increases Chapter 24: The Issuer's Earning Power

4. Asymmetric Information • Information asymmetry occurs when Board of Directors has valuable inside information about corporation • Information is not available to outside investors • External investors use cash dividend payments as a signal • Contain valuable information Chapter 24: The Issuer's Earning Power

5. Reactions to Cash Dividend Payments • Healy & Palepu (1988) examined stock prices of corporations for –60 to +20 days after announcement • 131 corporations that initiated cash dividend payments • Experienced abnormal stock price increase of 4% • Experienced average growth rate of 43% per year prior to beginning dividends • Experienced 164% increase in earnings in the 4 years after initiating dividends • Findings suggest firms initiate cash dividend payments if they believe the payments can be sustained • Signal by Board of Directors that future prospects look good Chapter 24: The Issuer's Earning Power

6. Reactions to Cash Dividend Payments • 172 corporations that eliminated regular cash dividend payments • Experienced abnormal stock price decrease of 9.5% • Earnings fell over next 4 quarters • Suggests that market views cash dividend omission as a signal of forthcoming bad news Chapter 24: The Issuer's Earning Power

7. Reactions to Cash Dividend Payments • Do these findings contradict M&M’s dividend irrelevance theorem? • No, market views changes in cash dividend payments as informational content • Many investors want more information than is available from annual reports and public announcements • Investors like corporate earnings forecasts Chapter 24: The Issuer's Earning Power

8. Forecasting EPS • Examples of corporations that provide earnings forecasts • Moody’s • Standard & Poors • Value Line • Forecast for a corporation is usually provided by a securities analyst who specializes in a particular industry Chapter 24: The Issuer's Earning Power

9. Surveys of Forecasts • Three corporations specialize in providing consensus earnings forecasts • Institutional Brokers Estimate System (I/B/E/S) [New York] • www.ibes.com • Zacks Investment Research [Chicago] • www.zacks.com • First Call [Florida] • Subsidiary of Thomson Financial Company • www.thomsonivest.net Chapter 24: The Issuer's Earning Power

10. Surveys of Forecasts • Employees call professional securities analysts, financial analysts, etc., periodically and solicit earnings forecasts • Publish high, low, average and median values • Data is updated frequently • Represent current estimates of continuously changing consensus forecast • Compute dispersion measures to determine level of uncertainty • Provided information on • Earnings growth rate • Stock split adjustment factor • Number of forecasters surveyed • Cash dividends per share • Stock price Chapter 24: The Issuer's Earning Power

11. Surveys of Forecasts • May purchase data in following formats • Paper (hardcopy) • Diskettes • Computer tapes • Electronic mail • Ability to search database 24 hours a day • May purchase data for • Single company • Industry averages • All companies within an industry • All companies listed on a stock exchange • All forecasts of a specific security analyst Chapter 24: The Issuer's Earning Power

12. Surveys of Forecasts • First Call’s internet site offers • News • Chat rooms • Insider trading information • Earnings information • Graphs • Financial research Chapter 24: The Issuer's Earning Power

13. How Expert Are The Experts? • After reviewing the forecasts of many different securities analysts, discovered forecasters • Tend to over-estimate EPS • Tend to revise forecasts downward as earnings announcement date approaches • Seem reluctant to say negative things about security issuers • Issue many more buy than sell recommendations • May be due to fact that analysts do not want to antagonize employer’s potential clients Chapter 24: The Issuer's Earning Power

14. How Expert Are The Experts? • Institutional Investor, a monthly publication, reports survey results of 2,000 money managers every October • Compiles list of the ‘best’ security analysts in each of over 60 industries • Forecasts of this ‘all-star’ team are compared with forecasts of other analysts • Results show that neither group did better than the other • Brown & Rozeff report that earnings forecasts reported in Value Line Investment Survey were better than forecasts generated by sophisticated mechanical models Chapter 24: The Issuer's Earning Power

15. Whisper Earnings • Whisper earnings are forecasts of EPS circulated among analysts and trades via web, television and financial press • Unofficial EPS forecasts • Bagnoli, Beneish and Watts (2000) find whisper forecasts to be more accurate than surveys of institutional forecasts • Check out www.WhisperNumber.com Chapter 24: The Issuer's Earning Power

16. Earnings Surprises and Stock Prices • Latane and Jones developed a model to measure earnings surprise • Standardized Unexpected Earnings • Numerator measures forecasting error • Represents difference in firm’s reported EPS and the consensus EPS forecast from I/B/E/S or Zacks • Can be either +, -, or 0 • Dividing by standard deviation of forecasting error creates a dimensionless index number • Allows comparisons between different companies and times Chapter 24: The Issuer's Earning Power

17. Earnings Surprise Example • Given • Corporation A and B both have forecasted EPS of $2 and actual EPS of $3 • Corporation A is a predictable public utility with a small standard deviation of forecast error of 50¢ • Corporation B is a volatile technology firm with a large standard deviation of forecast error of $2 Both have SUE > 0 because actual EPS exceeded expected, but investors in A were more pleasantly surprised—because having actual EPS of $1 above forecasted EPS is more unusual. Chapter 24: The Issuer's Earning Power

18. Foster-Olsen-Shevlin Event Study • In 1984 Foster, Olsen & Shevlin analyzed the impact of a public announcement of a firm’s quarterly earnings on the firm’s stock price • Computed SUE for 2,053 firms over 32 quarters • 65,696 SUEs were ranked in deciles • Decile 1 contained the 6,570 most negative SUEs (worst news announcements) • Deciles 10 contained the 6,570 largest positive SUEs (best news announcements) Chapter 24: The Issuer's Earning Power

19. Abnormal Common Stock Returns Surrounding Quarterly Earnings Announcement Dates During –60, 0 Period +5% When firm experiences + earnings surprise, stock prices tend to rise prior to announcement date. Decile Portfolio Number Abnormal Return 1 2 3 4 0% 6 8 5 7 9 10 When firm experiences - earnings surprise, stock prices tend to fall prior to announcement date. -5% Foster-Olsen-Shevlin Event Study • Suggests that the market correctly anticipates earnings changes prior to announcement and reacts rationally Chapter 24: The Issuer's Earning Power

20. Abnormal Common Stock Returns Surrounding Quarterly Earnings Announcement Dates During 1, 60 Period +3% Decile Portfolio Number Abnormal Return 1 2 3 4 0% 6 8 5 7 9 10 -3% Foster-Olsen-Shevlin Event Study • Shows that the relationship between earnings surprise and stock prices continues after the announcement Investor in Decile 10 can expect to earn abnormal returns of 3.23% during 60 days after unexpected + earnings surprise—an anomaly in efficient markets theory. Chapter 24: The Issuer's Earning Power

21. Foster-Olsen-Shevlin Event Study • Results suggests that investors could simply determine which firms have experienced +/- earnings surprise (using WSJ or other public information) • Then take a long/short position and earn abnormal returns • Study suggests • Earnings expectations are an important determinant of stock prices • If better measures of earnings were used, results would have been more compelling • Studies used earnings reports generated by firm’s own accountants Chapter 24: The Issuer's Earning Power

22. Ambiguities in Accounting Earnings • EPS are not easy to measure • GAAP leaves room for interpretation • Distorted income statements may result from • Inappropriate use of an accounting procedure • Use of accrual accounting technique that does not link revenues/expenses to period in which cash flow actually occurred • Window-dressing Chapter 24: The Issuer's Earning Power

23. Contrasting Income Statements • Compare the following income statements • Identical except in the accounting procedures Chapter 24: The Issuer's Earning Power

24. Contrasting Income Statements Minimizes taxable income. True represen- tation of economic income. Chapter 24: The Issuer's Earning Power

25. Contrasting Income Statements • Both income statements are correct in terms of accounting practices • Points of interest • Sales • Statement A includes both cash sales and current sales on installment contracts • Perhaps Statement B does not recognize a credit sales until the customer’s final cash payment on Accounts Receivable is actually received Chapter 24: The Issuer's Earning Power

26. Contrasting Income Statements • Inventory • Statement A used FIFO, while B used LIFO • During an inflationary environment FIFO results in higher reported profits • FIFO often causes profit to be more volatile than LIFO • Switching from one technique to the other can cause significant one-time distortions in earnings • Some companies keep two sets of books • One set for public display • One set for with firm use • Can try to determine if firm does this by comparing federal income taxes paid vs. the proportion of reported pre-tax income Chapter 24: The Issuer's Earning Power

27. Accelerated Methods Contrasting Income Statements • Depreciation • Can use several different depreciation methods • Straight-line • Units of production • May be used to accelerate depreciation during period of rapid production • Double-declining balance • Sum-of-the-digits • Modified accelerated cost recovery system (MACRS) Chapter 24: The Issuer's Earning Power

28. Contrasting Income Statements • Accelerated depreciation methods increase depreciation during early years of asset’s life • Decrease reported accounting income and net taxable profit • Postpones taxes on income • While the straight-line method may be more representative for the firm, IRS requires U.S. firms use MACRS • Encourages investment by giving rapid tax write-offs Chapter 24: The Issuer's Earning Power

29. Contrasting Income Statements • Pension costs categories • Defined contribution pension plans • Require employer to deposit a specified amount into a pension fund • AKA profit-sharing plans because specified amount may be a percentage of firm’s profit • Employer’s cost is deducted as a current business expense from each year • Liabilities for under-funded pension obligations never appear on balance sheet Chapter 24: The Issuer's Earning Power

30. Contrasting Income Statements • Defined benefit pension plans • Employer promises to pay retirees a pension • Creates a legally enforceable liability on balance sheet • Employer’s required contribution is based on annual estimates • Most hire actuarial consultants to estimate present value of legal liability • Once estimated, employer must decide how much of current year’s earnings to set aside in pension fund Chapter 24: The Issuer's Earning Power

31. Contrasting Income Statements • Assuming firm has a defined benefit pension plan, Statement B reflects a large deduction whereas A a small one • Large deduction may be due to fact that firm wants to • Minimize its income tax payments • Smooth out earnings • Accumulate surplus assets in pension fund Chapter 24: The Issuer's Earning Power

32. Contrasting Income Statements • Expensing vs. capitalizing • Many items can be either expensed or capitalized • Example: motion picture production costs, oil well exploration costs, advertising • Some items were expensed under Statement B (leading to lower taxable income) and capitalized under Statement A Chapter 24: The Issuer's Earning Power

33. Contrasting Income Statements • Amortization of Goodwill • An intangible asset equal to the amount paid for an acquired company in excess of book value • Arises because company has good growth potential, brand-name or customer loyalty • May be amortized up to 40 years • Statement A uses a longer amortization period which reduces costs and increases income Chapter 24: The Issuer's Earning Power

34. Contrasting Income Statements • Contingent liabilities • Potential obligations that will occur in future if certain conditions occur • Typically arise from pending litigation or guarantees of subsidiary debt • If liability cannot be reasonably forecasted it goes in a footnote to financial statements • If can be reasonably forecasted, firm must recognize as a contingent liability on balance sheet • Accountant has wide discretionary power • Unlikely that a firm could accomplish all the above distortions in a single year • Just highlights areas in which difference could occur Chapter 24: The Issuer's Earning Power

35. The Quality of Earnings • Does the firm’s accounting earnings reflect its true earning power • Reported earnings that accurately depict firm’s earning power are considered high quality • Even if negative • Reported earnings are consider low-quality if special items and/or inappropriate GAAP methods are used • Even if result in positive earnings • Securities analysts desire an earnings number that can be used in a P-E valuation model Chapter 24: The Issuer's Earning Power

36. The Quality of Earnings • More than one EPS may be reported if the potential dilution of EPS exists • An increase in future number of outstanding shares may occur if • Management elects to sell more shares • Options to purchase additional shares from firm exist (convertible bonds, preferred stock, employee stock options, warrants) • Corporation exchanges stock for debt • Extraordinary gains and losses • May distort the ‘normal’ income stream • Examination of the firm’s Statement of Cash Flows can help determine the stock’s earning power Chapter 24: The Issuer's Earning Power

37. Cash Flows • Cash flows are not obscured by accrual accounting, depreciation, amortization, etc. • Cash Flows from Operations • Measures cash flows arising from the production and distribution of goods and/or services • Found in the first part of a firm’s Statement of Cash Flows • Or, can be computed form Statement of Sources and Uses (of Cash) • Most firm’s accounting incomes are not highly positively correlated with Cash Flows from Operations • Should not value a firm’s common stock using Cash Flows from Operations if firm uses debt Chapter 24: The Issuer's Earning Power

38. Statement of Cash Flows Chapter 24: The Issuer's Earning Power

39. Statement of Cash Flows • Reports net cash flows generated from operations, investing and financing activities • Accounts for the net change in firm’s aggregate cash position • The firm’s Statement of Cash Flows and financial footnotes (or supplementary reports) contain needed information for determining cash flows to stockholders Chapter 24: The Issuer's Earning Power

40. Cash Flows Available to Equity Shareholders • Represents firm’s leverage-free cash flows • Adjust CFO for any debt-financing effects • Combined leverage effects • Cash required to service debt net of tax effects – net cash flow for investing plus (minus) any increase (decrease) in debt financing • Deduct combined leverage effect from CFO to obtain leverage-free cash flows • Present value of the leverage-free cash flows can be found using required rate of return on equity Chapter 24: The Issuer's Earning Power

41. Cash Flows to Equity Shareholders vs. Economic Income • Economic income represents the maximum amount of consumption opportunities that can be withdrawn from firm without reducing future consumption opportunities • Accounting income represents an upward biased estimate of economic income for most firms • Net income includes retained earnings which are unavailable for consumption • Cash flows available to shareholders measures consumption opportunities available to owners • Contains deductions needed to sustain firm’s future earning power • Must include effect of debt financing Chapter 24: The Issuer's Earning Power

42. Problems with Cash Dividends • Calculating present value of cash dividends provides an estimate of a stock’s value • But it is an invalid estimate if a firm is • Repurchasing shares • Generating more cash than paying out as dividends • Using some cash to repurchase shares which cause reverse dilution of EPS, cash dividend per share and value per share • Growing because projects have ROE > cost of capital • Declining because projects have ROE < cost of capital • Can maximize firm value by paying one large liquidating dividend • Many fundamental analysts prefer the P-E ratio approach Chapter 24: The Issuer's Earning Power

43. The Bottom Line • Asymmetric information exists because Board of Directors has access to inside information not known to investors • M&M theory does not mean a cash dividend cannot offer informational content • External investors evaluate cash dividends for signals about future • I/B/E/S, Zacks and First Call specialize in compiling earnings forecasts • Valuable in determining if a corporation’s earnings contain surprises Chapter 24: The Issuer's Earning Power

44. The Bottom Line • Stock prices tend to increase (decrease) prior to announcement of positive (negative) earnings surprises • Abnormal stock returns continue for a 2 month time period after earnings announcement • GAAP leaves room for interpretation • Should select accounting methods that represent true economic income • Security analysts must adjust accounting income to obtain true economic income estimates • Many analysts use corporate cash flows rather than earnings to measure earning power Chapter 24: The Issuer's Earning Power