The Roles of Performance Measures and Monitoring in Annual Governance Decisions in Entrepreneurial Firms

This paper analyzes annual corporate governance decisions at firms making initial public offerings (IPOs) of common stock between 1996 and 1999. Our objective is to examine relations between firms' corporate governance decisions and the informativeness of available measures of managerial performance. We consider financial measures such as earnings and stock return, as well as direct monitoring. We collect a sample of IPO firms from the manufacturing, Internet, and technology (non-Internet) industries, and examine how the use of various performance measures in annual compensation grants and turnover decisions varies with the information environment of the firm and with the extent of venture capital influence. Consistent with prior research that finds earnings are of limited usefulness in firm valuation for Internet firms, we find Internet firms place less importance on earnings and greater importance on stock returns in determining compensation grants than do non-Internet firms. We also find that compensation grants of firms with little or no venture capital influence display significantly stronger association with accounting and stock performance measures than those of firms with more intense monitoring by venture capitalists. This result is consistent with direct monitoring and the use of explicit performance measures acting as substitute governance mechanisms.     

Valuation of Internet Stocks—An IPO Perspective

We empirically investigate valuations of Internet firms at various stages of the initial public offering (IPO) from two perspectives. First, we examine the association between the valuation of Internet IPOs and a set of financial and nonfinancial variables, which prior anecdotal or empirical evidence suggests may serve as value drivers. Second, we document differences in IPO valuations between Internet and non-Internet firms as well as across different stages in the IPO process—i.e., initial prospectus price, final offer price, and first trading day price—within each set of firms. Our primary two conclusions are as follows. First, there are noticeable differences between valuations of Internet and non-Internet firms, especially at the prospectus and final IPO stage. Specifically, the valuation of non-Internet firms generally follows the conventional wisdom regarding valuation: positive earnings and cash flows are priced, while negative earnings and negative cash flows are not. The valuation of Internet firms, however, departs from conventional wisdom, with earnings not being priced, and negative cash flows being priced perhaps because they are viewed as investments. This difference between the two classes of firms may be expected, given the age and unique nature of the Internet industry. Second, there are significant differences between the initial valuation of firms at the prospectus and IPO stage and their valuation by the stock market at the end of the first trading day. For non-Internet firms, the difference is largely ascribed to the relative offering size. For Internet firms, however, the differences are with respect to positive cash flows, sales growth, R&D, and high-risk warnings, in addition to the relative offering size.     

Stock Market Valuation of Deferred Tax Assets: Evidence from Internet Firms

Abstract:   We use the provisions of SFAS No. 109 , Accounting for Income Taxes , to examine the extent to which stock prices of Internet firms were associated with expectations of future profitability before versus after the 'market correction' in early 2000. We find that the valuation of deferred tax assets of firms with business models reliant on the level of web site traffic was significantly greater after the market correction. In our view, this evidence is consistent with pre‐correction mispricing.     

Options and the Bubble

Many believe that a bubble existed in Internet stocks in the 1999 to 2000 period, and that short‐sale restrictions prevented rational investors from driving Internet stock prices to reasonable levels. In the presence of such short‐sale constraints, option and stock prices could decouple during a bubble. Using intraday options data from the peak of the Internet bubble, we find almost no evidence that synthetic stock prices diverged from actual stock prices. We also show that the general public could cheaply short synthetically using options. In summary, we find no evidence that short‐sale restrictions affected Internet stock prices.     

An analysis of earnings management by European private firms

This paper addresses the questions of whether private firms in eight European countries engage in earnings management, and if so, whether tax incentives affect such practices. To measure earnings management, we analyze the earnings distributions of private firms and compare these distributions with those of public firms in the same countries. The empirical evidence suggests that in absence of capital market pressures, firms still have incentives to manage earnings, as we find that private firms avoid reporting small losses. We further find that private firms in some countries where tax regulation strongly influences financial accounting do not avoid reporting small losses. We attribute this finding to tax incentives reducing firms’ benefits of (upward) earnings management. Finally, our results suggest that some types of earnings management are due to capital market pressures and are specific to public firms since we do not find evidence that private firms avoid earnings decreases.     

A Temporal Analysis of Earnings Surprises: Profits versus Losses

I show that median earnings surprise has shifted rightward from small negative (miss analyst estimates by a small amount) to zero (meet analyst estimates exactly) to small positive (beat analyst estimates by a small amount) during the 16 years, 1984 to 1999. I show that a rightward temporal shift in median surprise from negative to positive describes earnings, but neither profits nor losses. Median profit surprise shifts within the positive quadrant, from zero to one cent per share. Median loss surprise shifts within the negative quadrant from extreme negative (about -33 cents per share) to zero. I show that the median surprise for profits exceeds that for losses in every year. I document significant positive temporal trends in both meet and beat analyst estimates for both profits and losses, but I find a greater frequency of profits that either meet or beat analyst estimates in every year. I find a significant positive temporal trend in positive profits that are "a little bit of good news," and a significant negative temporal trend in managers who report losses that are an "extreme amount of bad news." My results are robust to the four internal validity threats I consider—namely temporal changes in: (1) analyst forecast accuracy, (2) the mix of earnings of one sign preceded by earnings of another sign four quarters ago, (3) the timeliness of the most recent analyst forecast, and (4) the I/B/E/S definition of actual earnings. I find that managers of growth firms are relatively more likely than managers of value firms to report good news profits. I show that when they do report positive profit surprises, managers of growth firms are more likely to report "a little bit of good news" in every year.     

A Rude Awakening: Internet Shakeout in 2000

This study explores various value-drivers of business-to-consumer (B2C) Internet companies' share prices both before and after the market correction in the spring of 2000. Although many market observers had predicted that the shakeout would eventually occur (e.g., Perkins and Perkins 1999), the ultimate and previously unanswered challenge lay identifying which stocks would fall and which ones would survive the shakeout. We develop an empirical valuation model and provide evidence that the Internet stocks that this model suggests were relatively over-valued prior to the Internet stock market correction experienced relatively larger drops in their price-to-sales ratios when the shakeout occurred. This result is robust to the inclusion of competing explanatory variables suggested by the economics literature related to industry rationalizations.We examine the ability of a valuation model comprised of both financial (accounting) variables and nonfinancial web traffic metrics to explain Internet companies' market values during each of 1999 and 2000. Our findings suggest that the reach and stickiness web traffic performance measures are value-relevant to the share prices of Internet companies in each of 1999 and 2000. Our findings of significance for the year 2000 contradict the recent claims of some analysts that web traffic measures are no longer important. We also explore the valuation role of our proxy for B2C companies' current rate of cash burn and find that this proxy is a significant value-driver in each of 1999 and 2000, but with differential valuation implications for each period. Our results suggest that the market was favorably disposed towards Internet companies' aggressive cash expenditures in 1999, but appeared to adopt a more critical view of Internet companies' cash burn rates in 2000. Our results further suggest that investors adopted a more skeptical attitude towards expenditures on intangible investments as the Internet sector began to mature. We find that investors appear to implicitly capitalize product development (R&D) and advertising expenses (customer acquisition costs) during the earlier period when the market was more optimistic about the prospects of B2C companies. However, only product development costs are implicitly capitalized into value, on average, subsequent to the shakeout in the spring of 2000. Finally, we provide statistical evidence to support the conjecture that different parameter vectors characterize the estimated market valuation models for each of 1999 and 2000. Overall, our study provides a preliminary view of the shakeout and maturation of one of the most important New Economy industries to emerge to date–the Internet.     

Short Interest,Returns, and Unfavorable Fundamental Information

Several months before information becomes public, the level of short interest contains value‐relevant information about publicly traded corporations. Short interest predicts future bad news, negative earnings surprises, and downward revisions in analyst earnings forecasts. This informational content is stronger for stocks that are harder to short. We also find that nearly half of the well‐known cross‐sectional relation between short interest and future stock returns is related to future changes in firms’ value‐relevant information. Our results suggest that short interest predicts future returns, in part, due to short sellers’ ability to uncover unfavorable information about firms.     

Accruals Management to Achieve Earnings Benchmarks: A Comparison of Pre-managed Profit and Loss Firms

Abstract:  This study examines whether firms with profits before accruals management are more likely than firms with losses before accruals management to meet or exceed earnings benchmarks when pre-managed earnings are below those benchmarks. We extend Brown (2001) by documenting that the differential propensity to achieve earnings benchmarks by profitable and nonprofitable firms results from differential accruals management behavior. We find that firms with profits before accruals management are more likely than firms with losses before accruals management to have pre-managed earnings below both analysts' forecasts and prior period earnings and reported earnings above these benchmarks.     

Should earnings thresholds be used as delisting criteria in stock market?

In Chinese stock market, firms reporting two consecutive annual losses are subject to special treatment (ST), with further losses causing the firms’ stocks to be suspended from trading or to be delisted. We argue that these earnings-based delisting requirements are misconstrued. Such policies drive financially healthy firms out of stock market, and induce listed firms to engage in rampant earnings manipulation in order to avoid delisting. The results carry important public policy implications for securities market regulation.     

ON THE INFORMATIONAL EFFECT OF SHORT‐SALES CONSTRAINTS: EVIDENCE FROM THE TOKYO STOCK EXCHANGE

Using a database of stock lending fees for Japanese centralized margin transactions, I show that short‐sales constraints reduce the adjustment speed of stock prices to negative information before the announcements of revised earnings forecasts disclosed by firms in the Tokyo Stock Exchange from July 1998 to December 2001. I find that the cumulative abnormal returns (CARs) of the stocks with high short‐sales costs are insensitive to negative information on pre‐announcement days, but the CARs of these stocks become significantly lower than the CARs of the stocks with low short‐sales costs when the announcements reveal negative information to the public.     

The effect of alternative goals on earnings management studies: An earnings benchmark examination

Firms’ management manages earnings because they have incentives or goals to do so. Earnings management studies have to account for these different goals as tests of earnings management can be compromised by the effect of conflicting goals. I illustrate this in the setting of Dechow et al. (2003). Their study examines whether firms with small profits and firms with small losses (loss-avoidance benchmark) have differing levels of discretionary accruals. Dechow et al. (2003) find that firms just above the loss-avoidance benchmark do not have discretionary accruals that are significantly different than firms just below the benchmark. However, they do not consider firms just below the loss-avoidance benchmark that might be using discretionary accruals to avoid missing an alternative benchmark. I find that after I consider these alternate earnings benchmark goals, firms just above the benchmark have significantly higher discretionary accruals. This provides direct evidence that the ‘kink’ in the distribution of earnings arises from earnings management. I find similar results for the earnings changes benchmark. These findings highlight the need to consider alternative earnings benchmark goals when examining firms immediately around benchmarks.     

A study of firms surrounding the threshold of Sarbanes–Oxley Section 404 Compliance

This study examines whether firms surrounding the Sarbanes–Oxley Section 404 market value compliance threshold behave opportunistically to reduce their market value to avoid compliance with Section 404. We find evidence that those firms reduce their market value temporarily during threshold measurement quarters, whereas control firms experience increasing market value. We find strong evidence of dampened stock returns and some evidence of insider trading as means to reduce the float. Additionally, we find that downward earnings management is used as a mechanism to alter investors’ expectations of firm value in order to temporarily reduce stock prices. We consider this opportunistic evidence of regulatory avoidance. Finally, we find that the likelihood of avoidance increases with the power of the CEO and decreases with the strength of the monitoring of the CEO, which suggest that avoidance is more likely to happen in firms with poor corporate governance mechanisms.     

The Impact of Fundamentals on IPO Valuation

We examine how initial public offering (IPO) valuation has changed over time by focusing on three time periods: 1986-1990, January 1997 to March 2000 (designated as the boom period), and April 2000 to December 2001 (designated as the crash period). Using a sample of 1,655 IPOs, we find that firms with more negative earnings have higher valuations than do firms with less negative earnings and firms with more positive earnings have higher valuations than firms with less positive earnings. Our results suggest that negative earnings are a proxy for growth opportunities for Internet firms and that such growth options are a significant component of IPO firm value.     

Short sales constraints and price adjustments to earnings announcements: Evidence from the Hong Kong market

This study examines how short sales constraints affect the stock price adjustment to the release of public information in the Hong Kong Stock Exchange. Using a unique feature of this market that allows us to directly investigate the impact of short sales restriction, we find the following. First, non-shortable stocks react more strongly to the publication of negative information than shortable stocks do. Second, non-shortable stocks are overpriced before negative earnings announcements. Hence, part of the strong market reaction of non-shortable stocks on announcement day could be due to the correction of such overpricing. Third, the prices of non-shortable stocks reverse following the announcement of negative information, suggesting that investors overreact to negative information on announcement day. Fourth, it takes longer for the prices of non-shortable stocks to adjust to negative earnings information. On the whole, our results support the research that finds short sales restrictions reduce the efficiency of stock markets.     

Managerial Actions, Stock Returns, and Earnings: The Case of Business-to-Business Internet Firms

In this study we investigate the valuation implications of managerial actions undertaken by 57 Internet firms engaged in Business-to-Business (B2B) e-commerce. We classify 3,007 managerial actions undertaken by our sample firms between the firm's IPO date and September 30, 2000 into nine action categories: (1) acquisition of major customers, (2) introduction of new products and services, (3) promotional and marketing actions, (4) actions taken to address the concerns of stakeholders such as employees and the community at large, (5) announcements of technology, marketing, and distribution alliances, (6) completion of acquisitions, (7) expansion into international markets, (8) management team building actions, and (9) organizational changes.
In the short window tests, we find a significant increase in stock price volatility over a three-day event window surrounding the announcement of almost all actions suggesting that announcement of managerial actions provides value-relevant information to the stock market. In the long window tests, we use factor analysis to group the counts of managerial actions taken by each firm over its post-IPO life into two broad managerial initiatives—market penetration and organization building. These two initiatives explain a substantial portion of the cross-sectional variation in the firms' post-IPO life stock market returns beyond that explained by both reported earnings and analysts' forecasts of future earnings and revenues. Thus, investors appear to supplement relatively meager accounting information with data about the cross-sectional intensity of managerial actions in setting stock prices of B2B Internet firms.     

The Extreme Future Stock Returns Following I/B/E/S Earnings Surprises

We investigate the stock returns subsequent to quarterly earnings surprises, where the benchmark for an earnings surprise is the consensus analyst forecast. By defining the surprise relative to an analyst forecast rather than a time‐series model of expected earnings, we document returns subsequent to earnings announcements that are much larger, persist for much longer, and are more heavily concentrated in the long portion of the hedge portfolio than shown in previous studies. We show that our results hold after controlling for risk and previously documented anomalies, and are positive for every quarter between 1988 and 2000. Finally, we explore the financial results and information environment of firms with extreme earnings surprises and find that they tend to be “neglected” stocks with relatively high book‐to‐market ratios, low analyst coverage, and high analyst forecast dispersion. In the three subsequent years, firms with extreme positive earnings surprises tend to have persistent earnings surprises in the same direction, strong growth in cash flows and earnings, and large increases in analyst coverage, relative to firms with extreme negative earnings surprises. We also show that the returns to the earnings surprise strategy are highest in the quartile of firms where transaction costs are highest and institutional investor interest is lowest, consistent with the idea that market inefficiencies are more prevalent when frictions make it difficult for large, sophisticated investors to exploit the inefficiencies.     

SEC product-line reporting and market efficiency

This study tests the efficiency of the securities market with respect to non-public segment earnings data for 1967–1969 which was first made public by many firms in 1970 SEC 10-K reports. Trading rule strategies are proposed in which segment-based earnings forecasts are compared to consolidated-based forecasts to anticipate ‘unexpected’ changes in earnings. Using the ‘market model’ to eliminate market related movements in security prices, average monthly abnormal returns conditional on this segment-based strategy are estimated for 1968, 1969, and 1970 for two groups of firms: (1) ‘Non-disclosure’ firms that did not publicly report either segment revenue or profit data prior to 1970, and (2) ‘partial disclosure’ firms that publicly reported segment revenue information, but no segment profits, prior to 1970.The results suggest that the market was not efficient with respect to the non-public segment revenue and profit data of non-disclosure firms for 1968–1969. However, this finding could not be replicated for 1970. The average monthly abnormal returns conditional on the segment-based trading rule strategy were found to be relatively small for the partial disclosure firms. This suggests that segment revenue data can be used to successfully anticipate changes in total entity earnings which would otherwise be ‘unexpected’ if only consolidated data were available.     

Stock market listing status and real earnings management

This study analyzes real earnings management among privately held versus publicly listed firms. Our first finding is that public firms engage in more earnings management through operating activities. When a clear incentive to manage earnings in a specific direction is present we continue to find that public firms manage their earnings more than private firms. We reason that capital market pressure and ownership characteristics drive our results. Additional analyses reveal that public firms employ more real earnings management as a proportion of the total earnings management strategy. Furthermore, we find that mitigating factors of real earnings management have stronger impact in public firms. This study contributes to literature on non-accrual earnings management and to the broader understanding about the private vis-à-vis public firm reporting and operating behavior. Finally, we contribute by identifying an important societal cost of stock market listing, which is the increase in potentially value-destroying real earnings management.     

Is the Mean Return of Hotel Real Estate Stocks Apt to Overreact to Past Performance?

This study examines the return patterns of hotel real estate stocks in the U.S. during the period from 1990 to 2007.We find that the magnitude and persistence of future mean returns of hotel real estate stocks can be predicted based on past returns, past earnings surprise, trading volume, firm size, and holding period. The empirical evidence found from this paper confirms that short-horizon contrarian profits can be partially explained by the lead-lag effects, while in the intermediate-term price momentum profits and long-term contrarian profits can be partially attributed to the firms’ overreaction to past price changes. Our results support the contrarian/overreaction hypothesis, and they are inconsistent with the Fama-French risk-based hypothesis or the underreaction hypothesis. The study also confirms the earning underreaction hypothesis and finds the high volume stocks tend to earn high momentum profits in the intermediate-term. The study finds that the earning momentum effect for hotel stocks is more short-lived and smaller in magnitude than the market average. Price momentum portfolios (or contrarian portfolios) of big hotel firms underperform small hotel firms and the hotel price momentum portfolio (or contrarian portfolios) significantly underperform the overall market over the intermediate-term (or the long-term). These findings imply that the U.S. hotel industry, particularly the big hotel firms, have experienced relatively conservative growth in the sample period. It suggests that a conservative hotel growth strategy accompanied by an internal-oriented financing policy is proper in a period of prosperity.