Information content of credit ratings in pricing of future earnings

This paper examines whether credit ratings convey information about the firm’s future earnings to the capital markets. Using the future earnings response coefficient methodology, we find that the current stock returns of rated firms reflect more future earnings than do the stock returns of non-rated firms. We also find that the market reflect more future earnings in current returns for higher-rated firms. In addition, we present evidence that returns impound future earnings to a greater extent after a ratings initiation or upgrade. We empirically eliminate the possibility that our findings are driven by earnings smoothing, market liquidity or omitted default risk factors associated with ratings. Our results are robust to controlling for potential omitted variables, endogeneity bias, loss versus profit firms, and serial correlation of error terms. Overall, the evidence suggests that credit ratings help disseminate private information to reduce information uncertainty about the firm’s future profitability among market participants.     

Bringing the Future Forward: The Effect of Disclosure on the Returns-Earnings Relation

This paper studies how firm disclosure activity affects the relation between current annual stock returns, contemporaneous annual earnings and future earnings. Our results show that firms with relatively more informative disclosures "bring the future forward" so that current returns reflect more future earnings news. We also find that changes in disclosure activity are positively related to changes in the importance of future earnings news for current returns. These results suggest that a firm's disclosure activity reveals credible, relevant information not in current earnings, and that this information is incorporated into the current stock price.     

Does financial reporting above or below operating income matter to firms and investors? The case of investment income in China

We explore a unique regulatory change in China in 2007 that moves investment income in an income statement from below the line of operating income to above the line. We find that, post-regulatory change, firms report high investment income when core earnings (operating income excluding investment income) are low and vice versa. Investment income and core earnings exhibit a significantly negative correlation every year post regulation, in contrast to a significantly positive correlation beforehand. We also find that investors do not fully see through the change. Before the regulation, both core earnings and investment income are positively correlated with contemporaneous stock returns and uncorrelated with future stock returns, suggesting appropriate pricing of the information. However, afterward, the results on core earnings are similar to those in the pre-regulation period, but investment income is negatively correlated with future stock returns, implying that the stock market overreacts to the information in investment income in the contemporaneous year.     

Earnings quality and the heterogeneous relation between earnings and stock returns

We adopt a heterogeneous regime switching method to examine the informativeness of accounting earnings for stock returns. We identify two distinct time-series regimes in terms of the relation between earnings and returns. In the low volatility regime (typical of bull markets), earnings are moderately informative for stock returns. But in high volatility market conditions (typical of financial crisis), earnings are strongly related to returns. Our evidence suggests that earnings are more informative to investors when uncertainty and risk is high which is consistent with the idea that during market downturns investors rely more on fundamental information about the firm. Next, we identify groups of firms that follow similar regime dynamics. We find that the importance of accounting earnings for returns in each of the market regimes varies across firms: certain firms spend more time in a regime where their earnings are highly relevant to returns, and other firms spend more time in a regime where earnings are moderately relevant to returns. We also show that firms with poorer accrual quality have a greater probability of belonging to the high volatility regime.     

Accounting-based downside risk,cost of capital,and the macroeconomy

We hypothesize that earnings downside risk, capturing the expectation for future downward operating performance, contains distinct information about firm risk and varies with cost of capital in the cross section of firms. Consistent with the validity of the earnings downside risk measure, we find that, relative to low earnings downside risk firms, high earnings downside risk firms experience more negative operating performance over the subsequent period, are more sensitive to downward macroeconomic states, and are more strongly linked to earnings attributes and other risk-related measures from prior research. In line with our prediction, we also find that earnings downside risk explains variation in firms’ cost of capital, and that this link between earnings downside risk and cost of capital is incremental to several earnings attributes, accounting and risk factor betas, return downside risk, default risk, earnings volatility, and firm fundamentals. Overall, this study contributes to accounting research by demonstrating the key valuation and risk assessment roles of earnings downside risk derived from firms’ financial statements, also shedding new light on the link between accounting and the macroeconomy.     

More than words: Can tone of consumer product reviews help predict firms’ fundamentals?

Although financial market participants are increasingly interested in the financial value of unstructured qualitative information regarding the prospects of a firm, empirical evidence remains sparse on the properties of qualitative content in consumer product reviews and their capital market implications. Using a broad sample of consumer reviews posted on Amazon.com, I examine whether the linguistic tone of aggregate consumer product reviews conveys information that is associated with firms’ sales, earnings, stock returns and risk. I find that aggregate review tone successfully predicts a firm's forthcoming quarterly sales. Moderating analyses show that this predictability is stronger for firms operating in a highly competitive environment. I further find that review tone predicts a firm's quarterly earnings surprises, abnormal stock returns and risk. A path analysis shows that the effect of review tone on stock prices is partially channeled through its effect on firms’ earnings. I finally find that negative review tone is more informative and useful than positive tone in predicting a firm's fundamentals. Importantly, these results hold after controlling for other review characteristics, including review rating, review volumeand review dispersion. Overall, my findings highlight the importance of considering the tone of consumer reviews when evaluating a firm's prospects and value.     

Share pledges,tone of earnings communication conferences,and market reaction: evidence from China

We investigate how share pledging affects firms’ disclosures and influences investors in Chinese stock market. The tone of firm disclosures when there are shares pledged by controlling shareholders is more positive than that of firms without them. Considering tone inflation motivation and ability simultaneously, we find share pledge risk has an inverted U‐shaped relation with tone. Investors react positively to tone in short‐run windows, and firms with controlling shareholders’ pledges have higher stock returns for earnings communication conferences. We identify an inverted U‐shaped link between margin distance of controlling shareholders and stock returns for earnings communication conferences.     

Impact of Earnings,Dividends and Cash Flows on Stock Returns: Case of Taiwan's Stock Market

The study uses Taiwan's stock market, a newly developed market with different characteristics from that of the U.S., as an experimental case to examine the influences of the market's characteristics on the relationship between stock returns and fundamental accounting information, such as earnings, dividends and cash flows. The testing period is from 1990 to 1994, right after the promulgation of Taiwan's accounting standard for statement of cash flows in 1989.Similar to the findings of U.S. studies, the study shows that earnings data is key information for investors. Unlike the U.S. results, however, both operating income and non-operating income are positively related to stock returns. The usefulness of non-operating income to explain stock returns is due mainly to its recurrent characteristic in Taiwan. The market views non-operating income, mostly from disposal of real-estate and short-term equity investments, as a complementary factor to operating income. It is a possible common phenomenon in a booming economy. Unlike from the results of U.S. studies, Taiwan's stock returns are strongly associated with stock dividends. Cash dividends, however, are relatively less important information to the market. The fast booming economy as well as Taiwan's free tax rate on capital gains are the explanations for the different findings. The results also support McNicholes and Dravid's (1990) and etc. results that stock dividends may act as a signal for favorable future earnings. Examining the association between stock returns and cash flow information, the results indicate that stock returns are positively associated with cash flows from both operating and financing activities. The phenomenon implies that the market appreciates not only the cash inflows from operating activities, but also cash inflows from new issues of bonds or stocks for further expansion. It is consistent to Taiwan's booming economy. The finding also supports Ross (1977) and Leland and Pyles' (1977) signaling hypothesis.The study concludes that the relationships between stock returns and fundamental variables are subject to the market's characteristics. The case of the Taiwan stock market shows that usefulness of accounting information depends upon the different roles of the information in the tested market. The results of the study also indicate that directly applying the U.S. experiences without any adjustment may cause incorrect conclusions for empirical studies.     

Does Greater Firm‐Specific Return Variation Mean More or Less Informed Stock Pricing?

Roll [1988] observes low R² statistics for common asset pricing models due to vigorous firm‐specific return variation not associated with public information. He concludes that this implies “either private information or else occasional frenzy unrelated to concrete information”[p. 56]. We show that firms and industries with lower market model R² statistics exhibit higher association between current returns and future earnings, indicating more information about future earnings in current stock returns. This supports Roll's first interpretation: higher firm‐specific return variation as a fraction of total variation signals more information‐laden stock prices and, therefore, more efficient stock markets.     

Bank Earnings Management and Tail Risk during the Financial Crisis

We show that a pattern of earnings management in bank financial statements has little bearing on downside risk during quiet periods, but seems to have a big impact during a financial crisis. Banks demonstrating more aggressive earnings management prior to 2007 exhibit substantially higher stock market risk once the financial crisis begins as measured by the incidence of large weekly stock price “crashes” as well as by the pattern of full‐year returns. Stock price crashes also predict future deterioration in operating performance. Bank regulators may therefore interpret them as early warning signs of impending problems.     

Market perceptions of discretionary accruals by debt renegotiating firms during economic downturn

This study addresses how a stock market prices earnings components around a sudden and severe economic downturn. In particular, the study examines the market valuation of discretionary accruals for debt renegotiating Malaysian firms during the Asian financial crisis. Our analysis shows that negative discretionary accruals for debt renegotiating firms are associated with higher market values of equity and are not related to the firms' future earnings. These findings are consistent with investors placing a positive value on the probability that negative accruals increase the likelihood that concessions can be extracted from lenders during renegotiation. In contrast, discretionary accruals for a control sample of non-debt renegotiating firms are not significantly associated with stock prices but are positively associated with future earnings.     

Inflation Illusion and Post-Earnings-Announcement Drift

This paper examines the cross‐sectional implications of the inflation illusion hypothesis for the post‐earnings‐announcement drift. The inflation illusion hypothesis suggests that stock market investors fail to incorporate inflation in forecasting future earnings growth rates, and this causes firms whose earnings growths are positively (negatively) related to inflation to be undervalued (overvalued). We argue and show that the sensitivity of earnings growth to inflation varies monotonically across stocks sorted on standardized unexpected earnings (SUE) and, consistent with the inflation illusion hypothesis, show that lagged inflation predicts future earnings growth, abnormal returns, and earnings announcement returns of SUE‐sorted stocks. Interestingly, controlling for the return predictive ability of inflation weakens the ability of lagged SUE to predict future returns of SUE‐sorted stocks.     

The outperformance of family firms: the role of variance in earnings per share and analyst forecast dispersion on the Swiss market

Recent studies provide empirical evidence that family firms are outperforming their non-family counterparts in terms of stock market performance. For the Swiss stock market we find that family firms indeed outperform their non-family counterparts after controlling for firm size and beta. In addition, our data shows that family firms display more stable earnings per share in contrast to their non-family counterparts. Furthermore we find that the variance of earnings per share positively affects analyst forecast dispersion. According to anomaly literature, lower analyst forecast dispersion has been found to induce higher excess return, which our data supports for the Swiss stock market. By linking variance of earnings per share, analyst forecast dispersion and stock performance we provide an insightful explanation for the excess stock market returns of family firms. In addition, our text extends the theory of dispersion effect with an additional empirical element, the variance of earnings per share.      

Do corporations manage earnings to meet/exceed analyst forecasts? Evidence from pension plan assumption changes

A significantly larger number of firms increase the expected rate of return on pension plan assets (ERR) to make their reported earnings meet/exceed analyst forecasts than would be expected by chance. In the short run, the stock market reacts positively to these firms’ earnings announcements, suggesting that investors fail to recognize that earnings benchmarks are achieved through ERR manipulation. In the long run, however, firms that employ this earnings management strategy significantly underperform control firms in both stock returns and operating performance.     

Pension Plan Funding and Stock Market Efficiency

The paper argues that the market significantly overvalues firms with severely underfunded pension plans. These companies earn lower stock returns than firms with healthier pension plans for at least 5 years after the first emergence of the underfunding. The low returns are not explained by risk, price momentum, earnings momentum, or accruals. Further, the evidence suggests that investors do not anticipate the impact of the pension liability on future earnings, and they are surprised when the negative implications of underfunding ultimately materialize. Finally, underfunded firms have poor operating performance, and they earn low returns, although they are value companies.     

Risk,Mispricing, and Value Investing

We evaluate the stock return performance of a modified version of the book-to-market strategy and its implications for market efficiency. If the previously documented superior stock return of the book-to-market strategy represents mispricing, its performance should be improved by excluding fairly valued firms with extreme book-to-market ratios. To attain this, we classify stocks as value or glamour on book-to-market ratios and accounting accruals jointly. This joint classification is likely to exclude stocks with extreme book-to-market ratios due to mismeasured accounting book values reflecting limitations underlying the accounting system. Using both 12-month buy-and-hold returns and earnings announcement returns, our results show that this joint classification generates substantially higher portfolio returns in the post-portfolio-formation year than the book-to-market classification alone with no evidence of increased risk. In addition, this superior stock return performance is more pronounced among firms held primarily by small (unsophisticated) investors and followed less closely by market participants (stock price <$10). Finally, and most importantly, financial analysts are overly optimistic (pessimistic) about earnings of glamour (value) stock, and for a subset of firms identified as overvalued by our strategy, the earnings announcement raw return, as well as abnormal return, is negative. These last results are particularly important because it is hard to envision a model consistent with rational investors holding risky stocks with predictable negative raw returns for a long period of time rather than holding fT-bills and with financial analysts systematically overestimating the earnings of these stocks while underestimating earnings of stocks that outperform the stock market.     

The Pricing of Relative Performance Based Incentives for Executive Compensation

Japanese firms report both parent-only and consolidated financial statements. Because of the unique business environment in Japan, there is a widely held view that parent-only data provides a better means for assessing the value of the entire firm. We find that both parent-only and subsidiary earnings are important in predicting future consolidated earnings. However, while stock prices accurately reflect the persistence of parent-only earnings, the Japanese stock market appears to underestimate the persistence of subsidiary earnings, causing a significant positive relation between changes in subsidiary earnings in year t and stock returns in year t +1. This relation between subsidiary earnings and future stock returns does not persist beyond year t 7plus;1. Taking a long (short) position in firms with large, positive (negative) changes in subsidiary earnings results in an average annual abnormal return of 7.06% with positive returns in 12 of the 13 years in the test period.     

Accruals,cash flows,and aggregate stock returns

This paper examines whether the firm-level accrual and cash flow effects extend to the aggregate stock market. In sharp contrast to previous firm-level findings, aggregate accruals is a strong positive time series predictor of aggregate stock returns, and cash flows is a negative predictor. In addition, innovations in accruals are negatively contemporaneously correlated with aggregate returns, and innovations in cash flows are positively correlated with returns. These findings suggest that innovations in accruals and cash flows contain information about changes in discount rates, or that firms manage earnings in response to marketwide undervaluation.     

Future Realized Return,Firm‐specific Risk and the Implied Expected Return

In this paper, I propose a novel approach to derive a firm‐specific measure of expected return. It builds on recent accounting‐based valuation models developed by Clubb (2013) and Ashton and Wang (2013). The measure is intrinsically linked to commonly used financial ratios, including book‐to‐market, (forward) earnings yield, and dividend‐to‐price, as well as growth and past returns. The empirical evidence shows that it is significantly positively associated with future realized stock returns and also significantly correlated with commonly used risk characteristics in a theoretically predictable manner. The results are likely to be of interest to practitioners and managers in making capital allocation decisions and to academics in need of proxies for firms’ discount rates and expected returns.     

Capital market consequences of cultural influences on earnings: The case of cross-listed firms in the U.S. stock market

We examine whether market reactions to earnings announcements vary according to differences in the cultural values of firms' countries of origin in the case of cross-listed firms in the U.S. stock market. To deal with time-varying volatility returns, market reactions are determined using the market model adjusted for GARCH. We also apply the Fama-French three factor model to determine market reactions. Using the dynamic panel generalized method of moments estimator, we analyze 5562 firm-year observations from 30 countries over the period 2000–2014. We find that market reactions to the earnings announcements of cross-listed firms are significantly negatively (positively) associated with firms’ home countries characterized by the culturally- based accounting values of conservatism (optimism) and secrecy (transparency). Overall, the results suggest that the informal institutional influences of culture relating to the financial performance of cross-listed firms are priced by the U.S. stock market.