Expected EPS and EPS Growth as Determinantsof Value

This paper develops a parsimonious model relating a firm’s price per share to, (i), next year expected earnings per share (or 12 months forward eps), (ii), short-term growth (FY-2 versus FY- l) in eps, (iii), long-term (asymptotic) growth in eps, and, (iv), cost-of-equity capital. The model assumes that the present value of dividends per share (dps) determines price, but it does not restrict how the dps-sequence is expected to evolve. All of these aspects of the model contrast sharply with the standard (Gordon/Williams) text-book approach, which equates the growth rates of expected eps and dps and fixes the growth rate and the payout rate. Though the constant growth model arises as a peculiar special case, the analysis in this paper rests on more general principles, including dividend policy irrelevancy. A second key result inverts the valuation formula to show how one expresses cost-of-capital as a function of the forward eps to price ratio and the two measures of growth in expected eps. This expression generalizes the text-book equation in which cost-of-capital equals the dps-yield plus the growth in expected eps.This revised version was published online in August 2005 with a corrected cover date.     

tay's as good as cay: Reply

In a recent comment on our published work [Lettau, M., Ludvigson, S., 2001. Consumption, aggregate wealth, and expected stock returns. Journal of Finance 56, 815–850], Michael Brennan and Yihong Xia [2005. tay's as good as cay. Finance Research Letters 2, 1–14] advance the following argument: A “mechanistic” variable tay, where t is a linear time trend, forecasts stock returns. Since “t has no foresight,” the argument goes, the predictive power of this variable must be attributable to what they call “look-ahead bias.” The authors assert that cay is subject to the same look-ahead bias (generated because we use the full sample to estimate the cointegrating parameters in cay), implying that its forecasting power must be spurious. In this response, we explain why this critique is misplaced.     

Conditional and Unconditional Conservatism:Concepts and Modeling

We develop a model that captures the distinct natures of and interactions between conditional and unconditional conservatism. Under unconditional conservatism, the book value of net assets is understated due to predetermined aspects of the accounting process. Under conditional conservatism, book value is written down under sufficiently adverse circumstances, but not up under favorable circumstances. The specification of earnings provided by the model yields hypotheses about how unconditional conservatism and other factors preempt conditional conservatism and so affect the asymmetric response of earnings to positive and negative share returns, both current and lagged, documented by Basu (1995, “Conservatism and the Asymmetric Timeliness of Earnings.” Ph.D. dissertation, University of Rochester’ 1997, “The Conservatism Principle and the Asymmetric Timeliness of Earnings.” Journal of Accounting and Economics 24, 3–37).This revised version was published online in August 2005 with a corrected cover date.     

Financialized accounts: Share buy-backs, mark to market and holding the financial line in the S&P 500

In recent years the US corporate sector has deployed more cash from operations to finance the repurchase of outstanding share capital for treasury stock. Shares repurchased for treasury stock can help flatter earnings per share, fund senior management share option compensation schemes and finance corporate acquisitions. In financialized accounts these are now significant transactions which, it is argued, serve the financial interests of managers and investors.The US Financial Accounting Standards Board (FASB) is now demanding a “greater use of fair value measurements in financial statements” with the result that share options and corporate acquisitions will be “marked to market”. This will force a financialized ratchet because managers in the S&P 500 will need step up cash extraction if they are to hold the financial line.     

Information Uncertainty and Expected Returns

This study examines the role of information uncertainty (IU) in predicting cross-sectional stock returns. We define IU in terms of “value ambiguity,” or the precision with which firm value can be estimated by knowledgeable investors at reasonable cost. Using several different proxies for IU, we show that (1) on average, high-IU firms earn lower future returns (the “mean” effect), and (2) price and earnings momentum effects are much stronger among high-IU firms (the “interaction” effect). These findings are consistent with analytical models in which high IU exacerbates investor overconfidence and limits rational arbitrage.This revised version was published online in August 2005 with a corrected cover date.     

A re-examination of the index effect: Gambling on additions to and deletions from the S&P 500's ‘gold seal’

This study examines the abnormal returns, trading activity, volatility and long-term performance of stocks that were added to the S&P 500 index. By using a three-factor pricing model that allows for firm size and value characteristics as well as market risk, we are able to shed new light on the widely observed ‘index effect’. We find that the CAPM tends to overstate the performance of large firms and to understate the performance of small firms. We also find a transitory increase in trading volume between the announcement and a few days after the effective date. In terms of the firm's operating performance, we find a significant increase in earnings per share after inclusion, which combines with the stock price rise to leave the average price-earnings ratio largely unaltered. Examining a unique sample of deletions of international companies and replacements with US companies, we find that deleted stocks experienced a considerable and permanent fall in price, inconsistent with the Investor Recognition Hypothesis. The “seal” of S&P 500 index membership has very long-term effects and inclusion appears not to be an information-free event.     

Who herds?

This paper develops a test for herding in forecasts by professional financial analysts that is robust to (a) correlated information amongst analysts; (b) common unforecasted industry-wide earnings shocks; (c) information arrival over the forecasting cycle; (d) the possibility that the earnings that analysts forecast differ from what the econometrician observes; and (e) systematic optimism or pessimism among analysts. We find that forecasts are biased, but that analysts do not herd. Instead, analysts “anti-herd”: Analysts systematically issue biased contrarian forecasts that overshoot the publicly-available consensus forecast in the direction of their private information.     

Price clustering in foreign exchange spot markets

This paper documents the existence of price clustering in the foreign exchange spot market for the German mark, the Japanese yen, the United Kingdom pound, the French franc, the Italian lira, and the Swedish krona. The U.S. dollar exchange rate indicative quotes for these currencies tend to exhibit clustering around right-most digits that end in either a “zero” or a “five.” The tendency for exchange rates to cluster has increased with increases in trading volume and volatility. Moreover, the tendency for exchange rates to cluster differs across currencies.     

Accounting diversity and firm valuation

We examine accounting numbers and stock prices across three countries: Germany, Norway, and the United Kingdom (UK). The accounting systems in the three countries differ in faithfulness to clean surplus accounting and in conservatism. We address three questions. First, are there systematic differences across countries in the value relevance of accounting? Second, are there systematic differences in the incremental and relative value relevance of book values and earnings per shape (EPS) across the countries? Third, do future earnings realizations (proxies for expected earnings) explain current stock prices? We find that accounting book value and EPS are significantly related to current stock prices across all three countries. German accounting numbers have the lowest relation with stock prices (R² ≈ 40%) and UK accounting numbers the highest (R² ≈ 70%), while Norwegian accounting numbers are in between (R² ≈ 60%). Second, the incremental and relative explanatory power of book value and of EPS differs across time and across countries. Book values explain more than earnings in Germany and Norway, but less in the UK. Finally, future income realization explain little about market prices not already explained by current book value and EPS.     

Discounting earnings with stochastic discount rates

This paper presents new equity valuation formulae in closed form that extend the abnormal earnings growth (AEG) valuation of Ohlson [2005. “On Accounting-Based Valuation Formulae.” Review of Accounting Studies 10: 323–347] to the cases of time-varying or stochastic cost of capital as in Ang and Liu [2004. “How to Discount Cash Flows with Time-Varying Expected Returns.” Journal of Finance 59 (6): 2745–2783] or to cases of stochastic interest rates as in Ang and Liu [2001. “A General Affine Earnings Valuation Model.” Review of Accounting Studies 6: 397–425]. Interest rates are modelled by quadratic term structure models, which are not hindered by restrictions to factors correlation or by other shortcomings of affine term structure models in discounting long-term earnings. This is crucial since valuation can be very sensitive to the correlation between the factors driving earnings and interest rates. Positive correlation reduces price-earnings ratios according to US data. Valuation is also sensitive to the ‘volatility’ of abnormal earnings growth. The residual earnings risk-neutral valuation of Ang and Liu (2001) is adapted to quadratic term structure models.     

Long memory options: LM evidence and simulations

This paper demonstrates the impact of the observed financial market persistence or long term memory on European option valuation by simple simulation. Many empirical researchers have observed the non-Fickian degrees of persistence in the financial markets different from the Fickian neutral independence (i.i.d.) of the returns innovations assumption of Black–Scholes’ geometric Brownian motion assumption. Moreover, Elliott and van der Hoek [Elliott, R.J., van der Hoek, J., 2003. A general fractional white noise theory and applications to finance. Math. Finance 13, 301–330] provide a theoretical framework for incorporating these findings into the Black–Scholes risk-neutral valuation framework. This paper provides the first graphical demonstration why and how such long term memory phenomena change European option values and provides thereby a basis for informed long term memory arbitrage. By using a simple mono-fractal fractional Brownian motion, it is easy to incorporate the various degrees of persistence into the Black–Scholes pricing formula. Long memory options are of considerable importance in corporate remuneration packages, since stock options are written on a company’s own shares for long expiration periods. It makes a significant difference in the valuation when an option is “blue” or when it is “red.” For a proper valuation of such stock options, the degrees of persistence of the companies’ share markets must be precisely measured and properly incorporated in the warrant valuation, otherwise substantial pricing errors may result.     

Valuing customers and loyalty: The rhetoric of customer focus versus the reality of alienation and exclusion of (de valued) customers

The accounting practice of customer valuation ostensibly emerged from the so-called “customer revolution" of the 1980s. Early conceptions centred around notions such as customer focus and providing value to customers, but these ideas have latterly given way to calculation of the financial value of customers to an organisation. Integral to customer valuation are the reconstruction of the customer as an asset (or liability) of the organisation, the segmentation of customers into identifiable groups, and the treatment of customers as dollars rather than people. Whilst rhetoric of “the customer is king" persists, accounting for customer valuation brings its own transformative terminology and has become a means for organisations to selectively focus on particular customers, rather than the customer in general. The paper examines the health insurance and banking industries as exemplars of the affects of customer valuation, and discusses pivotal issues of access, equity, alienation, and social exclusion. Customer valuation is shown to have become a means to increase shareholder income and wealth, almost inevitably at the cost of (further) marginalising the poor and disadvantaged.     

The appraisal of ordinary shares by Saudi investors

This paper reports on a questionnaire survey about share valuation practices among investors and their intermediaries in Saudi Arabia. The findings suggest that fundamental analysis is used most by investor respondents where a P/E multiple is applied to an earnings forecast to generate a prediction of future price. However, technical analysis is also used to a much greater extent than in developed markets. Finally, the results indicate that quarterly and annual reports as well as newspapers are widely consulted by investors when forming their expectations about share valuations.     

A note on accounting conservatism in residual income and abnormal earnings growth equity valuation

The impact of conservative accounting on residual income (RI) and abnormal earnings growth (AEG) valuation models is investigated in this note. Limiting the analyses to information dynamics constrained models (the core models in Ohlson, 1995; Ohlson & Juettner-Nauroth, 2005), we find that both models can handle accounting conservatism if the persistence factors of residual income or abnormal earnings growth fulfil certain conditions. In a comparison of permissible time-series specifications, the AEG model can potentially handle more conservatively biased earnings in the first forecast period than the RI model. However, this requires that the growth of the conservative bias in the second forecast period is not too large. In a 0-NPV competitive equilibrium with a constant steady state growth, both models work equally well. Further elaborations indicate that, in the presence of accounting conservatism a reasonable value of the persistence factor of residual income in the RI model should be in the interval between 1.0 and R (where R = 1 + discount rate), whereas the persistence factor of abnormal earnings growth in the AEG model should be close to 1.0. This implies that the persistence factor in the RI model appears to have been understated while the persistence factor in the AEG model appears to have been overstated in previous empirical research.     

Learning and the monetary policy strategy of the European Central Bank

This paper examines the welfare implications of alternative inflation targeting proposals for the monetary policy of the European Central Bank. We assume that policy makers have to “learn” the laws of motion of inflation in an economy characterized by “stickiness” in domestic price setting behavior and subjected to recurring shocks to productivity, exports and foreign price. We find that a switch from an “asymmetric” inflation targeting strategy to an “symmetric” makes little difference in welfare payoffs, but it comes at a cost of much higher interest-rate variability. We also find that there are practically no welfare gains from switching from an inflation-targeting strategy based on the Harmonized Index of Consumer Prices (HICP) to a strategy based on the domestic price component of the HICP.     

Earnings management and initial public offerings: The case of the depository industry

In a typical IPO, insiders are “net sellers” of IPO shares; however, in a demutualizing thrift, insiders are “net buyers” of IPO shares. Using a sample of mutual depository IPOs, we find evidence consistent with earnings management prior to the conversion of mutual thrifts. We find on average that mutuals report lower ROA and increased loan loss provisions and loan loss reserves in the period prior to the demutualization. Using a two-stage approach, we also find that the level of discretionary loan loss provisions and discretionary reserves are positively related to both the level of insider participation in the IPO and the first-day returns to investors. Our results are consistent with management of mutual thrifts benefiting at the conversion from reduced pre-IPO earnings and book equity resulting from earnings management.     

The two faces of organizational information

Organizational information, i.e. “facts” given and taken, and inferences drawn and established by participants within an organizational situation, may be examined in terms of its import to the relationship between an organization and its environment. A “locus” for organizational information is established in which information is classified as: (a) either inner- or other-directed: (b) either internally- or externally-based; and (c) either self- or other-referencing. Examples of organizational information in each of the eight possible categories are readily identified. Much, if not most, organizational information is probably best regarded as “two-faced”, i.e. as the product of inner- and other-directed needs taken together. For this reason, the basis, or justification of any item of organizational information is often obscure. This is seen to have consequences for organizational self-learning and self-delusion, and for the maintenance of organizational credibility and organizational secrets.     

Under-or-overreaction: Market responses to announcements of earnings surprises

We test whether the well-documented market reaction to the announcements of earnings surprises is a manifestation of an investor underreaction or overreaction to extremely good or bad earnings news. Using the market reaction in the three-day period surrounding the announcements of extreme earnings surprises (i.e., SUE) in quarter Q_t as a reference point, we show that firms reporting a high (low) SUE in subsequent quarter Q_t + 1 that confirms their initial quarter Q_t SUE ranking in the same highest or lowest SUE quintiles generate an incremental price run that moves in the same direction as that of the initial SUE. However, the price impact of the confirming SUE signal is weaker than that of its initial SUE. Our findings are robust to the Fama-French three-factor daily regression extended by the momentum factor and a number of other robustness tests. Our result is not consistent with the prevalent view that investors underreact to earnings news. To the contrary, the evidence suggests an initial investor overreaction to extreme SUE signals.     

Investor protection and price informativeness about future earnings: international evidence

This study draws on the investor protection literature to identify structural factors in a country’s information environment that are likely to explain cross-country differences in the extent to which future earnings information is capitalized in current stock returns. Using a sample of 55,900 firm-years from 32 countries, we find that greater financial disclosure, higher quality earnings, and greater information dissemination through news media are associated with stock prices that are more informative about future earnings, whereas strong enforcement of insider trading laws is associated with stock prices that are less informative about future earnings. We also find that, on average, price informativeness about future earnings is greater in countries with strong investor protection. Our results illuminate the importance of structural factors constituting a country’s information environment in explaining cross-country variation in price informativeness about future earnings.