Post on 20-Dec-2015
Francis & Ibbotson Chapter 24: The Issuer's Earning Power 11
Slides by:
Pamela L. Hall, Western Washington University
Measuring Earning PowerMeasuring Earning Power
Chapter 24
Francis & Ibbotson Chapter 24: The Issuer's Earning Power 22
BackgroundBackground
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
Francis & Ibbotson Chapter 24: The Issuer's Earning Power 33
Informational Content of Cash DividendsInformational 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
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Asymmetric InformationAsymmetric 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
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Reactions to Cash Dividend PaymentsReactions 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
Francis & Ibbotson Chapter 24: The Issuer's Earning Power 66
Reactions to Cash Dividend PaymentsReactions 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
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Reactions to Cash Dividend PaymentsReactions 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
Francis & Ibbotson Chapter 24: The Issuer's Earning Power 88
Forecasting EPSForecasting 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
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Surveys of ForecastsSurveys 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
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Surveys of ForecastsSurveys 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
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Surveys of ForecastsSurveys 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
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Surveys of ForecastsSurveys of Forecasts
First Call’s internet site offers– News– Chat rooms– Insider trading information– Earnings information– Graphs– Financial research
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How Expert Are The Experts?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
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How Expert Are The Experts?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
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Whisper EarningsWhisper 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
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Earnings Surprises and Stock PricesEarnings Surprises and Stock Prices
Latane and Jones developed a model to measure earnings surprise– Standardized Unexpected Earnings
Error gForecastin theofDeviation StandardEPSQuarterly ForecastedEPSQuarterly Actual
SUEi
ti, ti,
ti,
-
• 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
Francis & Ibbotson Chapter 24: The Issuer's Earning Power 1717
Earnings Surprise ExampleEarnings 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
2 $0.50
$2 - $3 SUE tA,
0.5 $2.00
$2 - $3 SUE tB,
Both have SUE > 0 becauseactual EPS exceeded expected, but
investors in A were more pleasantly surprised—because having actual EPS
of $1 above forecasted EPS is moreunusual.
Francis & Ibbotson Chapter 24: The Issuer's Earning Power 1818
Foster-Olsen-Shevlin Event StudyFoster-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)
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Foster-Olsen-Shevlin Event StudyFoster-Olsen-Shevlin Event Study
Suggests that the market correctly anticipates earnings changes prior to announcement and reacts rationally
-5%
+5%
0%
Abn
orm
al R
etur
n
Decile Portfolio Number
1
5
432
6 7 8 9 10
Abnormal Common Stock Returns Surrounding Quarterly Earnings Announcement Dates During –60, 0 Period
When firm experiences +
earnings surprise, stock prices tend to rise prior to
announcement date.
When firm experiences -
earnings surprise, stock prices tend to fall prior to
announcement date.
Francis & Ibbotson Chapter 24: The Issuer's Earning Power 2020
Foster-Olsen-Shevlin Event StudyFoster-Olsen-Shevlin Event Study
Shows that the relationship between earnings surprise and stock prices continues after the announcement
-3%
+3%
0%
Abn
orm
al R
etur
n
Decile Portfolio Number
1
5
432
6 7 8 9 10
Abnormal Common Stock Returns Surrounding Quarterly Earnings Announcement Dates During 1, 60 Period 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.
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Foster-Olsen-Shevlin Event StudyFoster-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
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Ambiguities in Accounting EarningsAmbiguities 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
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Contrasting Income StatementsContrasting Income Statements
Compare the following income statements– Identical except in the accounting procedures
Item Statement B, $ Statement A, $ Key
Sales Revenue $9,200 $11,000 (1)
Less: Returns and allowances -1,000 -1,000
Net sales $8,200 $10,000
Beginning inventory $2,000 $2,000
Purchases and freight in 6,000 6,000
Net purchases 8,000 8,000
Less: Ending inventory -2,000 -3,000 (2)
Cost of goods sold 6,000 5,000
Gross margin 2,200 5,000
Operating expenses
Selling costs 1,500 1,500
Depreciation 500 300 (3)
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Contrasting Income StatementsContrasting Income Statements
Item Statement B, $ Statement A, $ Key
Pension 100 20 (4)
Other expenses 200 50 (5)
Amortization of goodwill 110 30 (6)
Contingent liabilities 90 40 (7)
Salaries 200 200
Bonuses 100 100
Total operating expenses -2,800 -2,240
Net operating expenses (600) 2,760
Less: Interest -100 -100
Income (loss) before taxes (700) 2,660
Less: Federal taxes (33%) (refund) (233) -887
Net income (loss) from operations (467) 1,773
Minimizes taxable income.
True represen-tation of
economic income.
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Contrasting Income StatementsContrasting 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
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Contrasting Income StatementsContrasting 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
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Contrasting Income StatementsContrasting 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)
Accelerated Methods
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Contrasting Income StatementsContrasting 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
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Contrasting Income StatementsContrasting 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
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Contrasting Income StatementsContrasting 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
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Contrasting Income StatementsContrasting 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
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Contrasting Income StatementsContrasting 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
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Contrasting Income StatementsContrasting 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
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Contrasting Income StatementsContrasting 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
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The Quality of EarningsThe 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
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The Quality of EarningsThe 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
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Cash FlowsCash 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
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Statement of Cash FlowsStatement of Cash Flows
Firm’s Activity Cash Inflows Cash Outflows Net Cash Flows
Operating Cash inflows from sales of goods and services
Cash paid for operating goods and services
Cash flow from operations, or CFO
Investing Cash received from sales of property, plant, equipment, and/or other investments
Cash paid for acquisition of property, plant, equipment, and/or other investments
Cash flow from investing
Financing Cash received from issue of debt or capital stock (if relevant)
Cash paid for dividends and reacquisition of debt or capital stock (if relevant)
Cash flow from financing (if relevant)
Other Cash received from foreign exchange transactions, etc. (if relevant)
Cash paid for foreign exchange transactions, etc. (if relevant)
Cash flow from other activities (if relevant)
Total Net change in cash for the period
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Statement of Cash FlowsStatement 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
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Cash Flows Available to Equity ShareholdersCash 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
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Cash Flows to Equity Shareholders Cash Flows to Equity Shareholders vs. Economic Incomevs. 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
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Problems with Cash DividendsProblems 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
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The Bottom LineThe 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
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The Bottom LineThe 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