Corporate Governance and Valuation

8/2/2019 Corporate Governance and Valuation

1/35

Where Corporate Governance and FinancialAnalysts Affect Valuation

Ran R. Barniv

Kent State University, Department of Accounting, Graduate School of Management, Kent,OH 44242, USAe-mail: [email protected]

Yan Bao

Department of Accounting, Frostburg State University, College of Business, Frostburg,MD 21532, USA

Abstract

We examine whether corporate governance and financial analysts affect accounting-based

valuation models for B and H shares traded by foreign investors in China and Hong Kong,

respectively. We expect that better corporate governance and more effective analyst activity

mitigate potential adverse effects on accounting valuation models generated by country-

specific problems in accounting, auditing, and legal systems. We find that valuation models

perform better for companies with a greater analyst following, smaller forecast errors,relatively high public ownership and a strong board structure. Valuation models and

accounting numbers have only limited explanatory power and valuation role for companieswith weak governance and less effective analyst performance. The findings are robust across

various market value, return, unexpected return, and other accounting valuation models.

The results are consistent with less informed foreign investor clienteles searching for signals

of more effective analyst activity and better corporate governance mechanisms.

1. Introduction

In the United States recent literature suggests that corporate govern-

ance has a limited ability to explain firm value and studies find thatanalyst forecasts are useful for valuation. To examine these issues, we

evaluate the valuation role of accounting numbers under very parti-

cular circumstances: whether corporate governance and financial

analyst activities affect valuation models for Chinese shares traded

by foreign investors in China and Hong Kong.1 We expect that valuation

The authors thank Frederick Choi (the editor), an anonymous reviewer, Qi Chen (Duke) and inputsof participants in the annual and midyear meetings of the American Accounting Association. Data are

obtained from Thomson Financial IBES International Inc. and public sources identified in thepaper. The authors gratefully acknowledge the support of the Division of Research & GraduateStudies at Kent State University and the National Natural Science Foundation of China (Research

Journal of International Financial Management and Accounting 20:3 2009
mailto:[email protected]:[email protected]


2/35

models perform better for firms (1) with better corporate governance

characteristics and (2) that are followed by more financial analysts who

provide relatively accurate forecasts. Our empirical results support these

research expectations.Three types of shares have been traded during our research period in

China: A shares, traded only by local investors before changes in investor

rights in 2003; B shares, were available only to foreign investors between

January 1993 and March 2001; and H shares, traded by foreign investors

primarily on the Stock Exchange of Hong Kong (SEHK) since 1992.2

Prior studies suggest that domestic investors were better informed than

foreign investors and that information asymmetry played a significant

role in the pricing of A and B shares (Chakravatry et al., 1998; Zhang

and Zhao, 2004; Chan et al., 2008). The literature characterizes China as

an emerging equity market with relatively poor-quality accounting and

auditing systems (Ball et al., 2000; DeFond et al., 2000). Overall

corporate governance mechanisms in China appear to be relatively

fragile (Jen et al., 2001; Schipani and Liu, 2002; Gao and Tse, 2004).

The country rank for corporate governance and transparency is lower

than most other countries (Bushee, 2004; Khanna et al., 2004).

Our study is part of a growing domestic and international literature

that examines the impact of corporate governance on valuation. Gen-erally, these studies regress returns or such valuation measures as Tobins

Q on corporate governance characteristics. In the United States, Cremers

and Nair (2005) and Core et al. (2006) find that weak governance does

not cause poor stock performance.3 Around the world, Doidge et al.

(2004) examine the impact of corporate governance and transparency on

valuation and Leuz et al. (2005) show that foreigners invest significantly

less in firms that are poorly governed. Other studies suggest that only a

few board characteristics affect market-to-book values (Bai et al., 2004)and returns (Firth et al., 2003) for A-share companies in China.

We extend the research on the impact of corporate governance on

valuation in three ways. First, given the relatively weak accounting, legal,

and regulatory systems in China (Ball et al., 2000; DeFond et al., 2000;

Chen and Yuan, 2004), we examine whether improving corporate govern-

ance across firms increases the explanatory power of accounting-based

valuation models. Our study examines whether the models perform better

for companies with stronger corporate governance characteristics and workpoorly for companies with weaker corporate governance. Second, we

examine the impact of corporate governance on valuation models for

Where Corporate Governance and Financial Analysts Affect Valuation 241


3/35

the performance of the alternative models, particularly within companies

with better and then worse corporate governance.

We explore the role of financial analysts in China, particularly their

impact on valuation models. Our paper should be viewed as complemen-tary to Lang et al. (2004) who show that increasing analyst coverage is

associated with higher valuation for companies in 27 countries. Financial

analysts have followed primarily B-share or H-share companies in China,

they have strong incentives to be active and to provide accurate forecasts

because less informed foreign investor clienteles in B and H shares need

additional information. Finally, our study also complements recent studies

that compare the value relevance of book value of equity and historical

earnings for A versus B shares in China (e.g., Lin and Chen, 2005).

We use analysts for two reasons. First, because of the special demand

by foreign investors, we expect valuation models to perform better for

companies followed by more analysts and those providing more accurate

forecasts than for companies with less analyst coverage and for firms for

which forecasts are less accurate. These associations may affect valuation

models despite Chinas relatively low ranking for analyst coverage and

forecast accuracy compared with many other countries (Lang et al., 2003,

Table 1). Second, we assume that using analyst forecasts in valuation

models for Chinese firms would mitigate the potential adverse effectsgenerated by country-specific problems with the quality of accounting

and auditing systems.

Our empirical results show that increasing public ownership and

improved board structure and other proxies for corporate governance

increase the explanatory power of valuation models for investors in H

shares and B shares. We show that greater analyst coverage and more

accurate forecasts increase the explanatory power of the models and the

valuation role of accounting and forecasted numbers across B-share andH-share firms, while we report less explanatory power and valuation role

for companies with weaker corporate governance and poorer analyst

coverage and forecasts. Our results are robust across market value,

return, unexpected return, market-to-book value, and other accounting-

based valuation models.

Our brief review of the Chinese capital markets and the quality of

accounting systems in Section 2, includes a review of prior literature and

incremental contribution. Section 3 presents the models, research hypotheses,and potential impact of ownership and other corporate governance mechan-

ism and financial analysts on valuation models and Section 4 describes the

242 Ran R. Barniv and Yan Bao


4/35

2. The Chinese Equity Markets and Accounting Systems

2.1 Research on the Chinese Security Markets and AccountingStandards

H-share companies are traded mostly on the Stock Exchange of Hong

Kong (SEHK). A shares and B shares are traded on the Shanghai Stock

Exchange (SSE) and on the Shenzhen Stock Exchange (SZSE) (Abdel-

khalik et al., 1999; Chen et al., 2001; Sami and Zhou, 2004).4 We examine

research periods without changes in investor rights. Selecting these

periods reduces potential noise and confounded effects following changes

in investor rights in 2001 and 2003. H shares have been traded by foreign

investors without changes in investor rights during our entire research

period 19932007. B shares were traded only by foreign investors from

1993 though March 2001.5

Companies listed on the SEHK prepare financial statements using

the Hong Kong Society of Accountants Standards or the IAS (Fergu-

son et al., 2002). H-share companies in our sample provide financial

statements for foreign investors based on International Accounting

Standards (IAS). While subject to China Securities Regulation Com-

mission (CSRC) regulation, B-share firms base their financial state-

ments for foreign investors on IAS. A-share companies (were tradedonly by local investors and are not included in our sample) base their

financial statements on domestic accounting standards and follow

CSRC regulatory requirements.6 About 43 per cent of H-share compa-

nies and 77 per cent of B-share companies issue dual shares (H and A,

or B and A). Companies listing dual shares must report financial

statements using two sets of accounting standards; that is, domestic

GAAP and IAS for B shares and domestic-GAAP and HK GAAP or

IAS for H shares (Bao and Chow, 1999; Ferguson et al., 2002; Zhangand Zhao, 2004).

Some prior studies find the historical book value of equity or earnings

or both to be value relevant (Chen et al., 2002; Chen and Wang, 2004).

Others find marginal or mixed evidence (Abdel-khalik et al., 1999; Haw

et al., 2000). Several studies compare the value relevance of historical

earnings and book value of equity based on local- GAAP versus those

based on IAS for companies issuing A and B shares. Researchers find

that the IAS numbers have grater value relevance than the domestic

GAAP (Bao and Chow, 1999; Sami and Zhou, 2004), other show the

opposite results (Lin and Chen 2005) or mixed results (Abdel khalik



5/35

address valuation role of historical accounting numbers in China, to our

knowledge, researchers have not addressed either the role of financial

analysts or corporate governance on valuation models across Chinese

firms.

2.2 The Quality of Accounting Systems

Prior studies tend to express skepticism about the quality of accounting

information in China (Aharony et al., 2000; Chen et al., 2001). Ball et al.

(2000) suggest that private communication rather than financial state-

ment transparency provides at least some useful information, and issuer

incentives more than formal accounting standards per se determine thequality of financial statements in China. DeFond et al. (2000) note

some improvement in auditor independence following the adoption of

new auditing standards in China. A decline in market share of larger

auditors, suggests, however, that government regulation is insufficient

because of the absence of incentives and reduced demand for indepen-

dent auditors.7 Overall, prior research indicates that weaker demands

mean less incentive for managers and auditors to provide high-quality

transparency and disclosure of financial information, and to assure audit

independence.

3. Research Design and Hypotheses

We assume that the less informed foreign investors will demand

information primarily from companies with stronger corporate govern-

ance and this would increase the performance of valuation models and

the valuation role of the historical and forecasted numbers of these firms.We posit that these investors have special needs for additional informa-

tion. In response analysts would have greater incentives to exert more

effort and provide more coverage for some companies. These major

issues are tested in the second and third hypotheses.

3.1 Implementing Valuation Models

We hypothesize that effective corporate governance and financial analystefforts would improve the performance of valuation models, even though

some of these attributes appear to be somewhat weak in China We also



6/35


7/35

3.2 Corporate Governance

Allen et al. (2005) show that neither the legal systems nor the financial

system are well developed in China. With arguably poorer applicablelegal and financial mechanisms, the private sector grows much faster

than other sectors suggesting that alternative financing channels and

governance mechanisms, such as those based on reputation and relation-

ships support this growth. Other prior studies viewed the corporate

governance mechanism in China as relatively vulnerable, with weak

investor protection laws including inadequate protection of minority

shareholders, majority government ownership, general absence of in-

dependent directors and audit committees, insufficient competition in the

product and managerial labor markets, and limited internal operational

strategies such as management incentive plans (Jen et al., 2001; Schipani

and Liu, 2002; Bai et al., 2004).11 In contrast, Lu et al. (2009) show that

Chinese companies have been making recent progress in corporate

governance reform. We use only two corporate governance issues,

namely investor ownership and executive and board structure variables

to examine the impact of corporate governance constructs on valuation

models. We do not examine additional corporate governance constructs

(Li et al., 2001; Lins et al., 2001) that may affect valuation modelsbecause most data were unavailable.

Corporate governance mechanism and ownership structure in China

are unique and weak in several ways. First, only 35 per cent of stock

traded was owned by the public (individuals and institutional investors);

the state and other legal entities (nontrading shareholdings affiliated with

the state or regional governments) owned the rest (Jen et al., 2001; Gao

and Tse, 2004). In many countries, insiders include both managers and

controlling shareholders, but in China they consist primarily of the stateand other legal entities, so the public investors who hold minority

interests clearly face the risk of expropriation. While in the United

States, blockholders have incentives to monitor firms and prior studies

document a positive relation between blockholder ownership and firm

performance, elsewhere foreign governments may have different incen-

tives to monitor corporations (Shleifer and Vishny, 1986; McConnell and

Servaes, 1990; Shleifer and Vishny, 1994; Lins, 2003). Sun and Tong

(2003) show that legal-person (state) ownership has positive (negative)impact on profitability, and Wei et al. (2005) find a U shape association

between state and legal person ownership and firm value in China Firth



8/35

and exacerbates agency problem. He et al. (2008) examine the relation-

ship between ownership structure and private benefits of control in

Chinese listed firms. They show a significant positive (insignificant)

relationship between the controlling shareholders (tradable share value)and private benefits of control. We expect that greater public ownership

increases the valuation role of earnings and forecasted earnings and less

public ownership reduces it.

Second, state and legal-person entities select the oversight boards and

are overrepresented on those boards. Independent directors, representing

individual investors, represent less than one per cent of the directors in a

sample of companies (Jen et al., 2001). Managers are appointed by

bureaucrats who base their selections on personal connections rather

than merit managers, an effective way for the bureaucrats to extract

economic rents, and managers account on average for about 50 per cent

of board seats. There is little incentive and limited expertise to monitor

managers closely. Many managers and directors are government officials;

their compensation is their government salary, and they receive no

compensation from their companies. These arrangements limit the

incentive for managers to work conscientiously and maximize the value

of their companies (Xu and Wang, 1999; Jen et al., 2001).

In the United States, outside directors resolve agency problemsthrough monitoring management behavior and design of incentive

contracts (Tirole, 2001) and empirical evidence suggests that they tend

to act in the interests of shareholders (Hermalin and Weisbach, 1998).

Jensen (1993) suggests that larger boards are less effective than small

boards, and Yermack (1996), Eisenberg et al. (1998) and Vefeas (2000)

provide evidence in support of this expectation. Few studies find that

most variables representing board characteristics do not affect market-to-

book (MTB), Tobins Q ratios, and the return-earnings relation in China(Firth et al., 2003; Bai et al, 2004). Prior studies provide evidence that

good corporate governance practices are consistent with value maximiza-

tion in Hong Kong (Song and Lei, 2005; Connelly et al., 2007).12

Overall, we examine the impact of only two governance structures:

ownership and board-executive attributes. We hypothesize that variation

in ownership and board structure have a significant impact on our

valuation models, and we expect the valuation models to perform better

for firms with higher public ownership, greater shareholding by the topexecutives, smaller boards, higher proportions of outside directors and

non paid directors and an absence of CEO chair duality Our second



9/35

H2 : Valuation models perform better for companies with higher public

ownership and stronger other corporate governance factors than for

companies with lower public ownership and weaker corporate

governance.

3.3 The Role of Financial Analysts

Despite the lower quality of accounting and auditing systems, because

presence of foreign investor generates a high demand for information, we

assume that such a demand will motivate financial analysts to exert more

efforts. Analysts become more informative when investors can derive

greater benefits from their private information (Frankel et al., 2006).

Financial analysts have provided forecasts for H and B shares in

China since 1993. By the end of 2000, more than 300 analysts were

forecasting at least one-year-ahead earnings for 127 H- and B-share

companies. While a substantial number of analysts followed many

companies, analyst coverage in general was lower than that reported in

most other countries, and our reported forecast errors were comparable

to those reported in Hong Kong (for local listed companies), Singapore,

and other countries (Basu et al., 1998; Hope, 2003). Lang et al. (2003)

report lower ranking for analyst coverage and forecast accuracy in Chinathan in most other countries.

As the China CSRC permitted foreign investors to trade only in the

B and H shares, financial analysts base their earnings forecasts on IAS.

The lack of investor expertise and the particular Chinese circumstances

presumably affect foreign investor demand for additional information

and could also affect analysts forecasting activities. Financial analysts

follow only handful of A shares, but following implementation of the

Qualified Foreign Institutional Investor (QFII) program in 2003, ana-lysts initiated earnings forecasts for 73 A-share firms not followed before

the QFII. Thus, financial analysts responded to the new demands for

information by foreign investors and initiated immediate coverage for

A-share firms.13

Lang et al. (2003) suggest that more analyst coverage and more

accurate forecasts indicate a firm with a better information environment.

Uninformed foreign investors are more likely to invest in firms followed

by more analysts and firms with greater analyst activity because of thespecial demand by a foreign investor base. We therefore use absolute fore-

cast errors and the number of analysts following a firm to examine the



10/35

smaller forecast errors and increasing analyst coverage would affect the

performance of valuation models across companies. Our third research

hypothesis is

H3 : Valuation models perform better for companies with more effective

analyst activities than for companies with less effective analyst activities.

We use OLS regressions and panel GLS regressions to test the

hypotheses. First, our study presents tests for relative explanatory power

and for incremental valuation role of the independent variables across

the three valuation models. Next, we test our two major hypotheses by

separating each regression into two categories that represent high or low

public ownership, other weaker or stronger corporate governancecharacteristics, and analyst variables using the medians of public own-

ership, board structure, and analyst characteristics as the cutoff points.

Finally, we also use standardized market value per share regressions,

market value of equity and MTB regressions, and earnings-return

regressions to reexamine the impact of corporate governance and

financial analyst activity on valuation models.

4. Data and descriptive statistics

4.1 Data and Sample

We obtain most of our data from the Institutional Brokers Estimate

System (IBES) for the period between 1993 and 2007. While our sample

of H-share companies provides the accounting information for fiscal

year-ends between December 1993 and December 2006, analyst forecasts

range from January 1993 through May 2007. For the B shares, we

confine our analysis to the 19932000 fiscal years because our studyfocuses on valuation models only for foreign investors, and after March

of 2001 domestic investors could invest in B-share companies.14

We pool our data into two groups (H shares and B shares) to reflect

differences in the security markets, accounting standards, and regulatory

disclosure requirements.15 To facilitate an empirical examination and

comparison of the three valuation models, we use constant samples

across models. A company is included in our final sample if we could

obtain market values, EPS, 1- and 2-years-ahead earnings forecasts,number of analysts following, and dividends from IBES for a specific

fiscal year We obtain book value of equity and number of outstanding



11/35

shares, we obtain ownership, corporate governance information, and

additional book value of equity data from sources identified in our

acknowledgment.

Our final sample consists of 103 H-share companies with 530 firm-year observations and 89 B-share companies firms with 408 firm-year

observations for the MV models.16 For the return models presented in

the additional analyses section, the final sample with complete data for

all regression models includes 385 (233) H-share (B-share) firm-year

observations.

4.2 Descriptive Statistics

Table 1 reports the pooled statistics for the MV models and ownership,

board structure, and analyst activities. Panel A of Table 1 presents the

statistics for the H shares. The mean MVis twofold greater than the BV,

but the medians MVand BVare comparable, with a price-to-book (MV/

BV) ratio of 1.06. Most of the sample firms were profitable (about than

87 per cent of the firm-year observations). The mean of AERTERM is

0.44, five times greater than the mean for AER, indicating that the two-

year-ahead abnormal earnings may provide investors with only partial

information and that terminal values have a potentially incrementalvaluation role for H-share companies. The mean (median) of PUBOWN

is 42.4 (38.7) per cent and public investors have a majority ownership in

about 24 per cent of the H-share companies. The means (medians)

BOARDSIZE, absolute forecast errors (AFE), and the number of

analysts following (NUM) are 11.1 (11), 0.804 (0.206), and 10.8 (10),

respectively.17

Panel B presents the statistics for the B shares. The MVmedian, 2.09,

is lower than the BV median, 2.78, generating a lower average price-to-book (MV/BV) ratio than in the United States and other developed stock

markets. One possible reason for this finding is the thin market liquidity

and trading volume of the B shares that sold at a discount relative to the

A shares (Chan et al., 2008). Overall, most of the sample firms were

profitable (more than 85 per cent of the firm-year observations). The

median of AERTERM is 0.60, 10 times than the median for AER,

indicating that the 2-year-ahead abnormal earnings may provide inves-

tors with only partial information and that terminal values have apotentially incremental valuation role for B-share companies. The

mean (median) percentage of shares owned by public investors (institu



12/35


Table 1. Descriptive Statistics

Q1 Mean Median Q3

Panel A: H Shares (Final Sample, n5 530 firm-year observations)

MV 1.31 5.55 2.55 6.14BV 1.79 2.76 2.41 3.07X 0.07 0.23 0.17 0.30AER 0.16 0.08 0.01 0.21AERTERM 1.09 0.44 0.13 1.31PUBOWN (%) 32.19 42.41 38.71 48.76STATEOWN (%) 44.42 52.32 58.16 65.00EXEHOLD (%) 0.0000 0.0720 0.0000 0.4876BOARDSIZE 9 11.12 11 13NPDIR (%) 0 13.2 0 15.4CRDUAL 0 0.588 1 1

AFE 0.127 0.804 0.206 0.759NUM 3 10.8 10 17Panel B: B Shares (Final Sample, n5 408 firm-year observations)MV 1.34 3.38 2.09 3.97BV 2.19 3.34 2.78 3.92X 0.06 0.20 0.19 0.32AER 0.12 0.11 0.06 0.30AERTERM 1.09 1.22 0.60 2.61PUBOWN (%) 31.60 41.14 38.10 48.77STATEOWN (%) 0.00 35.33 43.33 58.55EXEHOLD (%) 0.0005 0.0229 0.0037 0.0158

BOARDSIZE 7 9.57 9 11NPDIR (%) 45.45 58.60 64.59 77.78CRDUAL 0 0.270 0 1AFE 0.159 1.538 0.452 1.388NUM 2 4.08 3 6

Univariate statistics are reported for samples of firm-year observations for H- and B-sharecompanies. The final sample includes 103 H-share companies for calendar years 19932006 and89 B-share companies for calendar years 19932000. Only earnings forecasts and prices are usedfor 19932007 and 19932001; the financial statement data are for 19932006 and 19932000.The fiscal year-end is December 31 for all Chinese companies. Most data are obtained fromIBES. Some book value of equity data are obtained from the Shanghai, Shenzhen, and Hong

Kong Stock Exchanges. Ownership and corporate governance data are obtained from sourcesidentified in the acknowledgment. H shares in our sample are listed on the Hong Kong StockExchange. B shares are listed on the Shanghai or Shenzhen Stock Exchanges. Q1 and Q2 are thefirst and third quartiles, respectively. Variables are defined as follows:MVis the market value per share for B (H) shares reported for May (June); BVis the book valueper share, common and ordinary equity deflated by common shares outstanding at fiscal year-end; Xis the annual earnings per share (EPS); AER is the abnormal earnings, 1-year and 2-yearahead expected residual income; PUBOWN(%) is the percentage of shares owned by the public(institutional and individual investors); STATEOWN (%) is the percentage of shares owned bythe state (non-traded shares). The remaining other shares are not traded and owned by legalentities often affiliated with the state and by local governments; EXEHOLD (%) is thepercentage of shares owned by the top-10 executives (N/A for H-share firms); BOARDSIZE

is the number of directors on the board (N/A for H-share firms); NPDIR (%) is the percentageof no-pay directors on the board (N/A for H-share firms); CRDUAL is a dummy variable thatequals 1 if the general manger/CEO is also the chair or vice chair of the board and 0 otherwise( /A f h fi ) i h b l f h b l l f ( l


13/35

public ownership (greater than 50 per cent) for only 20 per cent of the

B-share companies. The remaining shares were not traded and were

owned by the state, STATEOWN (mean 35.3 per cent and median 43.3

per cent) or by legal entities (median less than 20 per cent). We alsoreport executive ownership, board statistics, absolute forecast error

scaled by EPS, and number of analysts following.

5. Results

5.1 Comparing the performance of Valuation Models and theValuation Role of Earnings or Abnormal Earnings

Using the pooled cross-sectional samples, Table 2 reports the results for

the three MV OLS regression models in equations (1)(3). We also use


Table 2. OLS Regressions of Market Value on Book Value of Equity andEarnings or Abnormal Earnings

Intercept BV X AER AERTERM Adjusted R2

Panel A: H-share companies (n5 530), 19932007

0.187 0.875 13.043 0.439(0.17) (2.47)n (4.79)nn

0.727 1.801 10.069 0.658 (0.91) (5.84)nn (8.91)nn

2.300 2.634 0.585 0.516 (0.42) (4.00)nn (2.12)n

Panel B: B-share companies (n5 408), 199320011.708 0.212 4.728 0.163

(4.88)nn (2.00)n (5.20)nn

1.405 0.464 3.913 0.242(4.00)nn (4.49)nn (8.27)nn

1.632 0.395 0.350 0.254(4.55)nn (3.69)nn (7.87)nn

Panel C: Waldw2

tests for relative explanatory power

Models (2)Versus (1)



H shares 16.56nn 3.98n 19.03nn

B shares 8.95nn 7.20nn 0.67

See Table 1 for variable definitions.

Only earnings forecasts and prices are obtained for 19932007 and 19932001; financialstatement data are for and 19932007 and 19932000.Whites (1980) t-statistics adjusted for heteroskedasticity are in parentheses.


14/35

(but do not tabulate) an annual indicator variable to control for overall

annual change in MV across our sample period. To facilitate compar-

isons across models, we use a constant sample size for each type of

shares. We then examine the three regressions in order to compare thehistorical model and the RIMs.

To save space, we do not report correlation coefficients for the

independent variables in the models, which are very low for the B shares

and relative moderate for the H shares. Further variance-inflation factors

and other diagnostic tests suggest that multicollinearity and serial

correlations do not affect the regression results reported hereafter.

Panel A of Table 2 presents the results for the H shares. In the first

regression, the historical variables (BV and X) jointly explain 43.9 per

cent of the variation in stock prices, while the RIM (model 2) explains

65.8 per cent. In the third regression, which incorporates AERTERM,

the adjusted R2(adjusted R2) is 51.6 per cent, suggesting that adding the

terminal value does not add incremental information not already

incorporated in AER. There are considerably greater adjusted R2s, for

the H shares than for the B shares. All The independent variables are

significant and positive (as predicted).

Panel B presents the results for the B shares. In the first regression,

BV and X jointly explain 16.3 per cent of the variation in stock prices.The adjusted R2 is 24.2 per cent in the second regression, indicating that

the second forecast-based model has more information content than the

first model.18 The adjusted R2 is 25.4 per cent in the third regression,

suggesting that adding the terminal value adds some incremental

information not already incorporated in AER. The independent variables

are significant and positive (as predicted).

Panel C of Table 2 presents the Wald x2-tests for relative information

content. For the H shares, the explanatory power for the RIM [equation(2)] is significantly greater than for the historical model [equation (1)].

Further, the regression with the term value, AERTERM [equation (3)],

has significantly greater explanatory power than the historical regression

[equation (1)] but significantly smaller explanatory power than the AER

regression [equation (2)]. Overall, these results support our first research

hypothesis. As the results for the B shares suggest the RIMs in the second

and the third regressions [equations (2) and (3)] have significantly greater

explanatory power than the historical model in the first regression[equation (1)].19

The estimated coefficients on X AER and AERTERM are positive (as



15/35

findings in other studies, our results also suggest significant valuation

role of historical earnings and book value of equities for investors in H

shares and B shares. Overall, our study provides evidence that earnings,

unexpected earnings, book value of equity, and abnormal earnings(AER) generated by the RIM explain the variation in market values.

Yet, the intrinsic RIM valuation model, which implements earnings

forecasts representing the role of other information and possibly omitted

variables, has greater information content and AER has incremental

valuation role than a simple model that uses book value of equity and

historical earnings to create value.20 Overall, the results reported in

Table 2 support our first research hypothesis.

5.2 Testing the Effect Impact of Corporate Governance and AnalystActivities

To test our second and third hypotheses, we present separate regressions

using above and below the medians of public ownership, board structure,

and financial analyst activities to differentiate between subsamples of

firms.

We also use panel GLS regression procedures to control for fixed and

random firm-year effects and to mitigate potential cross-correlationproblems arising from using multiple time-series observations for the

same firm in our pooled regressions. Table 3 reports the results of the

panel data regressions. In Panel A, we show that the forecast-based

regressions perform better than the historically based regressions. The

Hausman statistics reject the random effects for the H-share observa-

tions, suggesting fixed-year effects. The estimated coefficients on X, AER,

and AERTERM are positive and significant at po0.01. For the B-share

observations, the Hausman statistics suggest a random year effect for thesecond and third regressions, but the results of the first regression suggest

a fixed year effect. The estimated coefficients on X, AER, and AER-

TERM are positive and significant at po0.01, but the estimated

coefficients on BV are not statistically significant for the first regression.

Taken together, the results reported in Panel A are similar to OLS

findings reported in Table 2.

Panel B examines the impact of ownership on valuation models. The

R

2

s are 0.493, 0.551, and 0.433 for the first, second, and third regressions,respectively, for H-share firms with higher public ownership. In contrast,

for H share firms with lower public ownership the R2s are 0 330 0 357



16/35


le3.PanelGLSRegressionsof

MarketValueonBookV

alueofEquityandEarningsorAbnormalEarningsforAll

mpanie

sandbyOwnership

res

Intercept

BV

X

AER

AERTERM

Ha

usman-

Statistic

Model-

Specification

R2

elA:Allcompanies

2.361

1.757

8.487

57.830

Fixed

0.353

(1.99)n

(8.88)

nn

(7.86)nn

[0.001]

2.352

2.181

10.972

37.320

Fixed

0.511

(2.43)n

(14.74)nn

(15.58)n

n

[0.001]

2.967

2.561

0.160

50.810

Fixed

0.382

(2.31)n

(13.81)nn

(2.30)n

[0.001]

2.869

0.117

3.728

10.545

Fixed

0.351

(1.54)

(1.34)

(7.29)nn

[0.005]

2.699

0.217

2.979

0.390

Random

0.504

(1.56)

(2.97)

nn

(10.24)n

n

[0.823]

2.794

0.205

0.211

2.380

Random

0.452

(1.63)

(2.65)

nn

(9.21)nn

[0.304]

elB:Above/belowthemedianpublicownership

bove

3.295

2.424

5.987

2.25

Random

0.493

(3.14)nn

(8.68)

nn

(5.14)nn

[0.325]

elow

0.735

1.680

3.539

11.05

Fixed

0.330

(0.74)

(7.25)

nn

(3.24)nn

[0.004]

bove

2.774

2.591

5.883

2.29

Random

0.551

(2.82)nn

(11.12)nn

(7.98)n

n

[0.319]

elow

0.052

1.698

3.618

9.31

Fixed

0.357

(0.05)

(8.21)

nn

(4.42)n

n

[0.010]

bove

6.052

3.878

0.347

1.69

Random

0.433

(4.23)nn

(9.42)

nn

(2.11)n

[0.429]

elow

1.039

2.101

0.043

9.23

Fixed

#

0.297

(1.00)

(9.96)

nn

(0.50)

[0.010]


17/35


Table3.(C

ontinued.)

res

Intercept

BV

X

AER

AERTERM

Ha

usman-

Statistic

Model-

Specification

R2

bove

2.761

0.077

6.086

0.56

Random

0.616

(1.54)

(0.62)

(7.68)nn

[0.756]

elow

3.755

0.066

1.294

15.46

Fixed

0.091

(1.81)

(0.44)

(1.94)

[0.001]

bove

2.756

0.142

3.351

0.32

Random

0.733

(1.69)

(1.64)

(10.12)n

n

[0.850]

elow

2.964

0.267

2.774

3.70

Fixed

0.310

(1.49)

(2.01)

n

(4.30)n

n

[0.016]

bove

2.739

0.143

0.260

0.13

Random

0.756

(1.79)

(1.72)

(10.79)nn

[0.936]

elow

3.260

0.205

0.179

5.75

Fixed

#

0.228

(1.61)

(1.49)

(3.47)nn

[0.057]

Table1

forvariabledefinitions.

finalsa

mpleincludes103H-shareand

89B-sharecompanies.Further

detailsandvariabledefinitions

arereportedonTables1and2

.

luesfortheHausmanstatisticareinbrackets,andt-statisticsareinparentheses.

rginally

fixed.

nifican

tatpo.01.

nificant

atpo.05.


18/35

The R2s are 0.616, 0.733, and 0.756 for the first, second, and third

regressions, respectively, for B-share firm-year observations with higher

public ownership. They are considerably lower for observations with

PUBOWN below the median, 0.091, 0.310, and 0.228, respectively. Forabove the median PUBOWN, the estimated coefficients on AER and

AERTERM are positive and significant for the H-shares firms and B-

share firms. For B-share firms, the estimated coefficients on BV and all

coefficients for model (1) for below the median public ownership are not

statistically significant. Finally, for the median PUBOWN, the estimated

coefficient on AERTERM is not significant for the H-shares firms.

Overall, the results reported in Table 3 suggest that increasing PUBOWN

enhances the performance of valuation models and support our first and

second research hypotheses.

To save space, Table 4 reports only the explanatory powers for the

valuation models by categories of board structure and financial analyst

activity. Results for the above and below the median of board structure

characteristics appear in Panels A through D. We show greater explana-

tory power of valuation models for companies with higher shareholding

by top executives EXEHOLD), smaller board size (BOARDSIZE), a

greater percentage of non-paid directors (NPDIR), and CEOs who do

not hold dual chair positions (CRDUAL).Panels E and F report the results for the effect of analyst activity on

valuation models. The adjusted R2s for H-share firms with lower

absolute forecast errors are 0.605, 0.690, and 0.572 for the first, second,

and third regressions, respectively and 0.207, 0.255, and 0.306 for

companies with higher absolute forecast errors. For B-share firms, the

adjusted R2s for companies with lower absolute forecast errors are 0.329,

0.390, and 0.395 for the first, second, and third regressions, respectively,

but only 0.024, 0.094, and 0.072 for companies with higher absoluteforecast errors. These findings suggest that valuation models perform

well for companies for which analysts provide more accurate forecasts

and relatively poorly for firms for which forecast errors are higher. Next,

we report that valuation models perform better for companies with

greater number of analysts following a firm than for companies with

fewer analysts.

Overall, our findings support the second and third hypotheses. The

results reported in Table 3 and the untabulated estimated coefficients forTable 4 regressions indicate that better analyst activity and corporate

governance improve the explanatory power and the valuation role of



19/35

companies traded by foreign investors in Hong Kong and China. These

findings are obtained despite somewhat weak accounting, auditing, and

legal systems, and relatively vulnerable corporate governance documen-

ted in prior research, but we assume that investor demand has stronger

effect on valuation than these issues. Financial analysts of Chinesecompanies appear to perform much like analysts in other emerging

capital markets and we conclude that they are probably a major source


Table 4. Adjusted R2s by Board Structure and Financial Analysts Categories

Shares Category

FirstRegression

(Equation 1)Adjusted R2

SecondRegression


ThirdRegression


Panel A: Percentage of shares owned by top ten executives (EXEHOLD)H Above the median 0.576 0.713 0.697

Below the median 0.105 0.212 0.250B Above the median 0.281 0.279 0.297

Below the median 0.047 0.088 0.115Panel B: Number of directors on board (BOARDSIZE)H Below the median 0.560 0.670 0.582

Above the median 0.249 0.447 0.410B Below the median 0.218 0.333 0.392

Above the median 0.121 0.123 0.136Panel C: Percentage of no-pay directors on board (NPDIR)H Above the median 0.526 0.694 0.532


Below the median 0.053 0.096 0.113Panel D: A dummy variable equals 1 if general manager or CEO is also chair or vice chair(CRDUAL)H CRDUAL5 0 0.483 0.685 0.603

CRDUAL5 1 0.230 0.384 0.361B CRDUAL5 0 0.251 0.265 0.281

CRDUAL5

1 0.115 0.172 0.188Panel E: Absolute forecast errors (AFE)H Below the median 0.605 0.690 0.572

Above the median 0.207 0.255 0.306B Below the median 0.329 0.390 0.395

Above the median 0.024 0.094 0.072Panel F: Number of analysts following a firm (NUM)H Above the median 0.491 0.688 0.558


Below the median 0.094 0.166 0.169

See Table 1 for variable definitions.Because of some missing data for EXEHOLD and NPDIR, the final H-share (B-share) samplein panels A and C includes only 483 (208) firm-year observations.


20/35

forecast errors and higher analyst following enhance the performance of

valuation models, which suggests that accounting information and

analyst forecasts are useful primarily for companies with strong analyst

performance. A reader can interpret these results as consistent with aspecific demand among less informed foreign investors for effective

analyst activity.

6. Additional Tests and Sensitivity Analyses

6.1 Market Value of Equity and Market-to-Book Value Regressions

Since the historical regressions tend to provide weaker results and to

alleviate potential scale factor effects in MV models, we examine twopartial additional empirical models suggested in the literature (Core

et al., 2003):

MVEit b0 b1BVEit b2NIit b3NEGNIit eit 4

MVE=BVEit b0 b11=BVEit b2NI=BVEit b3NEGNI=BVEit eit 5

where MVE is the market value of equity, BVE is the book value ofequity, NI is net income before any extraordinary items, and NEGNI

equals the income before extraordinary items if NI 0 and 0 otherwise;all variables in equation (5) are deflated by the BVE.

Table 5 reports the results for the pooled regression models. Panel A

presents the results for all the H-share and B-share companies. The

market value models perform well and have very high explanatory power

for the H-share companies and high explanatory power for the B-share

companies. Overall, these results suggest that the book value of equityand earnings are value relevant for foreign investors in Chinese compa-

nies. Panel B shows the results for H-share and B-share companies with

higher versus lower public ownership, and Panels C and D present the

results for analyst activity. For both types of shares, the adjusted R2s are

substantially higher for companies with higher public ownership, lower

absolute forecast errors, and more analysts following. For B-share

companies, many estimated coefficients are insignificant for above

(below) the median forecast errors (analyst following). We also examinebut do not tabulate similar results for board structure characteristics.

Overall the results are comparable to those reported for the MV



21/35


le5.OLSRegressionsofMark

etValueorMarkettoBo

okonBookValueofEqu

ityandEarnings

res

Intercept

BV

E

NI

NEGNI

1/BVE

NI/BVE

NEGNI/

BVE

Adjusted

R2

elA:Allcompanies

3.070

E16

0.074

3.517

3.016

0.878

(2.04)n

(2.27)n

(2.81)nn

(1.72)

0.008

3.092

E18

8.010

6.925

0.604

(0.17)

(3.99)nn

(4.80)nn

(3.99)nn

1.612

E18

0.111

8.368

8.632

0.354

(4.12)nn

(1.05)

(4.59)nn

(4.04)nn

0.943

1.662

E17

1.937

2.943

0.473

(8.99)nn

(2.40)n

(2.03)n

(2.50)n

elB:Companiesabove[below]them

edianpublicownership

4.602

E16

0.412nn

4.830nn

8.027nn

0.894

[1.430

E17]n

[0.120]

[2.433]nn

[4.390]n

[0.425]

0.075

3.746

E18nn

10.511nn

9.781nn

0.926

[0.811]

[3.423

E16]n

[4.913]

[4.982]n

[0.208]

5.884

E17

0.393nn

6.117nn

6.590nn

0.399

[2.303

E18]nn

[0.031]

[9.519]nn

[9.825]nn

[0.335]

0.140

1.597

E17n

5.211n

7.702nn

0.593

[1.037]n

[1.85

E16]

[2.301]nn

[3.908]

[0.061]

elC:Absoluteforecasterrorsbelow[

above]themedian

3.210

E18n

0.061n

7.061nn

21.739nn

0.926

[1.400

E18]

[0.138]nn

[4.942]nn

[5.446]n

[0.528]

0.021

2.635

E18n

11.088nn

30.952nn

0.801

[0.052]

[1.986

E18]nn

[3.816]

[8.006]

[0.143]

2.26

E18nn

0.148

11.085n

6.743nn

0.424

[1.884

E17]

[0.946]n

[6.607]

[4.514]

[0.347]

0.843

5.159

E17

4.882n

2.609nn

0.522

[1.033]n

[5.741

E16]

[2.313]

[4.203]

[0.046]


22/35


Table5.(C

ontinued.)

res

Intercept

BV

E

NI

NEGNI

1/BVE

NI/BVE

NEGNI/

BVE

Adjusted

R2

elD:N

umberofanalystsfollowinga

firmabove[below]themedian

7.136

E18n

0.012

6.765nn

13.458nn

0.934

[6.409

E16]

[0.109]nn

[4.815]n

[8.017]nn

[0.608]

0.143

3.005

E18n

9.130nn

23.191nn

0.685

[0.010]nn

[3.183

E18]n

[8.535]nn

[8.423)n

[0.467]

8.195

E17

0.104

11.078nn

19.454nn

0.480

[8.154]

E17

[0.728]nn

[5.018]nn

[3.811]

[0.349]

0.337nn

1.257

E15

7.383nn

11.350nn

0.512

1.243nn

[2.182

E17]

[0.015]

[0.438]

[0.019]

depend

entvariablesareMVE(marketvalueofequity)fortheregressio

nandmarkettobookvalue(MV

E/BV)thesecondregressionsineachpanel.

ablesaredefinedasfollows:

sthebo

okvaluesofequityatfiscalyear-end;NIistheannualearnings;

NEGNIequalsearningsifNIislessthanzero,and0otherwise;

1/BVEisthe

deflatedbyBE;NI/BVEistheNIdefl

atedbyBVE;andNEGNI/BVE

istheNEGNIdeflatedbyBV.

tes(1980)t-statisticsadjustedforheter

oskedasticityarereportedonlyforPanelA(inparentheses).TheyarealsousedbutnotreportedinPanelsB

ughD.

nifican

tatpo.01.

nificant

atpo.05.


23/35

the more efficient the board structure, the greater the forecast accuracy

and analyst coverage, the better the performance of valuation models.

6.2 Return-Earnings Regressions

We examine a simple earnings-return regression and unexpected earn-

ings-unexpected return regressions. The empirical regression for return-

earnings relationship is presented in equation (6), followed by regression

of unexpected returns on unexpected earnings in a preordered regression

[equation (7)] suggested by Liu and Thomas (2000):

Rit b0

b1

EPSit b2

DEPSit eit 6

where Rit is the annual return for firm in period t, EPSit is the earnings

per share, and DEPSit is the change in EPS, both deflated by share price

at the beginning of period t;

URit b0 b1UEit b2RAE2it b3RTERMit eit 7

where URit is the unexpected return for firm i in period t, UEit is the

unexpected earnings (earnings minus earnings forecast) for the period,

and RAE2it and RTERMit are the changes in abnormal earnings and theterminal values.21 All variables are deflated by share price at the

beginning of period t.

Table 6 reports the results for the return model [equation (6)] and the

unexpected return model, presented in equation (7). The return

model has higher explanatory power for annual returns compared with

findings in many other countries. Panel A of Table 6 shows the

three regressions for all B and H shares. The returns-earnings regression

reveals a relatively high explanatory power, particularly for the Bshares, but the estimated coefficient for DEPS is not significant. The

estimated coefficients for unexpected-returns on unexpected-earnings are

statistically significant and positive (as predicted) and the explanatory

powers are 11.5 for H-share companies and 6.9 per cent for B-share

companies.

Panels B, C, and D of Table 6 show the regression results for high and

low degrees of public ownership, higher and lower forecast errors, and

higher and lower analyst coverage. The findings suggest that greaterpublic ownership, more analyst coverage, and lower forecast errors

improve the results of the return models We do not tabulate the results



24/35


Table 6. OLS Regressions of Returns or Unexpected Returns (UR) asDependent Variables

Shares Intercept EPS DEPS UE RAE2 RTERM

Adjusted

R2

Panel A: All firmsH 0.592 1.814 1.582 0.043

(2.38)n (2.35)n (2.81)nn

0.162 2.019 0.216 0.009 0.115(0.88) (1.98)n (3.02)nn (2.35)n

B 0.523 3.845 1.026 0.104(3.40)nn (2.28)n ( 0.50)0.838 2.478 0.143 0.004 0.069

(6.22)nn (2.57)n (2.56)n (2.04)n

Panel B: Companies above [below] median public ownership

H 0.102 8.272nn 0.785n 0.165[0.424]nn [2.009]n [0.014] [0.068]0.250 3.062nn 0.298nn 0.005 0.299

[0.401]nn [2.010]n [0.092] [0.007] [0.010]B 0.179 6.450nn 0.399 0.214

[0.807]nn [3.519]nn [ 0.441] [0.074]0.807nn 3.182nn 0.265nn 0.001 0.203

[0.957]nn [1.929] [0.086] [0.008] [0.016]Panel C: Absolute forecast errors below [above] the medianH 0.081 9.437nn 1.361nn 0.124

[0.764]nn [2.095]n [0.522] [0.031]

0.172 10.973nn

0.191nn

0.006 0.218[0.925]nn [1.009] [0.143] [0.004] [0.003]

B 0.105 8.467nn 1.185n 0.108[0.853]nn [1.305]n [0.181] [0.042]0.869nn 10.156nn 0.165n 0.005 0.117

[0.817]nn [0.833] [0.237] [0.005] [0.001]Panel D: Number of analysts following a firm above [below] the medianH 0.206 10.683nn 1.926nn 0.157

[0.885]nn [2.205]n [ 0.084] [0.039] 0.016 3.634nn 0.297nn 0.002 0.240

[0.947]n [2.459]nn [0.113] [0.014] [0.021]B 0.538nn 9.959nn 1.973nn 0.534

[1.005]nn [2.539]n [ 0.063] [0.041]0.406nn 2.395n 0.235nn 0.001 0.112

[1.229]nn [2.821]nn [0.095] [0.010]n [0.060]

Data for the two returns models are available for 385 (233) firm-year H-share (B-share)observations. Variables are defined as follows:EPSis the annual earnings per share; DEPS is the change in EPS; UR is the unexpected return;UE is the unexpected earnings (earnings minus earnings forecast); RAE2 is the change inabnormal earnings; and RTERM is the change in terminal values. All variables are deflated byshare price at the beginning of the period.Whites (1980) t-statistics adjusted for heteroskedasticity are reported only for Panel A (inparentheses). They are also used but not reported in Panels B through D.nnSignificant at po.01.nSignificant at po.05.


25/35

Overall, the results for the return-earnings models tend to resemble the

MV models, and reinforce our conclusion that stronger corporate

governance, public ownership, and analyst activity enhance the perfor-

mance of valuation models and the valuation role of historical andforecasted accounting numbers.

6.3 Standardized Market Value Regressions and AdditionalProcedures

We deflate the dependent and independent variables by share price at the

beginning of the period to mitigate potential scale effect factors (Easton,

1998; Brown et al., 1999), but Gu (2005) concludes that their effects are

unpredictable and the choice of level versus return models is depends on

researchers belief and the research question. We find that the explana-

tory powers of the untabulated standardized MV regressions tend to be

similar to those reported in Tables 24. Overall, these results support the

previous conclusions that the forecast model provides greater informa-

tion content than the historical model for both H-share and B-share

companies and valuation models perform better for companies with

stronger corporate governance and analyst activities.

We also use panel GLS procedures for the regressions reported inTables 46. The GLS regressions control for fixed and random firm-year

effects and mitigate potential cross-correlation problems arising from

using multiple time-series observations for the same firm in our pooled

analyses. The untabulated results are similar to those reported using the

OLS regressions and our conclusions are unaffected.

6.4 Controlling for Potential Size and Joint Effects

To examine whether size rather than corporate governance and analyst

activity affect our results, we estimate the MV models for larger and

smaller firms according to size measures such as market and book value

of equity. Untabulated results within subsamples of small or large firms

with strong or weak corporate governance and financial analyst char-

acteristics in each group are similar to those reported in Tables 2 through

4. Overall, regression and univariate findings suggest that size has no

material impact on our reported results and conclusions.We examine the MVmodels for firms with both less public ownership

and poorer board structure or analyst activity characteristics versus firms



26/35

activity. While observations in the regressions are only about 65 to 80 per

cent of the complete samples (50 per cent would be expected using

random splits of two joint characteristics for each test), the results (not

tabulated) provide stronger support for our research expectations. Forexample, the adjusted R2s for H-share firms with lower absolute forecast

errors and higher public ownership are 0.652, 0.760, and 0.713 for the

first, second, and third regressions, respectively and only 0.169, 0.195,

and 0.158 for companies with higher absolute forecast errors and lower

public ownership. For B-share firms, the adjusted R2s with lower

absolute forecast errors and higher public ownership are 0.486, 0.581,

and 0.604 for the first, second, and third regressions, respectively, but

only 0.018, 0.058, and 0.061 for companies with higher absolute forecast

errors and lower public ownership. These results strengthen the separate

findings based on above and below the median results reported by

ownership in Table 3 and by absolute forecast earnings in Panels E

and F of Table 4.

6.5 Direct Impact of Corporate Governance and Analyst Activity onValuation

We also examine the overall and incremental impacts of corporategovernance and analyst activity on firm value (results are not tabulated).

For example, we regress MVE/BVE on the right-hand side variables in

equation (5) and add analyst activity and other corporate governance

characteristics as independent variables. Corporate governance and

analyst activity variables tend to be insignificant. This result further

enhances examining valuation models and the valuation role of account-

ing and forecasted numbers for firms with strong or weak corporate

governance and analyst activity (see, e.g., Lang et al., 2004).

7. Conclusions

We examine the impact of corporate governance and financial analysts

on valuation models and the valuation role of historical and forecasted

accounting numbers for shares traded by foreign investors in China.

Examining valuation models and the valuation role of accounting

numbers is an important research issue in many countries including foremerging capital markets (Lang et al., 2003; Bushman et al., 2004;

Khanna et al 2004) Our paper contributes to the corporate governance



27/35

attributes to valuation models. Our major research expectations are that

stronger board structure and analyst activity improve the performance of

valuation models that present the valuation role of historical or fore-

casted accounting numbers.The primary valuation models we examine include book value of

equity and earnings or abnormal earnings generated by the intrinsic

RIM. We assume that greater information content (e.g., higher R2)

means better performance of valuation models (e.g., Bernard, 1995;

Biddle et al., 1995; Collins et al., 1997; Francis and Schipper, 1999). We

partition the sample according to corporate governance and analyst

activity variables, and find valuation models performing better for

subsamples of companies with greater analyst following and smaller

forecast errors as well as for firms with greater public ownership, smaller

boards, higher ownership by executives, more of no-pay directors on the

board, and a CEO distinct from the chair of the board. Our results

suggest that historical and forecasted accounting numbers explain the

variation in market values, returns, and other measures of value for

companies with stronger corporate governance and more effective

analyst activity. These numbers provide only limited valuation role for

companies with weaker corporate governance and less effective analyst

activity.We show that stronger corporate governance and analyst activity

enhances the valuation role of historical and forecasted accounting

numbers of for foreign investors in China and Hong Kong. Better

corporate governance and more effective analyst activity appear to

complement accounting and forecast information necessary to foreign

investors and mitigate the potential negative impact of country-specific

problems in accounting, auditing, and legal systems. Such results are

consistent with research that links corporate governance, transparency,disclosure, and analyst activity to valuation across countries (Lang et al.,

2003, 2004; Doidge et al., 2004; Leuz et al., 2005). Overall, we conclude

that corporate governance and analyst activities matter for valuation

models and the valuation role of historical and forecasted accounting

numbers of B- share companies in China and H-share of Chinese

companies listed in Hong Kong.

A variety of issues that remain unaddressed are ripe for further

research. They include: individual analyst effort; studying investordemand for information; further testing the direct impacts of corporate

governance on the value of the firm for example through regressing



28/35

factors and political forces in China that may affect such results (Sun and

Tong, 2003; Zhang and Zhao, 2004; Allen et al., 2005); using historical

and forecasted accounting numbers for debt and contracting rather than

foreign investors setting prices; and the impact of transparency anddisclosure on valuation.

Notes

1. We use valuation models where the dependent variable is market value of equity or

market-to-book ratio or returns. Our study examines the valuation role of the independent

variables that generally include book value of equity and historical earnings or intrinsic

values (residual income) based on forecasted earnings.

2. The Wall Street Journal, among other business press, has provided details on

investment by foreign investors in B shares in China (November 18, 1999, p. A21; July17, 2001, p. C1; and July 31, 2001, p. A12).

3. Larcker et al. (2005) find that structural indicators of corporate governance have

limited ability to explain firm value beyond the explanatory power of other control

variables and Bebchuk et al. (2004) and Brown and Caylor (2006) find that only small

number of corporate governance factors are associated with firm value.

4. As of December 2000, the market capitalization of the two stock exchanges, the

Shanghai Stock Exchange (SSE) and the Shenzhen Stock Exchange (SZSE), was about

three trillion Yuan (about 365 billon dollars). Sami and Zhou (2004) show that only 223

firms were listed in 1993. The number of listed firms on the Chinese stock exchanges has

increased significantly in recent years reaching 1,160 in December of 2001, when about

1,000 traded companies listed only A shares, 112 companies were listed as B-sharescompanies: 24 with only B shares and 88 with both A and B shares. In December 2001, 60

companies issued H shares of which 25 had both A and H shares. Chen and Yuan (2004)

and Haw et al. (2005) examine the 19961998 China Securities Regulation Commission

(CSRC) regulation of rights issues, which triggered earnings management by some

Chinese firms, and discuss relevant characteristics of the CSRC. Yang et al. (2005) study

the relevance of lower cost or market accounting regulations for investors in China.

5. About two-thirds of all stocks, owned by state or legal entities (shareholdings

affiliated with the state or regional governments), were not tradable (Jen et al., 2001).

Morck et al. (2000) find an 80 per cent Chinese stock return synchronicity (measured by

the fraction of stocks moving together), the second-highest in a large sample of

representative stock markets (compared with 68 per cent in HK but only 58 per cent inthe United States). These trends are accompanied by rather weak investor protection laws

(Allen et al., 2005).

6. The Ministry of Finance promulgates the local accounting standards in China. In

1992, it issued new standards, known as the Accounting Standards for Business

Enterprise, modifying them in 1998 and 2000 (Chen et al., 1999; Firth et al., 2003).

7. Chinese professionals tended to be relatively old, and 480 per cent did not hold

university degrees (Tang, 2000). Most auditing firms were state-owned, but the H and B

companies that issue financial statements based on IAS were audited mostly by interna-

tional firms with auditors generally appear to be independent (Xiao, 1999). Fan and Wong

(2005) suggest that big-five auditors play a corporate governance role in emerging markets

from East Asia.

8. Barniv and Myring (2006) show that the RIMs are more value relevant than



29/35

using analyst earnings forecasts. Financial analysts and earnings forecasts represent the role

of other information and potential omitted variables in the RIM (Frankel and Lee, 1998;

Dechow et al., 1999) and may provide more information to foreign investors in China than

historical earnings. This presumption further enhances the role of financial analysts

responding to particular demands of the less informed foreign investors in China, wherefinancial analysts may use other information not impounded in earnings to provide fore-

casts.

9. We do not examine linear information dynamic models (Feltham and Ohlson, 1995;

Ohlson, 1995; Myers, 1999). Truncated firm-specific persistence parameters are not

reliable and long sequences of past earnings are not available.

10. Our empirical variant of the RIM is stated in Ohlson (1995) with a term value

(Frankel and Lee, 1998; Penman, 1998) for a company i:

MVt BVt X2

t1

EtFXtt rtBVtt1

1 rtt

EFXt3 rtBVt2

1 rt2rt

BVt X2

t1

EtAEtt

1 rtt TERMt BVt AERt TERMt

where FX is the forecasted EPS for a subsequent periods, and rt is the cost of equity

capital at the end of t, assumed to be constant for future periods. Other variables are

defined in the text. For estimating the term value, we use clean surplus and long-term

growth rate predictions (assuming constant current growth for firms missing this

prediction) to calculate future book value of equity and the later for estimating three-

year-ahead earnings forecasts for firms where forecasts are unavailable.

11. Bushman et al. (2004) find that governance transparency is related to a countrys

legal/judicial regime. Other studies examine corporate governance including ownershipissues (Claessens et al., 2000) and auditors corporate governance role (Fan and Wong,

2005) in Asian countries.

12. In Hong Kong, Jaggi and Tsui (2007) find that a higher proportion of independent

directors on corporate boards moderates a positive association between insider selling and

earnings management.

13. Domestic investors have been effectively allowed to invest in B shares since March

2001. In 2003, China opened the A-share market to foreign investors through the Qualified

Foreign Institutional Investor (QFII) program. As of November 2004, the QFII had

approved 27 institutional foreign investors, including Citigroup and Morgan Stanley

(Shenzhen Daily, November 11, 2004).

14. During our sample period all Chinese companies have been calendar-year firms, theregulations required the release of financial statements by the end of April in China and by

the end of May in Hong Kong, 4 and 5 months, respectively, after the fiscal year-end. Weuse the IBES Summary-History International file. Analysts continued to provide forecasts

at the latest until April (May) in the following year when actual earnings are released for

the B-share (H-share) companies included in our sample. Data for Chinese firms were

unavailable on IBES before 1993.

15. We assume that the few B- and H-share companies not on IBES may have had only

local analyst follow their A shares (if any) or have had no analyst coverage at all. Only a

handful of A-share companies were followed by analysts before 2003.

16. We exclude observations with missing values. For example, IBES includes 780H

firm-year observations with 1-year ahead forecast data, but complete IBES and additional

BV data are available only for 571 firm-year observations for all variables used in the three



30/35

17. We also examine the absolute value of the forecast error deflated by the beginning-

of-year price but do not tabulate the results because of missing values for several firm-year

observations. Further regression results using the median of this variable resemble those

reported for AFE. The mean (median) absolute forecast errors standardized by the

beginning-of-year stock price are 5.3 (1.6) per cent and 5.1 (2.0) per cent, respectively, forH-share and B-share companies. These results are comparable to those reported by Lang

et al. (2003) who report median forecast errors of 3.1 per cent for the year 1996 for the

Chinese firms in their global sample. Lang et al. (2003) report a median of six analysts

following for the Chinese companies in their global sample. The maximum analyst

coverage for our sample is 36 for H shares and 14 for B shares.

18. For both models, the adjusted R2s are smaller than those reported in the United

States (Tse and Yaansah, 1999). Graham and King (2000) examine the historical

regression for five Asian-Pacific countries other than China and find that the averageR2 to be between 0.236 in Taiwan and 0.903 in the Philippines.

19. See Biddle et al. (1995) for tests of relative and incremental explanatory powers, and

for a discussion of the advantage of the Wald w2

-statistic over the Vuong Z-statistic fortesting relative explanatory power.

20. Further untabulated analyses suggest that abnormal earnings or abnormal earnings

with terminal values have relative and incremental valuation contents to earnings, but X

has no significant incremental explanatory power when AER or AERTERM is already

included in the model.

21. Liu and Thomas (2000, p. 77) provide details for these variables and suggest that

model (7) incorporates forecasts of future earnings and overcomes the misspecification of

return-earnings regressions that omit current information about future earnings.

References

Abdel-khalik, A.R., K.A. Wong and A. Wu, The Information Environment of Chinas A

and B Shares: Can We Make Sense of the Numbers?, The International Journal of

Accounting 34 (1999), pp. 467489.

Aharony, J., C.J. Lee and T.J. Wong, Financial Packaging of IPO Firms in China,

Journal of Accounting Research 38 (Spring 2000), pp. 103126.

Allen, F., J. Qian and M. Qian, Law, Finance and Economic Growth in China, Journal

of Financial Economics 77 (2005), pp. 57116.

Bai, C-E., Q. Liu, J. Zhou, F. Song and J. Zhang, Corporate Governance and Firm

Valuation in China, Journal of Comparative Economics 32 (2004), pp. 599616.

Ball, R., A. Robin and J. Wu, Accounting Standards, the Institutional Environment andIssuer Incentives: Effect on Timely Loss Recognition in China, Asia-Pacific Journal of

Accounting and Economics 7 (2000), pp. 7196.

Bao, B.H. and L. Chow, The Usefulness of Earnings and Book Value for Equity

Valuation in Emerging Capital Markets: Evidence from Listed Companies in the

Peoples Republic of China, Journal of International Financial Management and

Accounting 10 (1999), pp. 85104.

Barniv, R. and M. Myring, An International Analysis of Historical and Forecast

Earnings in Accounting Based Valuation Models, Journal of Business Finance and

Accounting 33 (2006), pp. 10871109.

Basu, S., L. Hwang and C.L. Jan, International Valuation in Accounting Measurement

Rules and Analysts Earnings Forecast Errors, Journal of Business Finance and

Accounting 25(9) (1998), pp. 12071247.



31/35

Bernard, V., The Feltham-Ohlson Framework: Implications for Empiricists, Contem-

porary Accounting Research 11 (1995), pp. 733747.

Biddle, G.C., G.S. Seow and A.F. Siegel, Relative Versus Incremental Information

Content, Contemporary Accounting Research 12 (1995), pp. 123.

Brown, L. and M. Caylor, Corporate Governance and Firm Valuation, Journal ofAccounting and Public Policy 25 (2006), 409434.

Brown, S., K. Lo and T. Lys, Use of R2 in Accounting Research: Measuring Changes in

Value Relevance over the Last Four Decades, Journal of Accounting and Economics 28

(1999), pp. 83115.

Bushee, B.J., Discussion on Disclosure Practices of Foreign Companies Interacting with

U.S. Markets, Journal of Accounting Research 42 (2004), pp. 509525.

Bushman, R., J.D. Piotroski and A. Smith, What Determines Corporate Transpar-

ency?, Journal of Accounting Research 42 (2004), pp. 207252.

Chakravatry, S., A. Sarkar and L. Wu, Information Asymmetry, Market Segmentation

and the Pricing of Cross-listed Shares: Theory and Evidence from A and B Shares,

Journal of International Financial Markets, Institutions & Money 8 (1998), pp. 325356.Chan, K., A.J. Menkveld and Z. Yang, Information Asymmetry and Asset Prices:

Evidence from the China Foreign Share Discount, Journal of Finance 63(1) (2008), pp.

159196.

Chen, C.J., S.M. Chen and X.J. Su, Is Accounting Information Value-relevant in the

Emerging Chinese Stock Market?, Journal of International Accounting, Auditing and

Taxation 10 (2001), pp. 122.

Chen, G.M., M. Firth and N. Gao, The Information Content of Concurrently

Announced Earnings, Cash Dividends, and Stock Dividends: An Investigation of the

Chinese Stock Market, Journal of International Financial Management and Accounting

13 (2002), pp. 101124.Chen, J.P., F. Gul and X.J. Su, A Comparison of Reported Earnings under Chinese

GAAP vs. IAS: Evidence from the Shanghai Stock Exchange, Accounting Horizons

13(2) (1999), pp. 91111.

Chen, K.C. and H. Yuan, Earnings Management and Capital Resource Allocation:

Evidence from Chinas Accounting-based Regulation of Rights Issues, The Accounting

Review 79 (2004), pp. 645666.

Chen, S. and Y. Wang, Evidence from China on the Value Relevance of Operating

Income vs. Below-the-line Items, The International Journal of Accounting 39 (2004),

pp. 339364.

Claessens, S., S. Djankov and L. Lang, The Separation of Ownership and Control in

East Asian Corporations, Journal of Financial Economics 58 (2000), pp. 81112.Collins, D., E. Maydew and I. Weiss, Changes in the Value-relevance of Earnings and

Book Values over the Past Forty Years, Journal of Accounting and Economics 24

(1997), pp. 3967.

Connelly, J.T., S. Cheung, R. Limpaphyom and L. Zhou, Do Investors Really Value

Corporate Governance? Evidence from the Hong Kong Market, Journal of Interna-

tional Financial Management and Accounting 18 (2007), pp. 86122.Core, J.E., W.R. Guay and T.O. Rusticus, Does Weak Governance Cause Weak Stock

Returns? An Examination of Firm Performance and Analysts Expectations, Journal

of Finance 61 (2006), pp. 655687.Core, J.E., W.R. Guay and A. Van Buskirk, Market Valuations in the New Economy:

An Investigation of What Has Changed, Journal of Accounting and Economic 28

(2003), pp. 83115.



32/35

Dechow, P.M., A.P. Hutton and R.G. Sloan, An Empirical Assessment of the Residual

Income Valuation Model, Journal of Accounting and Economics 26 (1999), pp. 134.

DeFond, M., T. Wong and S. Li, The Impact of Improved Auditor Independence on

Audit Market Concentration in China, Journal of Accounting and Economics 28

(2000), pp. 269305.Doidge, C., G.A. Karolyi and R.M. Stulz, Why Do Countries Matter so Much for

Corporate Governance? Working paper, Ohio State University and University of

Toronto, 2004.

Easton, P.D., Discussion of Revalued Financial, Tangible, and Intangible Assets:

Association with Share Prices and Non-market Based Value Estimates, Journal of

Accounting Research 36 (1998), pp. 235247.

Eccher, A.E. and P.M. Healy, The Role of International Accounting Standards in

Transitional Economies: A Study of the Peoples Republic of China. Working paper,

MIT and Harvard University, 2000.

Eisenberg, T., S. Sundgren and M. Wells, Large Board Size and Decreasing Firm Value

in Small Firms, Journal of Financial Economics 48 (1998), pp. 3554.Ely, K. and G. Waymire, Accounting Standard-Setting Organizations and Earnings

Relevance: Longitudinal Evidence from NYSE Common Stocks, 192793, Journal of

Accounting Research 37 (1999), pp. 293317.

Fan, J.P.H. and T.J. Wong, Do External Auditors Perform a Corporate Governance

Role in Emerging Markets? Evidence from East Asia, Journal of Accounting Research

43 (2005), pp. 3572.

Feltham, G. and J. Ohlson, Valuation and Clean Surplus Accounting for Operating and

Financial Activities, Contemporary Accounting Research 11 (1995), pp. 689731.

Ferguson, M., K. Lam and G. Lee, Voluntary Disclosure by State-Owned Enterprises

Listed on the Stock Exchange of Hong Kong, Journal of International FinancialManagement and Accounting 13 (2002), pp. 125152.

Firth, M., P. Fung and O. Rui, Ownership, Board Structure, and the Informativeness of

Earnings: Evidence from an Emerging Market. Working paper, Hong Kong Poly-

technic University, 2003.

Francis, J. and K. Schipper, Have Financial Statements Lost Their Relevance?, Journal

of Accounting Research 37 (1999), pp. 319352.

Frankel, R., S.P. Kothari and J. Weber, Determinants of the Informativeness of Analyst

Research, Journal of Accounting and Economics 41 (2006), pp. 2954.

Frankel, R. and C. Lee, Accounting Valuation, Market Expectation, and Cross-sectional

Stock Returns, Journal of Accounting and Economics 25 (1998), pp. 283319.

Gao, Y. and Y.K. Tse, Capital Control, Market Segmentation and Cross-Border Flowof Information: Some Empirical Evidence from the Chinese Stock Market, Interna-

tional Review of Economics & Finance 13(4) (2004), pp. 455474.

Gebhardt, W., C. Lee and B. Swaminathan, Toward an Implied Cost of Capital,

Journal of Accounting Research 39(1) (2001), pp. 135176.

Graham, R.C. and R.D. King, Accounting Practices and the Market Valuation of

Accounting Numbers: Evidence from Indonesia, Korea, Malaysia, the Philippines,

Taiwan, and Thailand, Journal of International Accounting 35 (2000), pp. 445470.

Gu, Z., Scale Factor, R2, and the Choice of Level versus Return Models, Journal of

Accounting Auditing and Finance 20 (2005), pp. 7191.

Haw, I-M., D.Q. Qi, D. Wu and W. Wu, Market Consequences of Earnings Manage-

ment in Response to Security Regulation in China, Contemporary Accounting

Research 22 (2005), pp. 95140.



33/35

China, Journal of International Financial Management and Accounting 11 (2000), pp.

108131.

He, W., Z. Zhang and S. Zhu, Ownership Structure and the Private Benefits of Con-

trol: An Analysis of Chinese Firms, Corporate Governance 8 (2008), pp. 286298.

Hermalin, B. and M. Weisbach, The Determinants of Board Compensation, RandJournal of Economics 19 (1998), pp. 589606.

Hope, O., Disclosure Practices, Enforcement of Accounting Standards and Analysts

Forecast Accuracy: An International Study, Journal of Accounting Research 41(2)

(2003), pp. 235272.

Jaggi, B. and J.S.L. Tsui, Insider Trading, Earnings Management and Corporate

Governance: Empirical Evidence based on Hong Kong Firms, Journal of International

Financial Management & Accounting 18(3) (2007), pp. 192222.

Jen, F.C., F. Liu and X. Zheng, (2001) Establishing Effective Internal Corporate

Governance Systems for State-Owned Enterprises in China. China Accounting and

Finance Review International Conference, Beijing, China.

Jensen, M., A Modern Industrial Evolution, Exit and the Failure of Internal ControlSystems, Journal of Finance 48 (1993), pp. 831880.

Khanna, T., K.G. Palepu and S. Srinivasan, Disclosure Practices of Foreign Companies Inter-

acting with the U.S. Markets, Journal of Accounting Research 42(2) (2004), pp. 475508.

Lang, M., K. Lins and D. Miller, ADRs, Analysts, and Accuracy: Does Cross Listing in

the U.S. Improve a Firms Information Environment and Increase Market Value?,

Journal of Accounting Research 41 (2003), pp. 317345.

Lang, M., K. Lins and D. Miller, Concentrated Control, Analysts Following and

Valuation: Do Analysts Matter Most when Investors are Protected Least?, Journal of

Accounting Research 42(3) (2004), pp. 589623.

Larcker, D.F., S.A. Richardson and I. Tuna, How Important is Corporate Govern-

ance? Working paper, University of Pennsylvania, 2005.Leuz, C., K.V. Lins and F.E. Warnock, Do Foreigners Invest Less in Poorly Governed

Firms? Working paper, University of Pennsylvania, University of Utah, and Uni-

versity of Virginia, 2005.

Li, S., F. Liu, S. Liu and G.A. Whitemore, Comparative Performance of Chinese Banks:Analysis, Findings and Policy Implications, Review of Quantitative Finance and

Accounting 16 (2001), pp. 149170.

Lin, Z.J. and F. Chen, Value Relevance of International Accounting Standards

Harmonization: Evidence from A- and B-Share Markets in China, Journal of

International Accounting, Auditing, and Taxation 14 (2005), pp. 79103.

Lins, K.V., Equity Ownership and Firm Value in Emerging Markets, Journal of

Financial and Quantitative Analysis 38 (2003), 159184.Lins, K.V., F. Chen and Q. Tang, An Empirical Evaluation of the New System of

Business Accounting in China, Journal of International Accounting, Auditing andTaxation 10 (2001), pp. 2349.

Liu, J., D. Nissim and J. Thomas, Equity Valuation Using Multiples, Journal of

Accounting Research 40(1) (2002), pp. 135172.

Liu, J. and J. Thomas, Stock Returns and Accounting Earnings, Journal of Accounting

Research 38 (2000), pp. 71101.

Lu, T., J. Zhong and J. Kong, How Good is Corporate Governance in China?, China

and World Economy 17 (2009), pp. 83100.

McConnell, J. and H. Servaes, Additional Evidence on Equity Ownership and Corporate

Value, Journal of Financial Economics 27 (1990), pp. 595612.

Morck, R., B. Yeung and W. Yu, The Information Content of Stock Markets: Why do



34/35

Myers, J.M., Implementing Residual Income Valuation with Linear Information

Dynamics, The Accounting Review 74 (1999), pp. 128.Ohlson, J.A., Earnings, Book Values, and Dividends in Equity Valuation, Contempor-

ary Accounting Research (1995), pp. 661687.

Ohlson, J.A., Earnings, Book Value

Corporate Governance and Valuation

Documents

Transcript of Corporate Governance and Valuation