1 / 44

Measuring Earning Power

Measuring Earning Power. Chapter 24. Background. 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

Download Presentation

Measuring Earning Power

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript


  1. Measuring Earning Power Chapter 24 Chapter 24: The Issuer's Earning Power

  2. Background • 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 Chapter 24: The Issuer's Earning Power

  3. Informational 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 Chapter 24: The Issuer's Earning Power

  4. Asymmetric 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 Chapter 24: The Issuer's Earning Power

  5. Reactions 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 Chapter 24: The Issuer's Earning Power

  6. Reactions 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 Chapter 24: The Issuer's Earning Power

  7. Reactions 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 Chapter 24: The Issuer's Earning Power

  8. Forecasting 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 Chapter 24: The Issuer's Earning Power

  9. Surveys 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 Chapter 24: The Issuer's Earning Power

  10. Surveys 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 Chapter 24: The Issuer's Earning Power

  11. Surveys 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 Chapter 24: The Issuer's Earning Power

  12. Surveys of Forecasts • First Call’s internet site offers • News • Chat rooms • Insider trading information • Earnings information • Graphs • Financial research Chapter 24: The Issuer's Earning Power

  13. 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 Chapter 24: The Issuer's Earning Power

  14. 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 Chapter 24: The Issuer's Earning Power

  15. Whisper 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 Chapter 24: The Issuer's Earning Power

  16. Earnings Surprises and Stock Prices • Latane and Jones developed a model to measure earnings surprise • Standardized Unexpected Earnings • 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 Chapter 24: The Issuer's Earning Power

  17. Earnings 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 Both have SUE > 0 because actual EPS exceeded expected, but investors in A were more pleasantly surprised—because having actual EPS of $1 above forecasted EPS is more unusual. Chapter 24: The Issuer's Earning Power

  18. Foster-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) Chapter 24: The Issuer's Earning Power

  19. Abnormal Common Stock Returns Surrounding Quarterly Earnings Announcement Dates During –60, 0 Period +5% When firm experiences + earnings surprise, stock prices tend to rise prior to announcement date. Decile Portfolio Number Abnormal Return 1 2 3 4 0% 6 8 5 7 9 10 When firm experiences - earnings surprise, stock prices tend to fall prior to announcement date. -5% Foster-Olsen-Shevlin Event Study • Suggests that the market correctly anticipates earnings changes prior to announcement and reacts rationally Chapter 24: The Issuer's Earning Power

  20. Abnormal Common Stock Returns Surrounding Quarterly Earnings Announcement Dates During 1, 60 Period +3% Decile Portfolio Number Abnormal Return 1 2 3 4 0% 6 8 5 7 9 10 -3% Foster-Olsen-Shevlin Event Study • Shows that the relationship between earnings surprise and stock prices continues after the announcement 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. Chapter 24: The Issuer's Earning Power

  21. Foster-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 Chapter 24: The Issuer's Earning Power

  22. Ambiguities 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 Chapter 24: The Issuer's Earning Power

  23. Contrasting Income Statements • Compare the following income statements • Identical except in the accounting procedures Chapter 24: The Issuer's Earning Power

  24. Contrasting Income Statements Minimizes taxable income. True represen- tation of economic income. Chapter 24: The Issuer's Earning Power

  25. Contrasting 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 Chapter 24: The Issuer's Earning Power

  26. Contrasting 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 Chapter 24: The Issuer's Earning Power

  27. Accelerated Methods Contrasting 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) Chapter 24: The Issuer's Earning Power

  28. Contrasting 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 Chapter 24: The Issuer's Earning Power

  29. Contrasting 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 Chapter 24: The Issuer's Earning Power

  30. Contrasting 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 Chapter 24: The Issuer's Earning Power

  31. Contrasting 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 Chapter 24: The Issuer's Earning Power

  32. Contrasting 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 Chapter 24: The Issuer's Earning Power

  33. Contrasting 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 Chapter 24: The Issuer's Earning Power

  34. Contrasting 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 Chapter 24: The Issuer's Earning Power

  35. The 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 Chapter 24: The Issuer's Earning Power

  36. The 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 Chapter 24: The Issuer's Earning Power

  37. Cash 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 Chapter 24: The Issuer's Earning Power

  38. Statement of Cash Flows Chapter 24: The Issuer's Earning Power

  39. Statement 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 Chapter 24: The Issuer's Earning Power

  40. Cash 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 Chapter 24: The Issuer's Earning Power

  41. Cash Flows to Equity Shareholders vs. 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 Chapter 24: The Issuer's Earning Power

  42. Problems 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 Chapter 24: The Issuer's Earning Power

  43. The 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 Chapter 24: The Issuer's Earning Power

  44. The 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 Chapter 24: The Issuer's Earning Power

More Related