Capital Markets Research (Using Archival Data)

Oriented towards financial accounting issues

Links with finance and economics

Questions?• Do earnings matter? (Ball and Brown, JAR, 1968;

Beaver, JAR, 1968)• Are earnings components valued similarly?• Do earnings have incremental information content

over cash flows• Does the perceived quality of an auditor affect the

relation between earnings and returns?• Are disclosures about pension benefits or other post-

retirement benefits value relevant? • Would financial statements be more informative if

GAAP were changed to permit managers to capitalize R&D?

Developments in Finance and Accounting

Finance Literature

Market efficiency -- Fama, 1970, 1971

-- prices fully reflect all available information

CAPM -- Sharpe, 1964; Linter, 1965

-- a model of firm-specific expected returns

Developments in Finance and Accounting

Accounting Literature Positive Accounting Theory -- Watts and Zimmerman,

1986• Predicts that the use of accounting numbers in

compensation and debt contracts and in the political process will influence a firm's reporting choices

Valuation Theory -- Ohlson, CAR, 1995• Provides accounting with theory, based on finance

theory, on how earnings and book values map into prices.

Relation between Accounting Equity Values & Stock Market Equity Values

Accounting Measure of Wealth

A0 - L0 = E0

Relation between Accounting Equity Values & Stock Market Equity Values

Accounting Measure of Wealth

A0 - L0 = E0

+ NI1

- Div1 E1

Relation between Accounting Equity Values & Stock Market Equity Values

Accounting Measure of Wealth

A0 - L0 = E0

+ NI1

- Div1

A1 - L1 = E1

Relation between Accounting Equity Values & Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0

+ NI1

- Div1

A1 - L1 = E1

Relation between Accounting Equity Values & Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0 Price0

+ NI1

- Div1

A1 - L1 = E1

Relation between Accounting Equity Values & Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0 Price0

+ NI1 Return1

- Div1

A1 - L1 = E1 Price1

Relation between Accounting Equity Values & Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0 Price0

+ NI1 Return1

- Div1

A1 - L1 = E1 Price1

We have 2 measures

of wealth and

changes in wealth

Relation between Accounting Equity Values & Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0 Price0

+ NI1 Return1

- Div1

A1 - L1 = E1 Price1

↔

Relation between Accounting Equity Values & Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0 Price0

+ NI1 Return1

- Div1

A1 - L1 = E1 Price1

↔

↔

Relation between Accounting Equity Values & Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0 Price0

+ NI1 Return1

- Div1

A1 - L1 = E1 Price1

↔

↔

Observations:

• E0 = Price0

• NI1 = Return1 (cum div)

Relation between Accounting Equity Values & Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0 Price0

+ NI1 Return1

- Div1

A1 - L1 = E1 Price1

↔

↔

Observations:

Returns happen everyday.

Earnings are reported periodically.

Relation between Accounting Equity Values & Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0 Price0

+ NI1 Return1

- Div1

A1 - L1 = E1 Price1

+ NI2 - Div2

A2 - L2 = E2

↔

↔

Relation between Accounting Equity Values & Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0 Price0

+ NI1 Return1

- Div1

A1 - L1 = E1 Price1

+ NI2 - Div2

A2 - L2 = E2

↔

↔

Are current earnings good predictors of future earnings?

NI1 = NI2

Common Market-Based Tests

• Returns tests– Event study– Association test

• Price tests

Event Study

• “Direct” link between information and use of information

• Event (loose definition)– Identifiable happening or announcement

that you can pinpoint in time

that provide NEW information

relevant to the market

• Short window (days)

Event Study• Like ---

– Earnings announcement (Compustat, IBES)– Auditor change (press release, Dow Jones Interactive, Lexis/Nexis)– Change in accounting standard (press release, Dow Jones Interactive,

Lexis/Nexis)

– New laws or regulations

• Does the market react to this event (or information from this event)?

• Model: Unexpected Returns = Unexpected Earnings

(or Other New Information)

Issues in Event Studies

• Event date?• Model? Unexpected Returns = Unexpected Earnings• Event window? (cumulative abnormal returns [CARs])• Expectation models?• For returns

– CAPM (estimate parameters in event window/non-event period and apply to event period)

– market adjusted returns (adjust by market index or industry index or small cap and large cap index)

• For earnings (or other info)– Last year’s earnings– Last year’s earnings with growth– Time-series model– Analysts forecasts

Association Tests

• Link between information and use of that information

• Longer window tests (year)

 

• Two Basic Approaches --

Earnings Responses CoefficientModel? (Un)expected Returns = Unexpected Earnings

  (Un)expected Returns = INT + ERC*Unexpected Earnings + e

• Earnings are like an annuity

• So, an Earnings Responses Coefficient (ERC) should be near 1 + 1/rate (where r is the risk adjusted discount rate for equity)

 

Economic Determinants of ERC--• persistence, risk, growth and interest rate control for in studies• Kormendi and Lipe, JOB, 1987; Easton Zmijewski, JAE, 1989; Collins and Kothari, JAE, 1989

Some Problems with ERC Studies• heavily statistical based -- time series of earnings• predictive ability• do not control for accounting methods –• ERC coefficients too low (1 to 3)

- price lead earnings

- inefficient capital markets

- GAAP deficient

- transitory earnings

Another ApproachModel?Returns = Earnings + Changes in Earnings (Easton Harris, JAR, 1991)

• Earnings are an increase in the book equity value and returns are an increase in the market equity value.

• So the coefficient on earnings should be one. 

• Changes in earnings are like an annuity so coefficient should be near 1 + 1/rate

Some similar problems -- - price lead earnings- inefficient capital markets- GAAP deficient- transitory earnings

Price Tests-- the longest window!-- Ohlson theoretical work

Model Variations:

1. Price = Earnings

Earnings are an annuity So, the coefficient on earnings should be near 1 + 1/rate where r is the risk adjusted discount rate for equity

2. Price = Book Value

Book value is the accountants' measure of equityMarket Value is the Market's measure of equitySo, the coefficient on book value should equal one.

Price Tests (continued)

3. Price = Book Value + Earnings

Price is a weighted average of book values and earnings

So, weights are also part of coefficientsBarth, Beaver, Landsman, JAE, 1998Collins, Maydew, Weiss, JAE, 1998

4. Price = Book Value+Residual Income (or Abnormal Earnings)

where residual income=current year's earnings - beginning book value * r

Some Problems -- - value of r

- persistence of earnings

- GAAP deficient (for 4 it should not matter)

- GAAP conservative

- transitory earnings

- econometric issues -- size

Other Areas to Investigate• accruals and accruals models• earnings versus cash flows• disclosure versus recognition• financial statement analysis • properties of accounting earnings related to

corporate governance, ownership…• market inefficiency explanations versus

behavioral explanations related to accounting anomalies

• Usefulness of accounting information in credit markets

Useful Tools• One page summary of research idea,

research question and motivation• Kinney paragraphs

– What is the research question?– Why do we care? (motivation)– How are we going to answer?

• Libby boxes– Economic construct– Empirical proxies (& explanation)– Variable description (& data source)