Slides by: Pamela L. Hall, Western Washington University Francis & IbbotsonChapter 24: The Issuer's Earning Power1 Measuring Earning Power Chapter 24

Francis & Ibbotson Chapter 24: The Issuer's Earning Power 11

Slides by:

Pamela L. Hall, Western Washington University

Measuring Earning PowerMeasuring Earning Power

Chapter 24


BackgroundBackground

Miller & Modigliani’s dividend irrelevance theorem– Dividend policy of normal firm has no impact on

firm’s stock price

This chapter shows how a change in firm’s cash dividend payments can cause short-term stock price fluctuations– Without violating M&M’s theory

Also shows how firm’s EPS are important in valuing stock


Informational Content of Cash DividendsInformational Content of Cash Dividends

Board of Directors base cash dividend payments upon the following– Long-run targeted dividend payout ratio

– Smoothing of cash dividend payments so they follow long-run trend in corporate earnings

• Short-term changes in earnings usually have little impact on cash dividend payments

– Reluctance to change (especially decrease) cash dividend payments

• Prefer small infrequent increases


Asymmetric InformationAsymmetric Information

Information asymmetry occurs when Board of Directors has valuable inside information about corporation– Information is not available to outside

investors

External investors use cash dividend payments as a signal– Contain valuable information


Reactions to Cash Dividend PaymentsReactions to Cash Dividend Payments

Healy & Palepu (1988) examined stock prices of corporations for –60 to +20 days after announcement– 131 corporations that initiated cash dividend

payments• Experienced abnormal stock price increase of 4%• Experienced average growth rate of 43% per year prior to

beginning dividends• Experienced 164% increase in earnings in the 4 years

after initiating dividends– Findings suggest firms initiate cash dividend payments if

they believe the payments can be sustained» Signal by Board of Directors that future prospects

look good



– 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



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


Forecasting EPSForecasting EPS

Examples of corporations that provide earnings forecasts– Moody’s– Standard & Poors– Value Line

Forecast for a corporation is usually provided by a securities analyst who specializes in a particular industry


Surveys of ForecastsSurveys of Forecasts

Three corporations specialize in providing consensus earnings forecasts– Institutional Brokers Estimate System (I/B/E/S)

[New York]• www.ibes.com

– Zacks Investment Research [Chicago]• www.zacks.com

– First Call [Florida]• Subsidiary of Thomson Financial Company

• www.thomsonivest.net



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



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



First Call’s internet site offers– News– Chat rooms– Insider trading information– Earnings information– Graphs– Financial research


How Expert Are The Experts?How Expert Are The Experts?

After reviewing the forecasts of many different securities analysts, discovered forecasters– Tend to over-estimate EPS– Tend to revise forecasts downward as earnings

announcement date approaches– Seem reluctant to say negative things about

security issuers• Issue many more buy than sell recommendations

– May be due to fact that analysts do not want to antagonize employer’s potential clients


How Expert Are The Experts?How Expert Are The Experts?

Institutional Investor, a monthly publication, reports survey results of 2,000 money managers every October– Compiles list of the ‘best’ security analysts in each of over

60 industries– Forecasts of this ‘all-star’ team are compared with

forecasts of other analysts• Results show that neither group did better than the other

Brown & Rozeff report that earnings forecasts reported in Value Line Investment Survey were better than forecasts generated by sophisticated mechanical models


Whisper EarningsWhisper Earnings

Whisper earnings are forecasts of EPS circulated among analysts and trades via web, television and financial press– Unofficial EPS forecasts– Bagnoli, Beneish and Watts (2000) find

whisper forecasts to be more accurate than surveys of institutional forecasts

Check out www.WhisperNumber.com


Earnings Surprises and Stock PricesEarnings Surprises and Stock Prices

Latane and Jones developed a model to measure earnings surprise– Standardized Unexpected Earnings

Error gForecastin theofDeviation StandardEPSQuarterly ForecastedEPSQuarterly Actual

SUEi

ti, ti,

ti,

-

• Numerator measures forecasting error» Represents difference in firm’s reported EPS and the

consensus EPS forecast from I/B/E/S or Zacks

» Can be either +, -, or 0

• Dividing by standard deviation of forecasting error creates a dimensionless index number

» Allows comparisons between different companies and times


Earnings Surprise ExampleEarnings Surprise Example

Given– Corporation A and B both have forecasted EPS

of $2 and actual EPS of $3• Corporation A is a predictable public utility with a

small standard deviation of forecast error of 50¢

• Corporation B is a volatile technology firm with a large standard deviation of forecast error of $2

2 $0.50

$2 - $3 SUE tA,

0.5 $2.00

$2 - $3 SUE tB,

Both have SUE > 0 becauseactual EPS exceeded expected, but

investors in A were more pleasantly surprised—because having actual EPS

of $1 above forecasted EPS is moreunusual.


Foster-Olsen-Shevlin Event StudyFoster-Olsen-Shevlin Event Study

In 1984 Foster, Olsen & Shevlin analyzed the impact of a public announcement of a firm’s quarterly earnings on the firm’s stock price– Computed SUE for 2,053 firms over 32

quarters• 65,696 SUEs were ranked in deciles

– Decile 1 contained the 6,570 most negative SUEs (worst news announcements)

– Deciles 10 contained the 6,570 largest positive SUEs (best news announcements)



Suggests that the market correctly anticipates earnings changes prior to announcement and reacts rationally

-5%

+5%

0%

Abn

orm

al R

etur

n

Decile Portfolio Number

1

5

432

6 7 8 9 10

Abnormal Common Stock Returns Surrounding Quarterly Earnings Announcement Dates During –60, 0 Period

When firm experiences +

earnings surprise, stock prices tend to rise prior to

announcement date.

When firm experiences -

earnings surprise, stock prices tend to fall prior to

announcement date.



Shows that the relationship between earnings surprise and stock prices continues after the announcement

-3%

+3%

0%

Abn

orm

al R

etur

n

Decile Portfolio Number

1

5

432

6 7 8 9 10

Abnormal Common Stock Returns Surrounding Quarterly Earnings Announcement Dates During 1, 60 Period Investor in Decile

10 can expect to earn abnormal

returns of 3.23% during 60 days

after unexpected + earnings

surprise—an anomaly in

efficient markets theory.



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


Ambiguities in Accounting EarningsAmbiguities in Accounting Earnings

EPS are not easy to measure– GAAP leaves room for interpretation

Distorted income statements may result from – Inappropriate use of an accounting procedure

– Use of accrual accounting technique that does not link revenues/expenses to period in which cash flow actually occurred

– Window-dressing


Contrasting Income StatementsContrasting Income Statements

Compare the following income statements– Identical except in the accounting procedures

Item Statement B, $ Statement A, $ Key

Sales Revenue $9,200 $11,000 (1)

Less: Returns and allowances -1,000 -1,000

Net sales $8,200 $10,000

Beginning inventory $2,000 $2,000

Purchases and freight in 6,000 6,000

Net purchases 8,000 8,000

Less: Ending inventory -2,000 -3,000 (2)

Cost of goods sold 6,000 5,000

Gross margin 2,200 5,000

Operating expenses

Selling costs 1,500 1,500

Depreciation 500 300 (3)



Item Statement B, $ Statement A, $ Key

Pension 100 20 (4)

Other expenses 200 50 (5)

Amortization of goodwill 110 30 (6)

Contingent liabilities 90 40 (7)

Salaries 200 200

Bonuses 100 100

Total operating expenses -2,800 -2,240

Net operating expenses (600) 2,760

Less: Interest -100 -100

Income (loss) before taxes (700) 2,660

Less: Federal taxes (33%) (refund) (233) -887

Net income (loss) from operations (467) 1,773

Minimizes taxable income.

True represen-tation of

economic income.



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



– 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



– Depreciation• Can use several different depreciation

methods– Straight-line

– Units of production

» May be used to accelerate depreciation during period of rapid production

– Double-declining balance

– Sum-of-the-digits

– Modified accelerated cost recovery system (MACRS)

Accelerated Methods



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



– 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



• 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



• 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



– 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



– 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



– 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


The Quality of EarningsThe Quality of Earnings

Does the firm’s accounting earnings reflect its true earning power– Reported earnings that accurately depict firm’s

earning power are considered high quality• Even if negative

– Reported earnings are consider low-quality if special items and/or inappropriate GAAP methods are used

• Even if result in positive earnings

Securities analysts desire an earnings number that can be used in a P-E valuation model


The Quality of EarningsThe Quality of Earnings

More than one EPS may be reported if the potential dilution of EPS exists– An increase in future number of outstanding shares may

occur if• Management elects to sell more shares • Options to purchase additional shares from firm exist

(convertible bonds, preferred stock, employee stock options, warrants)

• Corporation exchanges stock for debt

Extraordinary gains and losses – May distort the ‘normal’ income stream

Examination of the firm’s Statement of Cash Flows can help determine the stock’s earning power


Cash FlowsCash Flows

Cash flows are not obscured by accrual accounting, depreciation, amortization, etc.– Cash Flows from Operations

• Measures cash flows arising from the production and distribution of goods and/or services

• Found in the first part of a firm’s Statement of Cash Flows

– Or, can be computed form Statement of Sources and Uses (of Cash)

• Most firm’s accounting incomes are not highly positively correlated with Cash Flows from Operations

• Should not value a firm’s common stock using Cash Flows from Operations if firm uses debt


Statement of Cash FlowsStatement of Cash Flows

Firm’s Activity Cash Inflows Cash Outflows Net Cash Flows

Operating Cash inflows from sales of goods and services

Cash paid for operating goods and services

Cash flow from operations, or CFO

Investing Cash received from sales of property, plant, equipment, and/or other investments

Cash paid for acquisition of property, plant, equipment, and/or other investments

Cash flow from investing

Financing Cash received from issue of debt or capital stock (if relevant)

Cash paid for dividends and reacquisition of debt or capital stock (if relevant)

Cash flow from financing (if relevant)

Other Cash received from foreign exchange transactions, etc. (if relevant)

Cash paid for foreign exchange transactions, etc. (if relevant)

Cash flow from other activities (if relevant)

Total Net change in cash for the period


Statement of Cash FlowsStatement of Cash Flows

Reports net cash flows generated from operations, investing and financing activities– Accounts for the net change in firm’s aggregate

cash position

The firm’s Statement of Cash Flows and financial footnotes (or supplementary reports) contain needed information for determining cash flows to stockholders


Cash Flows Available to Equity ShareholdersCash Flows Available to Equity Shareholders

Represents firm’s leverage-free cash flows– Adjust CFO for any debt-financing effects

• Combined leverage effects– Cash required to service debt net of tax effects –

net cash flow for investing plus (minus) any increase (decrease) in debt financing

• Deduct combined leverage effect from CFO to obtain leverage-free cash flows

– Present value of the leverage-free cash flows can be found using required rate of return on equity


Cash Flows to Equity Shareholders Cash Flows to Equity Shareholders vs. Economic Incomevs. Economic Income

Economic income represents the maximum amount of consumption opportunities that can be withdrawn from firm without reducing future consumption opportunities

Accounting income represents an upward biased estimate of economic income for most firms– Net income includes retained earnings which are

unavailable for consumption

Cash flows available to shareholders measures consumption opportunities available to owners– Contains deductions needed to sustain firm’s future earning

power• Must include effect of debt financing


Problems with Cash DividendsProblems with Cash Dividends

Calculating present value of cash dividends provides an estimate of a stock’s value– But it is an invalid estimate if a firm is

• Repurchasing shares– Generating more cash than paying out as dividends– Using some cash to repurchase shares which cause reverse

dilution of EPS, cash dividend per share and value per share

• Growing because projects have ROE > cost of capital• Declining because projects have ROE < cost of capital

– Can maximize firm value by paying one large liquidating dividend

Many fundamental analysts prefer the P-E ratio approach


The Bottom LineThe Bottom Line

Asymmetric information exists because Board of Directors has access to inside information not known to investors

M&M theory does not mean a cash dividend cannot offer informational content– External investors evaluate cash dividends for

signals about future

I/B/E/S, Zacks and First Call specialize in compiling earnings forecasts– Valuable in determining if a corporation’s

earnings contain surprises


The Bottom LineThe Bottom Line

Stock prices tend to increase (decrease) prior to announcement of positive (negative) earnings surprises– Abnormal stock returns continue for a 2 month

time period after earnings announcement

GAAP leaves room for interpretation– Should select accounting methods that represent

true economic income– Security analysts must adjust accounting income

to obtain true economic income estimates• Many analysts use corporate cash flows rather than

earnings to measure earning power

Documents

Slides by: Pamela L. Hall, Western Washington University Francis & IbbotsonChapter 24: The Issuer's Earning Power1 Measuring Earning Power Chapter 24