Abnormal Earnings and Economic Value Added - Research Proposal Example

QUESTION Stock Valuation: Abnormal Earnings and Economic Value Added Valuing a stock has been a matter of concern for investors, shareholders and analysts for the reason that it gauges and evaluates a company's performance and the worth of investments chipped in by the investors. All these concerned parties tend to devise and search the best suitable valuation tools to analyse the worth a company returns to its shareholders. As put into words by Lee (1996, p32-37): For years, investors and corporate managers have been seeking a timely and reliable measurement of shareholders' wealth. With such a measure, investors could spot over- or underpriced stocks, lenders could gauge the security of their loans and managers could monitor the profitability of their factories, divisions and firms. The earnings that are reflected in a company's financial statements are considered to be the most important evaluator of a company's stock. The companies tend to report enhanced earnings every year so as to assure the shareholders of their performance and profitability. When a company reports lower earnings in its financial statements than investor-anticipated earnings, it can induce the stock prices to drop significantly. Whereas in case if a company reports more earnings than anticipated by the investors, it boosts up the company's stock prices. This motivates the managers to report discretionary results or earnings so as to live up to the expectations of the shareholders and investors leading to earnings manipulation. The companies report abnormal earnings that misrepresent its financial position and to artificially valuate the stock. Another metric used to gauge a company's performance and position is known as Economic value added that compares earnings with the cost of capital. Stewart (1991) has presented several arguments that go in the favour of using economic value added concept for valuation purpose. The major reason behind using the economic value added as a basis for stock valuation is to analyse the worth a company returns to its shareholders as a reward for their risk and investment. Stewart (1991) shows that the economic value added is calculated by subtracting the cost of capital from the after tax profit of a company. This implies that a company should be able to drive that much returns to the shareholders, as they would otherwise get out of another investment opportunity. If the company fails to provide that value, it implies that it actually incurring loss and is unable to provide sufficient returns to the shareholders. Therefore, it can be said that the ability of a company to procure returns for its shareholders greater than the capital costs can eventually increase or decrease its value. The studies conducted by researchers Stewart (1991), and Lehn and Makhija (1996) prove that economic value added concept bears a strong relationship with company's stock and therefore, has a great capability to influence its stock value. It is however to be noted that Topkis (1996) shows that economic value added could only be used as a basis for valuation of a company's future share price and cash flow expectations, but it can not be used to value current stock prices. QUESTION 2 (1) Difference in Processes followed by Quarterly and Annual Earnings Bernard and Thomas (1990) relate the differences between the processes followed by quarterly earnings and the annual earnings as a result of "post-earnings-announcement drift" to the studies put forth by Bernard and Thomas (1989) and Freeman and Tse (1989). He says that these studies indicate that when a company's earnings tend to be higher or lower than that anticipated by the investors for a single quarter, the investors' expectations remains stormed for the upcoming quarters. Thus, suggesting that the market remains irresponsive to the news encompassing the company for the previous quarters. He further illuminates that there is a negative relation between earnings for a single quarter and the annual returns. The empirical evidence by Bernard and Thomas (1990, 321) examine that the only difference in the patterns for the analysis of "post-earnings-announcement drift" for abnormal earnings from first quarter through the fourth one. The first three quarters can be referred to as the quarterly results and the last quarter can be called the annual result. He says that the single distinction in the pattern for his analysis was "positive but declining abnormal returns around the announcement of earnings for quarter t + 1, t + 2, and t + 3, and negative abnormal returns around the announcement of earnings for quarter t + 4". Thus according to his article, in a situation where the earnings follow a seasonal random walk with a drift, the process for quarterly earnings is different form the annual earnings (the last quarter). Salamon and Stober's (1994) add that the reason for this difference in the quarterly and annual earnings is due to the fact that managers tend to manipulate their earnings more in the last quarter than in the previous quarters and thus the process for annual earnings differs from the quarterly earnings. QUESTION 2 (2) Exploitation of Fundamental Analysts of the Discrepancy Bernard and Thomas (1990) show that the differences in quarterly and annual earnings can lead to some "bias" in the analysis or prediction of future earnings. He says that this distinction can cause the stock price of a company's shares to rise or decline significantly after the announcement of the subsequent quarter's earnings. The analysts can exploit this situation by inducing some investors' to take action on the basis of the annual earnings announcement. For instance, if an investor anticipated the earnings to be higher than that of the previous year and the earnings announcement turns out to be lower than that, he would prefer to sell the stock and vice versa. The study mentions that the investors would take this step even when the earnings were predictable before the annual announcement and the prices mirrored it. Therefore, in a situation where a company reports less annual earnings to the investors, it will lead to a decline in the closing price of the stock on that particular day. However, a market situation on the day of earnings announcement concerning the rise or fall of a company's stock price tends to return to normal after a few following days and the proportion of bid and ask comes also back to previous position. References Bernard, V. and J. Thomas (1989), Post-earnings-announcement drift: Delayed price response or risk premium", In Bernard, V. and J. Thomas (1990), Journal of Accounting and Economics, 13 Bernard and Thomas (1990), "Evidence That Stock Prices Do Not Fully Reflect The Implications Of Current Earnings For Future Earnings", Journal of Accounting and Economics, 13 Freeman, R. and S. Tse (1989), "The Multi-Period Information Content Of Earnings Announcements: Rational Delayed Reactions To Earnings News", In Bernard, V. and J. Thomas (1990), Journal of Accounting and Economics, 13 Grant J. L. (1996), "Foundations of EVA for investment managers", The Journal of Portfolio Management, Vol. 23 Lee, C., (1996), "Measuring wealth", The CA Magazine, April, 32-37. Lehn, K & Makhija, A. K. (1996), "EVA And MVA: As Performance Measures And Signals For Strategic Change" Strategy and leadership, Vol. 24 Salamon, G. L., and T. L. Stober. (1994). "Cross-quarter differences in stock price responses to earnings announcements: Fourth-quarter and seasonality influences." Contemporary Accounting Research, Vol. 11 Stewart, G.B., (1991), "The Quest for Value", New York: Harper. Topkis, Maggie (1996), "A New Way To Find Bargains", Fortune, Vol. 245 Read More