Persistence of Earnings - Literature review Example

Name: xxxxxxxxxx Course: xxxxxxxxxx Institution: xxxxxxxxxx Title: Persistence of earnings Date: xxxxxxxxxxxxx Persistence of earnings Introduction According to Kim Hwan Yeo (1993), earnings persistence or persistence of earnings is the indication of how much of current earnings will persist into the future and continue from period to period or the sustainability of firm’s earnings over a period of time (Kim 1993). Chen (2004) offers an operational and more comprehensive definition of earnings persistence as a measure of the statistical reliability of current earnings in predicting future earnings (Chen 2004). (Kormendi &Lipe 1987) have also proved that firms with higher earnings persistence will generally exhibit stronger returns or in general higher quality earnings. There have been a number of studies which have attempted to establish the relationship between the persistence of earnings of firms in various sectors and the quality of earnings of the same firms. The recurrent theme in the conclusion of these studies such as Sloan (1996) and Tschoegl (1983) is that firms which exhibit persistent earnings are empirically more likely to have higher quality earnings. This implies a positive correlation between higher persistent earnings and high quality earnings. This paper seeks to analyze the literature of persistent earnings. First, the paper will explore the motivations behind the research into earnings persistence for firms in different sectors with the banking sector given particular attention. This will be done by identifying the various benefits related to persistent earnings such as risk factors and profitability of firms. The paper will then isolate some of the factors impacting on the persistence of a firm’s earnings from the literature reviewed. Literature Review Shezhad, De Haan and Scholten (2009) explore the effect of persistence of earnings and bank size on the profitability of banks. The study uses a dynamic panel model to test hypotheses on whether bank growth or profitability and its variability is dependent on bank size, whether bank growth is persistent and whether bank growth has an effect on bank profitability. The study uses a sample of 1500 commercial banks from over 65 countries both from OECD and emerging market countries. Proxies for bank profitability and bank size used are the returns on average equity and bank assets respectively. The study uses three control variables in the regression. The first is the capital structure of the bank which measures the portion of assets financed by equity with the implication that the higher the ratio of assets financed by equity the higher the bank’s capital adequacy. The second control variable measures the managerial efficiency of the bank where the higher the overhead costs as a ratio of net income the lower the banks profitability. The third control variable measures the stability of bank earnings where recurring earning power or ability to match previous earnings is used as a proxy for the stability of the bank’s earnings (Shezhad, De Haan & Scholten 2009). After hypothesis testing, the study findings imply that whereas the growth of bank is not persistent, bank profitability is persistence and the size of the bank does not influence the growth of banks in non OECD countries. This shows that bank earnings are persistent for banks that record higher returns on average equity or that more profitable banks tend to have more persistent earnings. The study also shows that the growth of banks in non OECD countries is not dependent on their assets or bank size and that relatively larger banks in OECD countries grow at a slower speed. Furthermore, variability in growth tends to be higher for smaller banks (Shezhad, De Haan & Scholten 2009). The focus and scope of the study indicates several important motivations to study persistence of earnings among firms. First, the study attempts to predict the profitability of banks based on their size and returns which are used as the proxy of earnings. This shows that studying persistence of earnings could provide an important indication to the profitability of a business firm. Furthermore, the study depicts a relationship between firm size-in this case banks-and persistent earnings. The conclusion that larger banks grow at a slower rate indicates that the growth of a firm could be contingent on its size-the more compact a firm is, the faster it is expected to grow. The study also establishes the link between the persistence of earnings by banks and their quality of earnings (Brown 1993). The persistence of earnings is established by the bank profitability (returns) and the proxy for the quality of earnings can be derived from the growth of the bank’s assets or bank size. As mentioned in the findings of the study, larger firms are likely to grow at a slower rate while conversely; smaller firms can expect to grow at faster rate if they maintain high returns or persistent earnings (Shezhad, De Haan & Scholten 2009). The findings of the study also reveal that existing economic and political environments may impact on the persistence of earnings. The implication of the findings is that for banks in non OECD countries, persistent earnings through high returns may not necessarily translate to proportional growth in assets as is the case in OECD countries. This may be indicative of significant socio economic or political constraints. Even though the study by Shezhad, De Haan and Scholten attempts to objectively establish the correlation between earnings persistence of banks and their profitability, it fails to address a few statistical problems. Bank profitability and size cannot be entirely captured by its earnings and assets alone. There a number of factors discounted by the study. For example, it does not recognize that prudent management by banks includes long term investments and not just the ratio of assets financed by equity. The study also fails to address the problem of serial correlation or autocorrelation as banks in both OECD and non OECD countries are normally reactionary in their behavior when it comes to issues such as interest rates which in turn affect profitability (Shezhad, De Haan & Scholten 2009). Another motivation for studying the persistence of earnings is to establish the risk factor associated with a particular firm and the subsequent value of the firm. Allayanis (2003) attempts to present empirical evidence that volatility in earnings and cash flow have negative impacts on the perceptions of investors towards a firm and the firms’ value. This means that firms that do not display persistent earnings or experience volatile cash flows are often valued at a lower market price than firms with more consistent cash flows and earnings (Allayanis 2003). Allayanis uses a sample of non financial firms to try and confirm the hypothesis that firms which do not have smooth cash flows or persistent earnings have lower values. The proxy for value used is the firm’s Tobin’s Q. The Tobin’s Q is a measure of the firms market value constructed as the ratio of the market value of equity and book value of long-term debt to total assets. The study samples firms with at least 30 non-missing monthly observations for sales and observations for five years. This means that the firm must have maintained accurate and up to date records to qualify for the sample between the years 1990 and 1995. To circumvent the statistical problem of serial correlation or autocorrelation, the study selects records from independent periods within the five year period totaling 3390 samples. The variables used to gauge the firms’ value are total assets, equity market value, return on assets (earnings per share), debt to equity, growth as a ratio of capital-expenditure to sales and the market to book ratios. The study also establishes the firm’s risk component by using the volatility of earnings per share measured by the standard deviation of the earnings in successive periods (Allayanis 2003). The study analyses the “smoothness” of reporting financial statements as a critical component of a firm’s cash flow and earnings volatility. Firms which display competency and timeliness in reporting monthly financial statements and updating their records are considered as displaying this “smoothness”. The smoothness is also measured by minimal deviations in both the cash flow and earnings per share month to month within the five year period. The findings of the study confirm the hypothesis that firms which experience greater volatility in earnings per share tend to have a lower market value or Tobin’s Q value. The firms with non missing sales and assets observations sampled show that for those with lower standard deviations on their earnings per share had a higher Tobin’s Q. This implies that persistent earnings are an important determinant of the risk and ultimately the value attached to the firm. The study findings are statistically significant. However, the study notes that it is primarily volatility in earnings and not cash flow which is accountable for the higher risk and lower value. According to Allayanis, the findings are consistent with pre existing risk management theory that manager’s efforts to produce smooth financial statements add value to a firm (Allayanis 2003). However, the study by Allayanis tends to omit certain important variables normally associated with risk factors. For instance, it does not mention the effect of variables such as political uncertainty on volatility of earnings. Though it is objective and empirical, it may not be entirely practical to assume that earnings persistence is only based on financial market operations but may also be affected by variables outside it such as governmental policy (Allayanis 2003). Closely related to Allayanis, Hee (2008) has also studied the earnings persistence of firms which have restated or re-declared the information that they have already filed with the Securities and Exchange Commission (SEC). This study seeks to confirm the hypothesis that firms which make positive steps towards reassuring investors and shareholders by constantly updating their financial statements usually have a higher earnings quality-for which the proxy is earnings persistence. The focus of the study reveals another motivation for studying earnings persistence. It shows that a firm’s valuation and ultimately its quality of earnings are positively correlated with the practice of constantly restating its financial state of affairs which includes its assets, sales and profits or losses if any. This reinforces the idea that earnings persistence is important for market confidence in a firm (Hee 2008). By using regression analysis and data collected from the GAO, Hee confirms the hypothesis that restatement firms or firms that restate the information and reports contained in financial regulatory bodies such as the SEC attract investor confidence or conversely, investor perceptions about the value of firms are affected by restatement of the same. This lends credence to the findings of Allayanis (2003). A study by Chen (2004) confirms the findings of Allayanis and Hee. In analyzing the reaction of the stock market to earnings announcements, Chen concludes that the stock market returns and a firm’s stock price actually moves in the same direction as the change in earnings within that fiscal year. If for example a business firm announces subsequent quarterly declines in earnings, the stock price is expected to decline as well. This is what Chen refers to as Post Earnings Announcement Drift or PEAD. He uses PEAD to study investor reactions to the announcements of earnings by firms (Hee 2008). Chen’s operational definition persistence of earnings holds that it is the statistical consistency of present earnings in predicting future earnings. Chen samples all firm-quarter observations in the period 1975 to 2001 and using data from daily stock return records listed in the AMEX, New York Stock Exchange-NYSE or Nasdaq. To be able to determine earnings persistence, Chen starts the sample period from 1978 to allow the data prior to 1978 to be used to determine persistence since persistence is by its nature a time series phenomenon. To estimate the persistence at a quarter t for example, where t is a time period, Chen(2004) uses data from 1975 to the period just before t or time t-1. This method of estimating persistence allows firm earnings persistence to be measured cumulatively over time in progressive periods. Chen’s final sample consists of 153,653 firm quarter observations (Chen 2004). In persistence determination, Chen(2004) states that earnings persistence is determined or influenced by the economic characteristics of a firm, financial statement fundamentals and the accounting methodology used by the firm. Regarding economic characteristics, Chen quotes Lev (1983) pg 13 who proved that earnings persistence is affected by a number of characteristics including the type of product sold by the firm, the level or degree of competition in an industry measured by the presence or absence of barriers to entry and the firm’s size. The type of product a firm produces or sells determines the degree of competition in the industry or the barriers of entry present. Thus according to Lev (1983), firms in non-competitive industries like monopolies or oligopolies will tend to have more stable earnings. Similarly, this also occurs in firms with high competitive power. Conversely, firms in highly competitive industries are more likely to experience fluctuating earnings as the absence of barriers to entry leaves the door open for competition. In the actual estimation of earnings persistence, Chen (2004) uses the firm’s market share, industry concentration, capital intensity and the firm’s size. The firm’s market share is estimated as the ratio of the firm’s total sales to the market total sales or output. Industry concentration refers sum of squared market shares of all firms in an industry, the capital intensity is the ratio of depreciation, depletion and amortization to sales and the firm size is obtained by the natural logarithm of total assets. As an illustration, firms with high capital intensity can expect higher and more stable returns. Regarding financial statement fundamentals, Chen (2004) refers to evidence from analysis by Penman and Zhang (2002) who suggest that when a firm’s financial statement shows profit margins and asset turnover move in different directions, uncertainty arises about the true quality of the firm’s earnings and as a result the earnings persistence score decreases. In regards to accounting methodology, Chen quotes the findings of Sloan (1996) that a firm’s quarterly earnings in the same financial year tend to be serially correlated and as a result this may affect the estimation of earnings persistence. The study by Chen (2004) tests three hypotheses concerning the effect of earnings persistence and PEAD on stock prices. First, Chen tests the hypothesis that post-earnings-announcement abnormal returns are positively or negatively associated with stock returns when earnings persistence is high or low. This implies, for instance, that when earnings persistence is high, it will probably trigger a higher stock price for the firm’s equity and lead to abnormally high returns. The second hypothesis tests that earnings expectations embedded in stock prices are lower or higher than the expectations determined by earnings persistence when earnings persistence is high or low. This tests whether investors or the market tend to overreact or under react when it persistence is high or low. The third hypothesis is an illustration of the economic implications of the outcomes. It tests investor reactions. The hypothesis is that a trading strategy taking a long position in the stock of firms with large positive standardized returns and a short position in the stock of firms with large negative standardized returns produces higher abnormal profits for firms with high-persistence earnings relative to firms with low-persistence earnings. This shows that in essence, persistent earnings can either be a blessing or a curse in the context of PEAD. Firms with persistent negative returns will discourage investors who will take short positions on them leading to further abnormal declines in stock prices and those posting positive persistent earnings will attract longer term investments and stand to benefit from a windfall or positive abnormal returns which however, may not be as high or as low as expected in both cases (Chen 2004). The findings of the study by Chen (2004) give evidence that that stock prices under react to high-persistence earnings and overreact to low-persistence earnings. The findings also show hat stock prices behave as if the expectations of investors in regards to earnings persistence are moderated toward an average level that is not adequately high or low relative to the definite earnings persistence. The study by Chen reveals another aspect of the motivation to study earnings persistence. As proved by other reviewed studies such as Shezhad, De Haan and Scholten (2009) and Allayanis (2003), earnings persistence is an important determinant of investor perception towards a firm. Chen uses the stock price behavior as a proxy for the behavior or reaction of investors towards a firm. Thus earnings persistence not only informs traders or investors of the future short run and long run prospects of a firm but also informs their trading strategies. It is also an important tool for forecasting market conditions such as expectations of changes in stock prices and indirectly informs financial planning (Fama & French 2002). Conclusion A number of studies have attempted to establish the relationship between the persistence of earnings of firms in various sectors and the quality of earnings of the same firms. Persistence of earnings is indication of how much of current earnings will persist into the future and continue from period to period or the sustainability of firm’s earnings over a period of time. The scope and focus of the study indicates several important motivations to study persistence of earnings among firms. First, the study attempts to predict the profitability of companies based on their size and returns which are used as the proxy of earnings. This shows that studying persistence of earnings could provide an important indication to the profitability of a business firm. Moreover, the study depicts a relationship between firm size-in this case banks-and persistent earnings. Additionally, another motivation for studying the persistence of earnings is to establish the risk factor associated with a particular firm and the subsequent value of the firm (Ball & Brown 1968). Over the years analyst and researchers have employed empirical methods in determining earning persistence and its relationship with quality earnings. For instance, in persistence determination, Chen(2004) states that earnings persistence is determined or influenced by the economic characteristics of a firm, financial statement fundamentals and the accounting methodology used by the firm. There have been a number of studies which have attempted to establish the relationship between the persistence of earnings of firms in various sectors and the quality of earnings of the same firms. The recurrent theme in the conclusion of these studies such as Sloan (1996) and Tschoegl (1983) is that firms which exhibit persistent earnings are empirically more likely to have higher quality earnings. This implies a positive correlation between higher persistent earnings and high quality earnings (Brown & Han 2000). 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