Stock Prices Change And Earnings Changes - Essay Example

http highered.mcgraw-hill.com/sites/007253317x _view0/chapter12/chapter_ s.html Three questions in total. Each question needs about 500-word answer. 1) Do stock prices change in response to unexpected earnings changes? 2) How do stock prices reflect fundamental signals? What is the incremental value-relevance of fundamental signals over earnings? 3) How is accounting information used by the market in the valuation of internet firms? Stock prices fail to reflect fully the implications of unexpected earnings changes. The stock prices fail to reflect the extent to which the time-series behavior of earnings deviates from a naive expectation: a seasonal random walk, where expected earnings are simply earnings for the corre- sponding quarter from the previous year.’ It is well known that earnings It is difficult to understand why stock prices would appear not to respond completely and immediately to information as visible and freely available as publicly announced earnings. Journal of Accounting and Economics 13 (1990) 305-340. North-Holland EVIDENCE THAT STOCK PRICES DO NOT FULLY REFLECT THE IMPLICATIONS OF CURRENT EARNINGS FOR FUTURE EARNINGS* Victor L. BERNARD Harvard Business School, Boston, MA 02163, USA Unicersity of Michigan, Ann Arbor, MI 48109, USA Jacob K. THOMAS Columbia University, New York, NY 10027, USA Received May 1990, final version received December 1990 The principal focus of fundamental analysis is on valuation aimed at identifying mispriced securities.This has been popular at least since Graham and Dodd published their book Security Analysis in 1934.2 A large fraction of the nearly $5 trillion currently invested in US mutual funds is actively managed, with fundamental analysis as the guiding principle of most mutual fund managers.Fundam ental analysis entails the use of information in current and past .nancial statements, in conjunction with industry and macroeconomic data to arrive at a .rm’s intrinsic value.A di.erence between the current price and the intrinsic value is an indication of the expected rewards for investing in the security.Capital markets research on fundamental analysis has become extremely popular in recent years in part because of mounting evidence in the .nancial economics literature against the e.cient markets hypothesis. The belief that ‘‘price convergence to value is a much slower process than prior evidence suggests’’ (Frankel and Lee, 1998, p.315) has acquired currency among leading academics, spurring research on fundamental analysis. Capital markets research on fundamental analysis examines whether it successfully identi.es mispriced securities.Fundame ntal analysis research thus cannot be disentangled from capital markets research on testing market e.ciency. Journal of Accounting and Economics 31 (2001) 105–231 Capital markets research in accounting$ S.P. Kothari* Sloan School of Management, Massachusetts Institute of Technology, Cambridge, MA 02142, USA Received 22 November 1999; received in revised form 8 March 2001 Fundamental analysis is aimed at determining the value of corporate securities by a careful examination of key value-drivers, such as earnings, risk, growth, and competitive position. In the context of such analysis, we identify below a set of financial variables (fundamentals) claimed by analysts to be useful in security valuation and examine these claims by estimating the incremental value-relevance of these variables over earnings. Our findings support the incremental value-relevance of most of the identified fundamentals; in fact, for the 1980s, the fundamentals add approximately 70%, on average, to the explanatory power of earnings with respect to excess returns. We also show that the returns-fundamentals relation is considerably strengthened when it is conditioned on macroeconomic variables, thereby demonstrating the importance of a contextual capital market analysis. For example, several fundamentals that appear only weakly value-relevant or even irrelevant in the unconditional analysis exhibit strong association with returns under specific economic conditions (e.g., the accounts receivable and the provision for doubtful receivables signals during high infiation). From a general examination of the role of fundamentals in security valuation we turn to the related issues of earnings persistence, growth, and the earnings response coefficient. Journal of Accounting Research Vol. 31 No. 2 Autumn 1993 Printed in U.S.A. Fundamental Information Analysis BARUCH LEV* AND S. RAMU THIAGARAJANf We dc- not find a significant association between bottom-line net income and our sample firms market prices, consistent with the claim made by some investors that financial statement information is of very limited use in the valuation of Internet stocks. However, when we decompose net income into its components we find that gross profits are positively and significantly associated with prices. In addition, we find that in most instances both unique visitors and pageviews. as measures of internet usage. provide incremental explanatory power for stock prices, over and above the net income and its components In this paper we provide insights into the valuation of Internet stocks by examining the extent to which thier market values are associated with fundamental accounting information and by exploring the role played by Internet usage data in explaining the firms stock prices. This study is motivated by the high prices at which many of these stocks trade relative to their operating performance. For example, as of April II, 2000, Yahoo! had a P/E of 580. eBay a P.E of 1,945, and Amazon.com, traded at a multiple to revenue of 13.5 (it has been unprofitabie since inception) with a market cap of $22.2 billion. Manv new (and sometimes unique) valuation measures have been suggested, such as market value per eyeball or acquisition cost per user, to justify the high prices that investors are paying for Internet shares.* Just how hard it is to reconcile the value of these companies with fundamentals is reflected in a recent analyst research report on Amazon. com. At a time when the stock was trading for $130 a share, the analyst issued a buy recommendation, even though his official projections led him to a situation of only $30, Admitting that he could justify any valuation between $1 and $200 by varying his assumptions, the analyst stated that his recommendation was based on the opportunity, the company, and its management—all somewhat amorphous concepts. Internet stocks are difficult to value for at least two reasons. First., the industry and the firms in it are so young that there is very little historical financial information available with which to fore-cast future profitability. (Most of the firms have never reported a (quarterly profit. and are not expected to do so for some time.) Second, the industry is evolving at such a rapid, and unpredictable, pace that, whatever historical; information exists is likely to be less useful for valuing these firms than for valuing those in more established industries, c»r even those in non-Internet high-tech industries. These difficulties notwithstanding, the Internet industry offers an important advantage to the researcher—the availability of a substantial amount of non-financial data on Internet usage, which investors can employ in the prediction of future revenues. We expect that current traffic at an Internet firms web site(s) will be positively related to future revenues, since it reflects potential future demand for the companys products and, at least. indirectly, affects the rates the firm can charge for. Journal of Accounting Research Vol 38, Supplement 2000 The Eyeballs Have It: Searching for the Value in Internet Stocks BRETT TRLEMAN, M. H. FRANCO WONG, AND XIAO JUN ZHANG* 1) Compare the discounted cash flow method, the dividend discount method and the abnormal earnings method in a finite horizon. Provide and discuss empirical evidence on which of these methods of valuation works best for valuation purposes over a five-year horizon. 2) Provide empirical evidence on which of these methods has the highest incremental explanatory power with respect to future returns. There are a variety of equity valuation techniques used in practice and discriminating among them is difficult. Many involve forecastingthefuturebuttheydifferinwhatisforecasted. Someforecastdividends,someforecastcashflows,someforecastearningsorresidual income, and some forecast operating profit. Most techniques are based on a particular valuation model -- the dividend discount model, the discountedcashflowmodel,andtheresidualincomemodel,forexample--andthesemodelsworkforgoingconcernsiftheanalystforecasts aninfinitestream. http://www.expresstraining.com.br/exprtrain/eollearn.nsf/0/fa5ed2ca42917c8d83256975006d68bd/$FILE/Texto6.pdf One of the main purposes of discounted cash flow modeling is to provide meaningful benchmarks used to judge the operating performance of a company over time. The main market benchmark is usually earnings or earnings growth. However, many times the most important variables in the model are longer term interest or other operating variables. http://www.cfainstitute.org/cfaprogram/pdf/studyguides06/Level_II.Final.Equity.pdf Analysts use Discounted Cash Flow model to determine a companys current value according to its estimated future cash flows. Forecasted free cash flows (operating profit + depreciation + amortization of goodwill - capital expenditures - cash taxes - change in working capital) are discounted to a present value using the companys weighted average costs of capital. DCF analysis shows that changes in long-term growth rates have the greatest impact on share valuation. Investors can also use the DCF model as a reality check. Instead of trying to come up with a target share price, they can plug in the current share price and, working backwards, calculate how fast the company would need to grow to justify the valuation. The lower the implied growth rate, the better - less growth has therefore already been "priced into" the stock Taking Stock Of Discounted Cash Flow January 14, 2003 | By Ben McClure The dividend discount model is a more conservative variation of discounted cash flows, that says a share of stock is worth the present value of its future dividends, rather than its earnings. The dividend discount model can be applied effectively only when a company is already distributing a significant amount of earnings as dividends. But in theory it applies to all cases, since even retained earnings should eventually turn into dividends. Thats because once a company reaches its "mature" stage it wont need to reinvest in its growth, so management can begin distributing cash to the shareholders. (Plan "B" would be for the CEO to pursue some insane acquisition, just to gratify his bloated ego.) As Williams puts it, If earnings not paid out in dividends are all successfully reinvested... then these earnings should produce dividends later; if not, then they are money lost.... In short, a stock is worth only what you can get out of it. http://www.moneychimp.com/articles/valuation/dividend_discount.htm http://www.expresstraining.com.br/exprtrain/eollearn.nsf/0/fa5ed2ca42917c8d83256975006d68bd/$FILE/Texto6.pdf We generally find earnings developed in three Anglo-Saxon countries—where capital is traditionally raised in public markets and reporting rules are unencumbered by taxation requirements—to have greater explanatory power for stock returns than cash flow metrics. Conversely, in two non-Anglo-Saxon countries—where capital is traditionally raised from private sources—earnings are generally not superior to cash flows for equity valuation, except in Japan, non-consolidated sample. While sensitivity analyses generally support the conclusions of our primary tests, in some of the additional analyses, earnings were superior to cash flows for samples from all countries. As expected, in all countries earnings have incremental information content over cash flows in explaining returns. Collectively, our findings provide two contributions. First, we generalize the findings of prior US research by showing that earnings are more important than cash flows for equity valuation in other Anglo-Saxon countries. Second and more importantly, our findings demonstrate that the superiority of earnings over cash flows is not universal. Rather, it depends on the national reporting regime and attendant institutional factors http://www.blackwell-synergy.com/links/doi/10.1111/1467-646X.00068 model in Preinreich (1932). He introduces this model by way of comparison to the model of Fisher (1907), which argues that the value of an equity is the present value of future dividends. Preinreich calls the earnings-based model “an alternative method of computation, which is equally correct.” Elsewhere, Preinreich (1938) uses an analogous formula in the context of valuation of a productive asset, arguing that the asset’s value is its book value plus discounted residual income, which he calls “excess profits.” The argument that the earnings and dividends valuation approaches are equivalent begins with an assumption of clean surplus accounting. This says that the ending book value of shareholders’ equity equals its starting value plus income less dividends: St+1 = St + It+1 - Dt+1. Here S represents shareholders’ equity, D represents dividends, and I represents income. Letting r represent the rate of return on equity capital, one can decompose income into normal income rSt 1Lys and Lo (2000) present evidence that the model is much older, as is implied in Preinreich (1936). 4 2 THE RESIDUAL INCOME AND DIVIDENDS MODELS and residual income It+1 - rSt _ _t+1St. The clean surplus equation can then be written as St+1 = (1 + r + _t+1)St - Dt+1. (1) The discounted dividends model says that, in period t, the value of the equity is the present value of the expected future dividend stream: Pt = 1X_=1 Dt+_ (1 + r)_ = Dt+1 1 + r + Pt+1 1 + r . (2) The earnings approach, or residual income model, says that the period t value of the equity is the book value of shareholders’ equity plus the present value of the expected future residual income stream: Pt = St + 1X_=1 _t+_St+_-1 (1 + r)_ = St + _t+1St 1 + r + Pt+1 - St+1 1 + r . (3) Subtracting the book value of shareholders’ equity St from both sides of Equation 3 gives an interpretation of this model: the current premium of intrinsic value over book value equals the discounted value of next period’s residual income plus the discounted value of next period’s premium. Proposition 2.1 (Preinreich (1932)). Given the clean surplus equation, the residual income model is derivable from the dividend model. Proof. Equation 2 can be rewritten as Pt = Dt+1 1 + r + St+1 + Pt+1 - St+1 1 + r . Plugging in the clean surplus equation (1) then gives Pt = Dt+1 1 + r + (1 + r)St 1 + r + _t+1St 1 + r - Dt+1 1 + r + Pt+1 - St+1 1 + r , so that Pt = St + _t+1St 1 + r + Pt+1 - St+1 1 + r , which is just the residual income model as stated in Equation 3. Conversely, it is straightforward to show the rest of the equivalence argument: http://www.nhh.no/for/dp/2006/0106.pdf 1) Discuss the empirical evidence on returns to contrarian investment strategies in the context of both fundamental and technical analysis. 2) How is some on this empirical evidence interpreted by Fama and French, "The Cross-Section of Expected Stock Returns (1992, Journal of Finance)" ? investors buy future earnings, and long-term earnings growth expectation is a key determinant of valuation. Companies with better growth prospects can command higher price-to-earnings ratios. Investors face tremendous uncertainty regarding long-term growth, and information is needed to reduce the uncertainty. The proposed financial statement analysis model synthesizes financial statement-based signals about future earnings into an aggregate indicator of the firm’s growth prospects. The forecast can reliably inform about future earnings growth and explain traded P/E ratios. The predictive property of the forecast on stock returns is an additional finding of this study, indicating that investors have not fully exploited financial statement information about earnings growth. Applying Financial Statement Analysis to Forecast Earnings Growth and Evaluate P/E Ratios [Course textbook] Stephen Penman, Financial Statement Analysis and Security Valuation (2nd edn.), 2003, McGraw-Hill [Journal articles] *These are all the articles provided in the course. However, it goes without saying that not all of them are relevant to the questions above!! Please refer to these articles where appropriate. 1) Kothari, S. P., 2001, Capital Markets Research in Accounting, Journal of Accounting and Economics 2) Lev, B. and Thiagarajan, R., 1993, Fundamental Information Analysis, Journal of Accounting Research 3) Trueman, B., Wong, M. and Zang, X., 2000, The Eyeballs Have It: Searching for the Value in Internet Stocks, Journal of Accounting Research 4) Lakonishok, J., Shleifer, A. and Vishny, R., 1994, Contrarian Investment, Extrapolation, and Risk, Journal of Finance 5) Bernard, V. and Thomas, J., 1990, Evidence that Stock Prices Do Not Fully Reflect Implications of Current Earnings for Future Earnings, Journal of Accounting and Economics 6) Sloan, R., 1996, Do Stock Prices Fully Reflect Information in Accruals and Cash flows about Future Earnings?, Accounting Review 7) Teoh, S., Welch, I. and Wong, T., 1998, Earnings Management and the Long-Run Market Performance of Initial Public Offerings, Journal of Finance 8) Ou, J. and Penman, S., 1989, Financial Statement Analysis, Journal of Accounting and Economics 9) Fama, E. and French, K., 1992, The Cross-Section of Expected Stock Returns, Journal of Finance 10) Debondt, W. and Thaler, R., 1985, Does the Stock Market Overreact?, Journal of Finance 11) Jegadeesh, N. and Titman, S., 1993, Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency, Journal of Finance Read More