Abstract
Abstract Using A-share listed companies in China from 1999 to 2010, this paper investigates the influence of industry competition on earnings persistence from the perspective of the real options theory. Different from the traditional industrial economics theory, analyses based on the real options theory show that the influence of industry competition on earnings persistence may be nonlinear and that the relationship between the two may vary with the firm’s operating efficiency or profitability. Our empirical results show that for companies with low profitability, intense industry competition can encourage management to exercise abandonment options more effectively, thereby reducing the persistence of earnings; in contrast, for companies with high profitability, intense industry competition can encourage management to exercise growth options more effectively and offset the mean reverting effect, thus increasing the persistence of earnings. Additional tests illustrate that the influence of industry competition on earnings persistence is also reflected in the relationship between stock price changes and earnings changes, that is, the earnings response coefficient. Overall, this paper suggests that the influence of industry competition on the execution of real options is reflected in the earnings pattern
Highlights
The real options theory is an application of the financial options theory on physical assets which introduces financial market rules into enterprise strategy decision-making to help management make better investment decisions under uncertainties (Myers, 1977)
Based on the relationship between industry competition and investment flexibility, further tests illustrate that intense competition increases the equity value of growth and abandonment options. These findings indicate that industry competition, as an important mechanism of corporate governance, plays a major role in the process of investment decision-making and the efficiency of resource allocation, making management exercise growth and abandonment options more effectively
The earnings response coefficient (ERC) shows a similar pattern to earnings persistence, which further supports the finding of this paper that change in earnings persistence may be related to industry competition
Summary
The real options theory is an application of the financial options theory on physical assets which introduces financial market rules into enterprise strategy decision-making to help management make better investment decisions under uncertainties (Myers, 1977). Using the linear RIM, Cheng (2005) finds that intense industry competition reduces the persistence of residual income Different from those studies, we follow Zhang’s (2000) real-option-based valuation model and conditions on profitability opportunities and find that growth options can increase earnings persistence for companies with good profitability opportunities as industry competition becomes increasingly intensified. This indicates that the value of real options should not be neglected when we study the influence of industry competition on earnings pattern. The remainder of the paper proceeds as follows: Section II briefly reviews the related literature; Section III develops our hypotheses; Section IV describes the research design; Section V reports the empirical results; Section VI provides the robustness tests; and the last section concludes the paper
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