Valuation Weights Research Articles

Valuation of short-lived firms following waves of new listings

PurposeThe survival rate of newly listed firms is low, and there is evidence of a surge of poorly performing new listed firms leading up to the crash of the dot.com bubble. The author investigates this phenomenon and analyzes investors' ability to understand the quality of accounting information and to adjust their expectations.Design/methodology/approachThe author employs the dividend discount model in conjunction with clean surplus accounting discussed by Ohlson (1995) to compare the value relevance of earnings and research and development (R&D) expenditures for short and longer listed National Association of Security Dealer Automated Quotations (NASDAQ) firms between 1980 and 2014. The author also uses univariate tests and logistic regression to analyze both recently listed and short-listed firms. In this analysis, the author compares the differences in investors' expectations for the first five years for both types of firms.FindingsThe author provides convincing evidence that markets clearly placed lower valuation weights on accounting earnings and R&D expenditures for short-listed firms on NASDAQ. Market participants originally had high expectations for these ventures. But, they gradually understood the lower quality of accounting information and adjusted their expectations downward.Originality/valueThe author’s results show that optimistic expectations along with easy equity financing created a surge of new listings. My analysis of the interplay between the quality of accounting information and investors' expectations indicates a negative spillover effect where investors are overoptimistic about firms that rode on waves of new listings backed by liberal financing. The author shows that analysis of Tobin's Q and negative earnings can separate ill-prepared from longer-listed firms.

The effect of conservative financial reporting and tax aggressiveness on the market valuation of unrecognized tax benefits

PurposePrior studies document a positive relation between stock prices and tax-related contingent liability, unrecognized tax benefits (UTBs) and interpret the finding as evidence that investors reward tax aggressiveness. The purpose of this paper is to explore the nature of this puzzle finding by considering a link between UTBs and financial reporting strategy and propose that financial reporting conservatism may explain the positive association between UTBs and stock prices.Design/methodology/approachTo estimate the incremental valuation weights on UTBs, the authors employ the Ohlson (1995) valuation model and regress stock prices on UTBs and its interactions with the proxies for financial reporting conservatism and tax aggressiveness. Further, the authors adopt a UTB estimation model to decompose its balance into the predicted and unpredicted components.FindingsThe authors find that the reporting conservatism has a positive effect on the market valuation of UTBs. The authors also find some evidence that tax aggressiveness increases the valuation weight of UTBs. When UTBs are decomposed into predicted and unpredicted components, the authors find that the effect of financial reporting conservatism is more pronounced for the market valuation of predicted UTBs. Collectively, the evidence suggests that conservative financial reporting is a major driver of the positive valuation of UTBs and that tax aggressiveness plays a less significant role in investors' valuation decisions.Originality/valueWhile prior studies focus on how UTBs are associated with stock prices, this paper is the first attempt to explain why UTBs are positively valued by investors.

When Is Depreciation Meaningful in Valuation? Changing Valuation Weights for U.S. REITs and Non-REITs

This article regresses the market value of equity on pre-depreciation income and on depreciation expense for capital-intensive firms, referring to the coefficients from our model as valuation weights. The valuation weight on depreciation expense versus the weight on pre-depreciation income are compared, to detect depreciation biases, over time and across sectors. Our model shows that the valuation weights on depreciation expense change over time, if the persistence of the cash flow components of net income varies over time and if the accrual for depreciation is inflexible (e.g., straight-line depreciation). For Real Estate Investment Trusts (REITs), we find the valuation weight on pre-depreciation income increases with industry upturns, while the valuation weight on depreciation expense decreases during upturns. This result is contrasted to the nearly equal valuation weights for the cash flow and depreciation components of earnings for Resource firms (e.g., mines) over time. We conjecture this is because depletion accounting flexibly allows for “depreciation” to exhibit less bias than in other sectors. In summary, actual depreciation practices influence time variation in the valuation of depreciation, a point which has been underappreciated in prior studies.

Does reporting position affect the pricing of the volatility of comprehensive income?

AbstractThe FASB changed the reporting policy for comprehensive income (CI) by issuing ASU No. 2011‐05, which requires CI be reported in performance statements (i.e., either a single income statement with net income or a separate statement of CI following the income statement) rather than the previously allowed equity statements. We examine whether the change in reporting position of CI led to higher market pricing of CI volatility incremental to NI volatility (“incremental CI volatility”), as measured by the price‐earnings relationship. We find that the market pricing of incremental CI volatility increased from the pre‐ to the post‐ASU period for non‐financial firms forced to change the reporting position of CI from equity to performance statements. The increase is more prominent for firms that switched to the income statement than for firms that switched to a separate statement of CI. Further, we find that the increased market pricing of incremental CI volatility translates into lower valuation weights on other comprehensive income.

Conic Option Pricing

Lower and upper prudent valuations in two price economies obtained on sufficiently distorting physical probabilities for returns to horizons matching option maturities straddle the market prices of options. Market prices are then modeled as geometric averages of the extremal valuations. Upper valuation weights sensitive to moneyness are calibrated to market data for 203 underliers over seven years. Hedges are designed to minimize capital defined as the upper lower valuation spread. The hedging criterion is immune to cost of hedge issues, works on both aspects of super and sub replication and provides a dispersion measure with parametric control over hedge aggresiveness.

Recognition versus disclosure: evidence from fair value of investment property

The application of International Accounting Standard 40, Investment Property, in the European Union created a unique setting to study the implications of a decision to recognize versus disclose financial statements’ items, because in this setting recognized and disclosed investment-property-related amounts share a common measurement base, i.e., fair value. I use this setting to (1) explore a firm’s choice to recognize versus disclose fair values of investment properties, (2) test whether recognized and disclosed amounts are valued equally by investors, and (3) determine whether these amounts exhibit equivalent associations with future financial outcomes. To correct for self-selection concerns and assure I compare analogous amounts, I develop a selection model and construct investment-property-related amounts that differ only in whether their components are recognized or disclosed. I find that (1) contractual and asset-pricing incentives help to explain the recognition versus disclosure choice, (2) investors place smaller valuation weights on disclosed amounts, and (3) recognized and disclosed amounts exhibit statistically equivalent associations with future changes in net rental income and cash flows from operations. Taken together, the evidence suggests that managers are opportunistic in making the recognition versus disclosure choice and that even when recognized and disclosed amounts share an equivalent measurement base and are equally relevant for future financial outcomes, investors weight disclosed information less heavily in determining a firm’s value.

Have IFRS changed how stock prices are associated with earnings and book values?

Purpose – The purpose of this paper is to examine how the mandatory shift from Norwegian Generally Accepted Accounting Principles (NGAAP) to International Financial Reporting Standards (IFRS) in Norway affected the valuation weights of earnings and book values, with the aim of gaining insights that are relevant for standard setters, investors and other users of accounting information. Design/methodology/approach – The authors extend the IFRS literature on structural shifts between the pre- and post-adoption periods by comprehensively controlling for factors that vary between the IFRS sample and the domestic Generally Accepted Accounting Principles (GAAP) sample. Moreover, the tests are designed to reveal the underlying accounting causes of the observed differences in value relevance. Findings – IFRS are balance sheet-oriented and emphasize measurement at fair value. By contrast, NGAAP are earnings-oriented and focus on historical cost. IFRS also differ from NGAAP by recognizing more intangible assets. Overall, IFRS are thus less conservative than NGAAP. It was found that expanded fair value accounting increases the value relevance of book values and decreases the value relevance of earnings. However, the improved matching of intangible asset expenditures with the future economic benefits of such intangible assets increases the persistence and value relevance of earnings relative to book values. Originality/value – This paper introduces a test methodology that is designed to identify the effects that specific accounting differences between the IFRS sample and the domestic GAAP sample have on value relevance. Consequently, this paper not only identifies the overall effects on value relevance but also contributes to the literature by identifying specific accounting differences between IFRS and GAAP that cause these overall effects, and thus obtain insights that are valuable for standard setters and other users of accounting information.

Recognition Versus Disclosure: Evidence from Fair Value of Investment Property

The application of International Accounting Standard (IAS) 40, Investment Property, in the European Union created a unique setting to study the implications of a decision to recognize versus disclose financial statements’ items because in this setting recognized and disclosed investment-property-related amounts share a common measurement base, i.e., fair value. I utilize this setting to (1) explore factors associated with a firm’s choice to recognize versus disclose fair values of investment properties, (2) test whether recognized and disclosed amounts are valued equally by equity investors, and (3) determine whether these amounts exhibit equivalent associations with future financial outcomes. To correct for self-selection concerns and assure I compare analogous amounts, I develop a selection model and construct investment-property-related amounts that differ only in whether their components are recognized or disclosed. I find that (1) contractual and asset pricing incentives help explain the recognition versus disclosure choice, (2) investors place smaller valuation weights on disclosed amounts, and (3) recognized and disclosed amounts exhibit statistically equivalent associations with future changes in net rental income and cash flows from operations. Taken together, the evidence suggests that managers are opportunistic in making the recognition versus disclosure choice and that even when recognized and disclosed amounts share an equivalent measurement base and are equally relevant for future financial outcomes, investors weight disclosed information less heavily in determining a firm’s value.

Valuation Weights, Linear Dynamics and Accounting Conservatism: An Empirical Analysis

AbstractResidual income models provide an important theoretical link between equity valuation and financial statement variables. While various researchers have developed models of how accounting policy impacts on the structure of these models, empirical support for these models is at best weak and frequently contradictory. In this paper, we develop an analytical model, which identifies the dependency between valuation weights in residual income models and the associated structure of earnings information dynamics and accounting conservatism. In contrast to many earlier studies, we find strong evidence of conservatism in our reformulation of the linear dynamics. We proceed to test our predictions of the dependency of the weights on two measures of conservatism, the conventional measure of price‐to‐book ratio and the recent measure of a C‐Score index developed by Khan and Watts (2009) and find that the empirical results accord well with our theoretical predictions in the case of the former but not the latter measure.

Sarbanes–Oxley Act and the quality of earnings and accruals: Market-based evidence

In this paper we study the impact of the Sarbanes–Oxley Act (SOX) on the valuation weights of earnings and earnings components. The analysis seeks evidence that SOX is associated with changes in investors’ perception of earnings and accruals quality. Of particular interest in the analysis is the effect of SOX on the valuation weight of discretionary accruals that are perceived to be most vulnerable to manipulation prior to SOX. We find reliable increases in the valuation weights of earnings and earnings components after the passage of SOX. Nonetheless, we also find that the post-SOX shifts in the valuation weights of earnings and earnings components are indistinguishable from zero among firms in which the percentage equity shares held by institutional investors is 15% or greater.

Institutional Investors, Financial Health, and Equity Valuation

We investigate the relation between institutional ownership, financial health, and the market valuation weights on earnings and the book value of equity. We find that the valuation weight on earnings (book value) increases (decreases) with the level of institutional ownership for profit firms, while that on book value increases with the level of institutional ownership for loss firms. This valuation effect is not subsumed by incorporating current measures of financial health and is mainly driven by institutions with long investment horizons and monitoring incentives. We conclude that the institutional valuation effect is consistent with institutions playing a positive governance role.

Conservatism and the Ohlson Model

In this paper, we develop a framework for evaluating the impact of conservative accounting on the structure of residual income models of equity valuation. This affords a theoretical model of the signs and sizes of the valuation weights attached to book values, earnings and dividends as a function of conservatism. We proceed to generalize our model of conservatism and are able to show theoretically the likely numerical impact of conservatism on book values, price-earnings ratios and under valuations produced by residual income models. We investigate empirically the dependency of these valuation weights on conservatism using US data over the period 1963-2006 and find that they accord well with the theory developed. Finally, we explore the associated linear information dynamics and find strong evidence that the time-series properties of abnormal earnings are consistent with our model of accounting conservatism.

Accounting for Employee Stock Options: What Can We Learn from the Market's Perceptions?

AbstractThe scope of this is paper is to provide new empirical evidence on the value relevance of employee stock options (ESOs) in Europe. We show, empirically, that the market participants when pricing a firm's equity place approximately the same valuation weights on the ESO‐deferred compensation expense (the so called “ESO asset”) and the compensation option liability (the so called “ESO liability”). Our empirical findings support the theoretical work of Ohlson and Penman who suggest that the deferred compensation expense be treated as a contra‐liability. The second contribution of our work rests on the nature of the ESO expense. We show that the distinction between persistent and non‐persistent ESO expenses is of critical importance for the market participants. Accordingly, an improved accounting disclosure should assist the investors in assessing the long‐term goals of the ESO plans at the firm level.

Impact of Real Estate Cycles on the Valuation Weights on Funds From Operations and GAAP Net Income for Real Estate Investment Trusts

Impact of Real Estate Cycles on the Valuation Weights on Funds From Operations and GAAP Net Income for Real Estate Investment Trusts

Valuation Weights and Accounting Conservatism

In this paper we develop a general framework for evaluating the impact of conservative accounting on the structure of residual income models of equity valuation. This affords a theoretical understanding of the signs and sizes of the valuation weights observed in regression studies of the relationship between prices, book values, earnings and dividends. We proceed to generalize our model of conservatism and are able to show theoretically the likely numerical impact of conservatism on book values, price-earnings ratios and under valuations produced by residual income models. The analysis also affords an understanding of the limitations of empirical investigations of conservatism using linear information dynamics and hence to explain the failure of many such studies to detect conservatism.

Health Inequality Measurement in Korea Using EuroQol-5 Dimension Valuation Weights

Despite various government initiatives, including the expansion of national health insurance coverage, health inequality has been a key health policy issue in South Korea during the past decade. This study describes and compares the extent of the total health inequality and the income-related health inequality over time among Korean adults. This study employs the 1998, 2001 and 2005 Korean National Health and Nutrition Examination Surveys (KNHANESs). The self-assessed health (SAH) ordinal responses, measured on a five-point scale, rescaled to cardinal values to measure the health inequalities with using interval regression. The boundaries of each threshold for the interval regression analysis were obtained from the empirical distribution of the EuroQol-5 Dimension (EQ-5D) valuation weights estimated from the 2005 KNHANES. The final model predicting the individuals' health status included age, gender, educational attainment, occupation, income, and the regional prosperity index. The concentration index was used to measure and analyze the health inequality. The KNHANES data showed an unequal distribution of the total health inequality in favor of the higher income groups, and this is getting worse over time (0.0327 in 1998, 0.0393 in 2001 and 0.0924 in 2005). The income-related health inequality in 2005 was 0.0278, indicating that 30.1% of the total health inequality can be attributed to income. The findings indicate there are health inequalities across the sociodemographic and income groups despite the recent government's efforts. Further research is warranted to investigate what potential policy actions are necessary to decrease the health inequality in Korea.

The Value-Relevance and Timeliness of Goodwill and Goodwill Impairment Losses Following the Adoption of Section 3062

This paper investigates the relationship between 1) equity market values and goodwill and goodwill impairment losses; and 2) past and contemporaneous stock returns and transitional goodwill impairment losses recorded by Canadian firms following the adoption of Section 3062. Standard setters introduced SFAS 142/Section 3062 to increase the relevance and reliability of the goodwill figure by forcing firms to better reflect its fair value on their financial statements. However, in the debate that surrounded the adoption of SFAS 142/Section 3062, concerns were raised that the fair value of goodwill could not be measured reliably enough to produce a relevant goodwill figure and warrant an impairment-only approach. In addition, it was unclear whether TGILs could provide timely information to investors. We show that investors perceive goodwill as an asset, and goodwill impairment losses as sufficiently reliable measurements of a reduction in the value of goodwill to incorporate them in their valuation assessments. Lower valuation weights are put on transitional goodwill impairment losses reported by firms with an independent board of directors while a higher valuation weight is put on transitional goodwill impairment losses recorded by firms with market value of equity lower than book value. Finally, our results suggest that the adoption of SFAS 142/Section 3062 triggered the recognition of goodwill impairment losses already impounded in stock prices. Overall, the empirical evidence is consistent with SFAS 142/Section 3062 improving the quality of the financial information on goodwill provided in the financial statements.

Institutional Investors, Financial Health and Equity Valuation

This paper investigates the relation between institutional ownership, financial health, and the market valuation weights on earnings and book value of equity. We find that firms with high levels of institutional ownership are financially healthier, or less financially distressed, than firms with low levels of institutional ownership. More importantly, we find that the market valuation weight on earnings (book value of equity) increases (decreases) with the level of institutional ownership for profit firms. In contrast, the valuation weight on book value of equity increases with the level of institutional ownership for loss firms. Our findings of the above valuation effect of institutional ownership are consistent with two potential roles of institutions documented in prior literature: (1) institutions merely play a fiduciary role and (2) they play a positive governance role. Additional tests suggest that the level of institutional ownership appears to be an ex ante parsimonious proxy for both current and future financial health and that the valuation effect of institutional ownership cannot be subsumed by incorporating current measures of financial health. Moreover, we show that the valuation effect of institutional ownership is mainly driven by institutions with long investment horizons and monitoring incentives rather than institutions with short investment horizons and little monitoring incentives. We conclude that our findings of the valuation effect of institutional ownership are more consistent with institutions playing a positive governance role than merely playing a fiduciary role.

The pricing of earnings and cash flows in the presence of abnormal and normal accruals

This paper proposes a framework to assess the effects of abnormal and normal accruals on the valuation relevance of earnings and cash flows. We use this framework to investigate the relative weights placed by investors on earnings and cash flows, as a function of estimated normal and abnormal accruals. Assuming that the construct capitalised by investors is (unobservable) economic earnings, and that normal accruals capture the noise in cash flows as a measure of economic earnings, while abnormal accruals capture the noise in reported earnings as a measure of economic earnings, we predict that normal accruals (abnormal accruals) reduce the valuation weights placed by investors on cash flows (earnings). We find that abnormal accruals estimated using a modified version of the Jones (1991) model are associated with lower valuation weights placed on earnings. Results for the cash flow prediction are mixed, in that the valuation weight placed on cash flows in the presence of high magnitudes of normal accruals is lower when abnormal accruals are negative, but not when abnormal accruals are positive. © City University of Hong Kong.

The Dow Jones Industrial Average

The Dow Jones Industrial Average is a flawed index. The index uses price weights instead of conceptually superior market valuation weights. The companies included in the index are not chosen systematically and are not very representative of the U.S. market; and the index ignores returns from dividends. This article shows that alternative stock price indexes that use superior weighting methods and a more systematic inclusion criterion perform very similarly to the Dow Jones Industrial Average, but, ignoring dividends dramatically underestimates the long-run returns earned by stock market investors. If Dow Jones & Co. had included dividend returns in the DJIA when it was formed in 1928, the index would be over 250,000 today.