Measuring Earning Power

1
Measuring Earning Power

• Chapter 24

2
Background

• Miller Modiglianis dividend irrelevance
  theorem
• Dividend policy of normal firm has no impact on
  firms stock price
• This chapter shows how a change in firms cash
  dividend payments can cause short-term stock
  price fluctuations
• Without violating MMs theory
• Also shows how firms EPS are important in
  valuing stock

3
Informational Content of Cash Dividends

• Board of Directors base cash dividend payments
  upon the following
• Long-run targeted dividend payout ratio
• Smoothing of cash dividend payments so they
  follow long-run trend in corporate earnings
• Short-term changes in earnings usually have
  little impact on cash dividend payments
• Reluctance to change (especially decrease) cash
  dividend payments
• Prefer small infrequent increases

4
Asymmetric Information

• Information asymmetry occurs when Board of
  Directors has valuable inside information about
  corporation
• Information is not available to outside investors
• External investors use cash dividend payments as
  a signal
• Contain valuable information

5
Reactions to Cash Dividend Payments

• Healy Palepu (1988) examined stock prices of
  corporations for 60 to 20 days after
  announcement
• 131 corporations that initiated cash dividend
  payments
• Experienced abnormal stock price increase of 4
• Experienced average growth rate of 43 per year
  prior to beginning dividends
• Experienced 164 increase in earnings in the 4
  years after initiating dividends
• Findings suggest firms initiate cash dividend
  payments if they believe the payments can be
  sustained
• Signal by Board of Directors that future
  prospects look good

6
Reactions to Cash Dividend Payments

• 172 corporations that eliminated regular cash
  dividend payments
• Experienced abnormal stock price decrease of 9.5
• Earnings fell over next 4 quarters
• Suggests that market views cash dividend omission
  as a signal of forthcoming bad news

7
Reactions to Cash Dividend Payments

• Do these findings contradict MMs dividend
  irrelevance theorem?
• No, market views changes in cash dividend
  payments as informational content
• Many investors want more information than is
  available from annual reports and public
  announcements
• Investors like corporate earnings forecasts

8
Forecasting EPS

• Examples of corporations that provide earnings
  forecasts
• Moodys
• Standard Poors
• Value Line
• Forecast for a corporation is usually provided by
  a securities analyst who specializes in a
  particular industry

9
Surveys of Forecasts

• Three corporations specialize in providing
  consensus earnings forecasts
• Institutional Brokers Estimate System (I/B/E/S)
  New York
• www.ibes.com
• Zacks Investment Research Chicago
• www.zacks.com
• First Call Florida
• Subsidiary of Thomson Financial Company
• www.thomsonivest.net

10
Surveys of Forecasts

• Employees call professional securities analysts,
  financial analysts, etc., periodically and
  solicit earnings forecasts
• Publish high, low, average and median values
• Data is updated frequently
• Represent current estimates of continuously
  changing consensus forecast
• Compute dispersion measures to determine level of
  uncertainty
• Provided information on
• Earnings growth rate
• Stock split adjustment factor
• Number of forecasters surveyed
• Cash dividends per share
• Stock price

11
Surveys of Forecasts

• May purchase data in following formats
• Paper (hardcopy)
• Diskettes
• Computer tapes
• Electronic mail
• Ability to search database 24 hours a day
• May purchase data for
• Single company
• Industry averages
• All companies within an industry
• All companies listed on a stock exchange
• All forecasts of a specific security analyst

12
Surveys of Forecasts

• First Calls internet site offers
• News
• Chat rooms
• Insider trading information
• Earnings information
• Graphs
• Financial research

13
How Expert Are The Experts?

• After reviewing the forecasts of many different
  securities analysts, discovered forecasters
• Tend to over-estimate EPS
• Tend to revise forecasts downward as earnings
  announcement date approaches
• Seem reluctant to say negative things about
  security issuers
• Issue many more buy than sell recommendations
• May be due to fact that analysts do not want to
  antagonize employers potential clients

14
How Expert Are The Experts?

• Institutional Investor, a monthly publication,
  reports survey results of 2,000 money managers
  every October
• Compiles list of the best security analysts in
  each of over 60 industries
• Forecasts of this all-star team are compared
  with forecasts of other analysts
• Results show that neither group did better than
  the other
• Brown Rozeff report that earnings forecasts
  reported in Value Line Investment Survey were
  better than forecasts generated by sophisticated
  mechanical models

15
Whisper Earnings

• Whisper earnings are forecasts of EPS circulated
  among analysts and trades via web, television and
  financial press
• Unofficial EPS forecasts
• Bagnoli, Beneish and Watts (2000) find whisper
  forecasts to be more accurate than surveys of
  institutional forecasts
• Check out www.WhisperNumber.com

16
Earnings Surprises and Stock Prices

• Latane and Jones developed a model to measure
  earnings surprise
• Standardized Unexpected Earnings

• Numerator measures forecasting error
• Represents difference in firms reported EPS and
  the consensus EPS forecast from I/B/E/S or Zacks
• Can be either , -, or 0
• Dividing by standard deviation of forecasting
  error creates a dimensionless index number
• Allows comparisons between different companies
  and times

17
Earnings Surprise Example

• Given
• Corporation A and B both have forecasted EPS of
  2 and actual EPS of 3
• Corporation A is a predictable public utility
  with a small standard deviation of forecast error
  of 50
• Corporation B is a volatile technology firm with
  a large standard deviation of forecast error of
  2

Both have SUE gt 0 because actual EPS exceeded
expected, but investors in A were more pleasantly
surprisedbecause having actual EPS of 1 above
forecasted EPS is more unusual.
18
Foster-Olsen-Shevlin Event Study

• In 1984 Foster, Olsen Shevlin analyzed the
  impact of a public announcement of a firms
  quarterly earnings on the firms stock price
• Computed SUE for 2,053 firms over 32 quarters
• 65,696 SUEs were ranked in deciles
• Decile 1 contained the 6,570 most negative SUEs
  (worst news announcements)
• Deciles 10 contained the 6,570 largest positive
  SUEs (best news announcements)

19
Foster-Olsen-Shevlin Event Study

• Suggests that the market correctly anticipates
  earnings changes prior to announcement and reacts
  rationally

20
Foster-Olsen-Shevlin Event Study
Investor in Decile 10 can expect to earn abnormal
returns of 3.23 during 60 days after unexpected
earnings surprisean anomaly in efficient
markets theory.

• Shows that the relationship between earnings
  surprise and stock prices continues after the
  announcement

21
Foster-Olsen-Shevlin Event Study

• Results suggests that investors could simply
  determine which firms have experienced /-
  earnings surprise (using WSJ or other public
  information)
• Then take a long/short position and earn abnormal
  returns
• Study suggests
• Earnings expectations are an important
  determinant of stock prices
• If better measures of earnings were used, results
  would have been more compelling
• Studies used earnings reports generated by firms
  own accountants

22
Ambiguities in Accounting Earnings

• EPS are not easy to measure
• GAAP leaves room for interpretation
• Distorted income statements may result from
• Inappropriate use of an accounting procedure
• Use of accrual accounting technique that does not
  link revenues/expenses to period in which cash
  flow actually occurred
• Window-dressing

23
Contrasting Income Statements

• Compare the following income statements
• Identical except in the accounting procedures

Item Statement B, Statement B, Statement A, Statement A, Key
Sales Revenue 9,200 11,000 (1)
Less Returns and allowances -1,000 -1,000
Net sales 8,200 10,000
Beginning inventory 2,000 2,000
Purchases and freight in 6,000 6,000
Net purchases 8,000 8,000
Less Ending inventory -2,000 -3,000 (2)
Cost of goods sold 6,000 5,000
Gross margin 2,200 5,000
Operating expenses
Selling costs 1,500 1,500
Depreciation 500 300 (3)
24
Contrasting Income Statements
Item Statement B, Statement B, Statement A, Statement A, Key
Pension 100 20 (4)
Other expenses 200 50 (5)
Amortization of goodwill 110 30 (6)
Contingent liabilities 90 40 (7)
Salaries 200 200
Bonuses 100 100
Total operating expenses -2,800 -2,240
Net operating expenses (600) 2,760
Less Interest -100 -100
Income (loss) before taxes (700) 2,660
Less Federal taxes (33) (refund) (233) -887
Net income (loss) from operations (467) 1,773
Minimizes taxable income.
True represen- tation of economic income.
25
Contrasting Income Statements

• Both income statements are correct in terms of
  accounting practices
• Points of interest
• Sales
• Statement A includes both cash sales and current
  sales on installment contracts
• Perhaps Statement B does not recognize a credit
  sales until the customers final cash payment on
  Accounts Receivable is actually received

26
Contrasting Income Statements

• Inventory
• Statement A used FIFO, while B used LIFO
• During an inflationary environment FIFO results
  in higher reported profits
• FIFO often causes profit to be more volatile than
  LIFO
• Switching from one technique to the other can
  cause significant one-time distortions in
  earnings
• Some companies keep two sets of books
• One set for public display
• One set for with firm use
• Can try to determine if firm does this by
  comparing federal income taxes paid vs. the
  proportion of reported pre-tax income

27
Contrasting Income Statements

• Depreciation
• Can use several different depreciation methods
• Straight-line
• Units of production
• May be used to accelerate depreciation during
  period of rapid production
• Double-declining balance
• Sum-of-the-digits
• Modified accelerated cost recovery system (MACRS)

28
Contrasting Income Statements

• Accelerated depreciation methods increase
  depreciation during early years of assets life
• Decrease reported accounting income and net
  taxable profit
• Postpones taxes on income
• While the straight-line method may be more
  representative for the firm, IRS requires U.S.
  firms use MACRS
• Encourages investment by giving rapid tax
  write-offs

29
Contrasting Income Statements

• Pension costs categories
• Defined contribution pension plans
• Require employer to deposit a specified amount
  into a pension fund
• AKA profit-sharing plans because specified amount
  may be a percentage of firms profit
• Employers cost is deducted as a current business
  expense from each year
• Liabilities for under-funded pension obligations
  never appear on balance sheet

30
Contrasting Income Statements

• Defined benefit pension plans
• Employer promises to pay retirees a pension
• Creates a legally enforceable liability on
  balance sheet
• Employers required contribution is based on
  annual estimates
• Most hire actuarial consultants to estimate
  present value of legal liability
• Once estimated, employer must decide how much of
  current years earnings to set aside in pension
  fund

31
Contrasting Income Statements

• Assuming firm has a defined benefit pension plan,
  Statement B reflects a large deduction whereas A
  a small one
• Large deduction may be due to fact that firm
  wants to
• Minimize its income tax payments
• Smooth out earnings
• Accumulate surplus assets in pension fund

32
Contrasting Income Statements

• Expensing vs. capitalizing
• Many items can be either expensed or capitalized
• Example motion picture production costs, oil
  well exploration costs, advertising
• Some items were expensed under Statement B
  (leading to lower taxable income) and capitalized
  under Statement A

33
Contrasting Income Statements

• Amortization of Goodwill
• An intangible asset equal to the amount paid for
  an acquired company in excess of book value
• Arises because company has good growth potential,
  brand-name or customer loyalty
• May be amortized up to 40 years
• Statement A uses a longer amortization period
  which reduces costs and increases income

34
Contrasting Income Statements

• Contingent liabilities
• Potential obligations that will occur in future
  if certain conditions occur
• Typically arise from pending litigation or
  guarantees of subsidiary debt
• If liability cannot be reasonably forecasted it
  goes in a footnote to financial statements
• If can be reasonably forecasted, firm must
  recognize as a contingent liability on balance
  sheet
• Accountant has wide discretionary power
• Unlikely that a firm could accomplish all the
  above distortions in a single year
• Just highlights areas in which difference could
  occur

35
The Quality of Earnings

• Does the firms accounting earnings reflect its
  true earning power
• Reported earnings that accurately depict firms
  earning power are considered high quality
• Even if negative
• Reported earnings are consider low-quality if
  special items and/or inappropriate GAAP methods
  are used
• Even if result in positive earnings
• Securities analysts desire an earnings number
  that can be used in a P-E valuation model

36
The Quality of Earnings

• More than one EPS may be reported if the
  potential dilution of EPS exists
• An increase in future number of outstanding
  shares may occur if
• Management elects to sell more shares
• Options to purchase additional shares from firm
  exist (convertible bonds, preferred stock,
  employee stock options, warrants)
• Corporation exchanges stock for debt
• Extraordinary gains and losses
• May distort the normal income stream
• Examination of the firms Statement of Cash Flows
  can help determine the stocks earning power

37
Cash Flows

• Cash flows are not obscured by accrual
  accounting, depreciation, amortization, etc.
• Cash Flows from Operations
• Measures cash flows arising from the production
  and distribution of goods and/or services
• Found in the first part of a firms Statement of
  Cash Flows
• Or, can be computed form Statement of Sources and
  Uses (of Cash)
• Most firms accounting incomes are not highly
  positively correlated with Cash Flows from
  Operations
• Should not value a firms common stock using Cash
  Flows from Operations if firm uses debt

38
Statement of Cash Flows
Firms Activity Cash Inflows Cash Outflows Net Cash Flows
Operating Cash inflows from sales of goods and services Cash paid for operating goods and services Cash flow from operations, or CFO
Investing Cash received from sales of property, plant, equipment, and/or other investments Cash paid for acquisition of property, plant, equipment, and/or other investments Cash flow from investing
Financing Cash received from issue of debt or capital stock (if relevant) Cash paid for dividends and reacquisition of debt or capital stock (if relevant) Cash flow from financing (if relevant)
Other Cash received from foreign exchange transactions, etc. (if relevant) Cash paid for foreign exchange transactions, etc. (if relevant) Cash flow from other activities (if relevant)
Total Net change in cash for the period
39
Statement of Cash Flows

• Reports net cash flows generated from operations,
  investing and financing activities
• Accounts for the net change in firms aggregate
  cash position
• The firms Statement of Cash Flows and financial
  footnotes (or supplementary reports) contain
  needed information for determining cash flows to
  stockholders

40
Cash Flows Available to Equity Shareholders

• Represents firms leverage-free cash flows
• Adjust CFO for any debt-financing effects
• Combined leverage effects
• Cash required to service debt net of tax effects
  net cash flow for investing plus (minus) any
  increase (decrease) in debt financing
• Deduct combined leverage effect from CFO to
  obtain leverage-free cash flows
• Present value of the leverage-free cash flows can
  be found using required rate of return on equity

41
Cash Flows to Equity Shareholders vs. Economic
Income

• Economic income represents the maximum amount of
  consumption opportunities that can be withdrawn
  from firm without reducing future consumption
  opportunities
• Accounting income represents an upward biased
  estimate of economic income for most firms
• Net income includes retained earnings which are
  unavailable for consumption
• Cash flows available to shareholders measures
  consumption opportunities available to owners
• Contains deductions needed to sustain firms
  future earning power
• Must include effect of debt financing

42
Problems with Cash Dividends

• Calculating present value of cash dividends
  provides an estimate of a stocks value
• But it is an invalid estimate if a firm is
• Repurchasing shares
• Generating more cash than paying out as dividends
• Using some cash to repurchase shares which cause
  reverse dilution of EPS, cash dividend per share
  and value per share
• Growing because projects have ROE gt cost of
  capital
• Declining because projects have ROE lt cost of
  capital
• Can maximize firm value by paying one large
  liquidating dividend
• Many fundamental analysts prefer the P-E ratio
  approach

43
The Bottom Line

• Asymmetric information exists because Board of
  Directors has access to inside information not
  known to investors
• MM theory does not mean a cash dividend cannot
  offer informational content
• External investors evaluate cash dividends for
  signals about future
• I/B/E/S, Zacks and First Call specialize in
  compiling earnings forecasts
• Valuable in determining if a corporations
  earnings contain surprises

44
The Bottom Line

• Stock prices tend to increase (decrease) prior to
  announcement of positive (negative) earnings
  surprises
• Abnormal stock returns continue for a 2 month
  time period after earnings announcement
• GAAP leaves room for interpretation
• Should select accounting methods that represent
  true economic income
• Security analysts must adjust accounting income
  to obtain true economic income estimates
• Many analysts use corporate cash flows rather
  than earnings to measure earning power