Capital Markets Research
(Using Archival Data)
Oriented towards financial accounting issues
Links with finance and economics
Questions?
• Do earnings matter? (Ball and Brown, JAR, 1968;
Beaver, JAR, 1968)
• Are earnings components valued similarly?
• Do earnings have incremental information content
over cash flows
• Does the perceived quality of an auditor affect the
relation between earnings and returns?
• Are disclosures about pension benefits or other postretirement benefits value relevant?
• Would financial statements be more informative if
GAAP were changed to permit managers to capitalize
R&D?
Developments in Finance
and Accounting
Finance Literature
Market efficiency -- Fama, 1970, 1971
-- prices fully reflect all available information
CAPM -- Sharpe, 1964; Linter, 1965
-- a model of firm-specific expected returns
Developments in Finance
and Accounting
Accounting Literature
Positive Accounting Theory -- Watts and Zimmerman,
1986
• Predicts that the use of accounting numbers in
compensation and debt contracts and in the political
process will influence a firm's reporting choices
Valuation Theory -- Ohlson, CAR, 1995
• Provides accounting with theory, based on finance
theory, on how earnings and book values map into
prices.
Relation between Accounting Equity Values
& Stock Market Equity Values
Accounting Measure of Wealth
A0
-
L0
=
E0
Relation between Accounting Equity Values
& Stock Market Equity Values
Accounting Measure of Wealth
A0
-
L0
=
E0
+ NI1
- Div1
E1
Relation between Accounting Equity Values
& Stock Market Equity Values
Accounting Measure of Wealth
A0
-
L0
=
E0
+ NI1
- Div1
A1
-
L1
=
E1
Relation between Accounting Equity Values
& Stock Market Equity Values
Accounting Measure of Wealth
A0
-
L0
=
E0
+ NI1
- Div1
A1
-
L1
=
E1
Market’s Measure of Wealth
Relation between Accounting Equity Values
& Stock Market Equity Values
Accounting Measure of Wealth
A0
-
L0
=
E0
+ NI1
- Div1
A1
-
L1
=
E1
Market’s Measure of Wealth
Price0
Relation between Accounting Equity Values
& Stock Market Equity Values
Accounting Measure of Wealth
A0
-
L0
=
E0
Market’s Measure of Wealth
Price0
+ NI1
Return1
- Div1
A1
-
L1
=
E1
Price1
Relation between Accounting Equity Values
& Stock Market Equity Values
Accounting Measure of Wealth
A0
-
L0
=
E0
Market’s Measure of Wealth
Price0
+ NI1
Return1
- Div1
A1
-
L1
=
E1
Price1
We have 2 measures
of wealth and
changes in wealth
Relation between Accounting Equity Values
& Stock Market Equity Values
Accounting Measure of Wealth
A0
-
L0
=
E0
Market’s Measure of Wealth
↔
Price0
+ NI1
Return1
- Div1
A1
-
L1
=
E1
Price1
Relation between Accounting Equity Values
& Stock Market Equity Values
Accounting Measure of Wealth
A0
-
L0
=
E0
+ NI1
- Div1
A1
-
L1
=
E1
Market’s Measure of Wealth
↔
↔
Price0
Return1
Price1
Relation between Accounting Equity Values
& Stock Market Equity Values
Accounting Measure of Wealth
A0
-
L0
=
E0
+ NI1
- Div1
A1
-
L1
=
Market’s Measure of Wealth
↔
↔
E1
Price0
Return1
Price1
Observations:
•
E0 = Price0
•
NI1 = Return1 (cum div)
Relation between Accounting Equity Values
& Stock Market Equity Values
Accounting Measure of Wealth
A0
-
L0
=
E0
+ NI1
- Div1
A1
-
L1
=
E1
Market’s Measure of Wealth
↔
↔
Price0
Return1
Price1
Observations:
Returns happen everyday.
Earnings are reported
periodically.
Relation between Accounting Equity Values
& Stock Market Equity Values
Accounting Measure of Wealth
A0
-
L0
=
E0
+ NI1
- Div1
A1
-
L1
=
E1
+ NI2
- Div2
A2
-
L2
=
E2
Market’s Measure of Wealth
↔
↔
Price0
Return1
Price1
Relation between Accounting Equity Values
& Stock Market Equity Values
Accounting Measure of Wealth
A0
-
L0
=
E0
+ NI1
- Div1
A1
-
L1
=
- Div2
-
L2
=
↔
↔
E1
+ NI2
A2
Market’s Measure of Wealth
E2
Price0
Return1
Price1
Are current earnings
good predictors of
future earnings?
NI1 = NI2
Common Market-Based Tests
• Returns tests
– Event study
– Association test
• Price tests
Event Study
• “Direct” link between information and use of
information
• Event (loose definition)
– Identifiable happening or announcement
that you can pinpoint in time
that provide NEW information
relevant to the market
• Short window (days)
Event Study
• Like --– Earnings announcement (Compustat, IBES)
– Auditor change (press release, Dow Jones Interactive, Lexis/Nexis)
– Change in accounting standard (press release, Dow Jones Interactive,
Lexis/Nexis)
– New laws or regulations
• Does the market react to this event (or information from this
event)?
• Model:
Unexpected Returns = Unexpected Earnings
(or Other New Information)
Issues in Event Studies
•
•
•
•
•
Event date?
Model? Unexpected Returns = Unexpected Earnings
Event window? (cumulative abnormal returns [CARs])
Expectation models?
For returns
– CAPM (estimate parameters in event window/non-event
period and apply to event period)
– market adjusted returns (adjust by market index or industry
index or small cap and large cap index)
• For earnings (or other info)
–
–
–
–
Last year’s earnings
Last year’s earnings with growth
Time-series model
Analysts forecasts
Association Tests
• Link between information and use of
that information
• Longer window tests (year)
• Two Basic Approaches --
Earnings Responses Coefficient
Model?
(Un)expected Returns = Unexpected Earnings
(Un)expected Returns = INT + ERC*Unexpected Earnings + e
• Earnings are like an annuity
• So, an Earnings Responses Coefficient (ERC) should be near 1 + 1/rate
(where r is the risk adjusted discount rate for equity)
Economic Determinants of ERC-• persistence, risk, growth and interest rate
•  control for in studies
•
Kormendi and Lipe, JOB, 1987; Easton Zmijewski, JAE, 1989; Collins and Kothari, JAE, 1989
Some Problems with ERC Studies
•
•
•
•
heavily statistical based -- time series of earnings
predictive ability
do not control for accounting methods –
ERC coefficients too low (1 to 3)
- price lead earnings
- inefficient capital markets
- GAAP deficient
- transitory earnings
Another Approach
Model?
Returns = Earnings + Changes in Earnings (Easton Harris, JAR, 1991)
• Earnings are an increase in the book equity value and returns are an
increase in the market equity value.
• So the coefficient on earnings should be one.
• Changes in earnings are like an annuity so coefficient should be near
1 + 1/rate
Some similar problems -- price lead earnings
- inefficient capital markets
- GAAP deficient
- transitory earnings
Price Tests
-- the longest window!
-- Ohlson theoretical work
Model Variations:
1. Price = Earnings
Earnings are an annuity
So, the coefficient on earnings should be near 1 + 1/rate
where r is the risk adjusted discount rate for equity
2. Price = Book Value
Book value is the accountants' measure of equity
Market Value is the Market's measure of equity
So, the coefficient on book value should equal one.
Price Tests (continued)
3. Price = Book Value + Earnings
Price is a weighted average of book values and earnings
So, weights are also part of coefficients
Barth, Beaver, Landsman, JAE, 1998
Collins, Maydew, Weiss, JAE, 1998
4. Price = Book Value+Residual Income (or Abnormal Earnings)
where
residual income=current year's earnings - beginning book value * r
Some Problems --
value of r
-
persistence of earnings
-
GAAP deficient (for 4 it should not matter)
-
GAAP conservative
-
transitory earnings
-
econometric issues -- size
Other Areas to Investigate
•
•
•
•
•
accruals and accruals models
earnings versus cash flows
disclosure versus recognition
financial statement analysis
properties of accounting earnings related to
corporate governance, ownership…
• market inefficiency explanations versus
behavioral explanations related to accounting
anomalies
• Usefulness of accounting information in credit
markets
Useful Tools
• One page summary of research idea,
research question and motivation
• Kinney paragraphs
– What is the research question?
– Why do we care? (motivation)
– How are we going to answer?
• Libby boxes
– Economic construct
– Empirical proxies (& explanation)
– Variable description (& data source)