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EARNINGS RESPONSE CO-EFFICIENT (ERC) Why would investors respond more strongly to good or bad news in earnings depending on the firm? i.e. for the same amount of earnings the security market response is not the same for different firms. ERC research - identification and explanation of differential market response to earnings. Definition: ERC measures the extent of the security’s abnormal market return in response to the unexpected component of the firm’s reported earnings. (i.e. ERC is the ratio of the change in the firm’s abnormal market return to the change in abnormal earnings.) Empirical evidence supports a differential market response depending on the factor associated with the firm and/or the nature of the earnings.. Affect on ERC a higher demand for a firm's shares implies a higher increase in market price and return in response to GN, therefore a higher ERC a lower demand for a firm's shares implies a lower increase in market price and return in response to GN, therefore a lower ERC FACTORS WHICH AFFECT ERC: BETA The more risk related to the firm's expected returns the lower will be the investor's reactions to a given amount of unexpected earnings. (Note: beta shows risk of a security so you can assume that a high beta means a high risk). CAPITAL STRUCTURE ERC for a highly levered firm is lower than for a firm with little or no debt, Any good news passed on means that the debt holders get this benefit instead of the investors. (Thus it is important to disclose the nature & magnitude of financial instruments including off-balance sheet) PERSISTENCE Source of increase in current earnings affects the ERC: - if earnings are expected to persist into the future this will result in a higher ERC - if the component in the earnings is non-persistent (i.e. unusual, non recurring items) this will result in lower ERC According to ERC theory it is desirable to report sufficient detail on the income statement so that investors can separate persistent and non-persistent components. (If the non-persistent components are buried, investors may get an exaggerated impression of the future earning power of the firm.) Note that “core profits” are those profits which are expected to continue into future years, therefore would be considered persistent. 81898129 1 EARNINGS RESPONSE CO-EFFICIENT (ERC) EARNINGS QUALITY Higher quality of earnings (as defined by the higher main diagonals of the related info system) results in a higher ERC. Note: A higher quality could mean BN -> high ERC for sale of shares. GROWTH OPPORTUNITIES To the extent that current good news in earnings suggests growth opportunities the ERC will be high . Consider Internet stocks - high MV of equity compared to BV, thus high ERC (although high risk pushes down ERC!) SIMILARITY OF INVESTOR EXPECTATIONS Although different investors may have different expectations of firm’s future performance based on prior expectations - to the extent that they use a common info source such as analysts’ forecasts, they will put the same interpretation on firm’s announcement of earnings. More similar the investors’ expectations, greater the effect of a $ of abnormal earnings on share price. (More precise the analysts’ forecasts -> more similar are investors’ earnings expectations -> greater the ERC.) Refer back to last lesson – different investors have different expectations – errors in ups and downs generally net out. However, if all move in the same direction – then the magnitude is higher, thus higher ERC. INFORMATIVENESS OF PRICE The more informative the price, the lower the information content of current earnings and therefore the lower the ERC. (Note: firm size is a proxy for informativeness of price) Market price includes all publicly known info large firms typically impart more info on a regular basis -> quarterly reports; media releases; forecasts small firms show higher ERC upon release of earnings info Implications of ERC theory: Information content of reported net income can be measured by the extent of the share price change upon release of current income. Note: the higher the main diagonal probabilities, the greater we would expect the ERC to be. Disclosure is important given specific research findings: Lower informativeness of price for smaller firms -> these firms should provide more overall disclosure Highly levered firms -> should expand disclosure of nature & magnitude of financial instruments, including off balance sheet instruments Growth opportunity firms -> should disclose segment info Earnings persistence & quality of earnings -> should disclose components of NI 81898129 2 EARNINGS RESPONSE CO-EFFICIENT (ERC) Forecasts – impact on ERC Increased disclosure should increase ERC Easier for investors to assess future prospects of firm Voluntary nature of forecast gives investors confidence that the firm is not hiding anything. In summary, information content of report NI can be measured by the extent of the share price change upon release of current income. Info content in current earnings => investors revise beliefs => buy/sell decisions happen => market price changes. From info system in Lesson 2 – the higher the main diagonal, the greater we would expect the ERC to be. i.e. more useful info should result in a higher ERC. Note: ERC is most commonly tested in a multiple choice. You could be tested on the definition of ERC or on the ERC factors. MCQ’s to test your knowledge: When is the earnings response coefficient (ERC) likely to be relatively high? 1) When the firm is high risk. 2) When the firm is very large. 3) When a large non-recurring gain is known to be included in operating income. 4) When analysts’ earnings forecasts are precise Research has demonstrated a decline in firms’ earnings response coefficients (ERC), other things being equal, when firms report numerous unusual and non-recurring items in earnings over time. Why does the ERC decline? 1) Numerous unusual and non-recurring items suggest that the firm is approaching financial distress and possible bankruptcy. 2) The firm is high risk. 3) Numerous unusual and non-recurring items over time suggest bad earnings management. 4) Unusual and non-recurring items have zero persistence. Which of the following statements is a correct statement about earnings response coefficients? 1) An earnings response coefficient is the ratio of unexpected earnings divided by abnormal returns 2) An earnings response coefficient is measured as the ratio of abnormal stock returns divided by unexpected earnings 3) An earnings response coefficient is measured only for quarterly earnings released by firms 4) An earnings response coefficient is positively related to beta risk (answers: 4, 3 and 2) 81898129 3