Download Research has demonstrated a decline in firms` earnings response

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.
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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
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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)
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