Price over earnings is the most common ratio quoted in valuing companies. Is it difficult to measure this ratio? After all, these figures are fully disclosed in earnings releases. The answer is, looking at the figures – just the figures – is not enough. When looking at earnings, we have to keep in mind two things, the intention of the discloser, and the quality of the earnings disclosed.
Source: https://www0.gsb.columbia.edu/mygsb/faculty/research/pubfiles/12923/FAJ%20EQ%20WP.pdf
In Value Destruction and Financial Reporting Decisions, FAJ (Nov/Dec 2006), by John Graham, Harvey Campbell and Rajgopal Shiva, found that “the destruction of shareholder value through legal means is pervasive, if not a routine way of doing business. Indeed, we assert that the amount of value destroyed by firms striving to hit earnings targets exceeds the value lost in these high profile fraud cases.”
There are many ways that managers can manipulate real activities of companies in order to avoid reporting losses. As per the model in Dechow et al. (1998), this is done through:
- price discounts,
- temporarily increasing sales,
- overproduction to report lower COGS,
- reduction of discretionary expenditures to improve reported margins.
In addition, Graham, Campbell and Shiva also included:
- delaying or cancelling valuable investment projects,
- cutting R&D,
- shirking on maintenance expenses,
- decreasing marketing expenditures.
The difficulty for outsiders in the midst of all this manipulation is therefore, how to determine the quality of earnings presented by insiders. On the flip side, how would managers (insiders) effectively communicate the quality of their earnings?
Here, most CFOs will insist that their earnings are revenues minus properly matched expenses. At first glance, emphasis on matching makes sense. However, standard setters believe that, “the idea that matching is important is somewhat misleading. Historical cost accounting necessarily involves allocating costs or benefits over some accounting period. However, we never do matching right. Most firms use straight-line depreciation. How can that reflect good matching?”¹
If the ideal solution lies in proper matching and we could never do matching right, or uniformly, or even objectively, hence, the quality of matching as a signal for quality earnings does not work in practice.
Then there is the question of whether we wish to take away managers discretion in reporting. There are two different directions which we could take from here, either to create yet more and more standards, or whether we should promote principles over rules-based accounting. Dichev, Graham and Shiva remarked in their paper, Earnings Quality : Evidence From The Field (2012), “81% of CFOs believe that the level of discretion today is lower than it used to be, suggesting that reporting discretion has been substantially reduced over time”.
There is no easy answer to how much discretion – too much, and it will be hard to judge the quality and open greater avenues for misreporting earnings, too little, and the report might as well be just a checklist of whether or not earnings meet the analyst consensus estimate.
According to Graham, Harvey and Shiva, “We would have thought that analyst consensus estimate would come out to be more important; and in the interviews, the CFOs told us that missing the consensus number leads to the largest stock price reaction”.²
What the earnings figure is benchmarked against is equally as important. The question of whether the huge stock price reaction is the market response to the information content in analyst consensus or the actual earnings figures, or the benchmarking process itself is still up in the ‘academic research’ air. It could very well be that institutional investors rely greatly on analyst consensus that any deviation from it, however slight, may move the market price.
Source: https://www0.gsb.columbia.edu/mygsb/faculty/research/pubfiles/12923/FAJ%20EQ%20WP.pdf
Another metric to look at is cash flow. Eventhough for young companies sales growth may be more important than earnings, cash flow, is the lifeblood of any company be they young or old.
Source: https://www0.gsb.columbia.edu/mygsb/faculty/research/pubfiles/12924/Rajgopal_value.pdf
In addition, it could be that we not only have to look at figures in the reports, but also compare reports between similar companies for signs of anomalies. According to Sugata Roychowdhury, ceteris paribus, unusually low expenses or unusually high production cost compared to the others in the same industry can be useful flags.³
Source: https://www0.gsb.columbia.edu/mygsb/faculty/research/pubfiles/12923/FAJ%20EQ%20WP.pdf
As Shiva pointed out, are we being too myopic in emphasising earnings as the end all and be all metric? And does concentrating on frequent earnings reporting mean that we are encouraging managers to prioritise short-term over long-term projects? Should we instead focus on the integrity and process of financial reporting?
Myopic or not, in light of how few metrics we can rely upon and systematically compare, any measure is a good measure if the alternative is none.
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Earnings Quality : Evidence from the Field
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Value Destruction and Financial Reporting Decisions
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Earnings Management Through Real Activities Manipulation
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