Abstract
We examine the premium/discount firm characteristic that fundamentally affects the value relevance of two key accounting line items, earnings and book values. We argue that from the perspective of both the residual income and option-style valuation models, the relative valuation roles of earnings and book values differ fundamentally between firms that trade at a premium vis-à-vis discount to book value. We find that book values play a significantly more important role in equity valuation than earnings when firms trade at a discount. We also find that other known influential conditions, such as the sign of earnings (Collins et al. in Acc Rev 74(1):29–61, 1999) or the relative levels of earnings and book value (Burgstahler and Dichev in Acc Rev 72(2):187–215, 1997), become inconsequential when the premium/discount condition of the firm is controlled for. The discovered relationships between the relative valuation roles of book values and earnings and the discount/premium characteristics of the firm are robust to the effect of time, information environment and the industry of the firm.
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Notes
It is implied that investors can learn about the existence of such assets from non-financial statement sources of information, and price them into the market value of firms accordingly.
Statement of Financial Accounting Standards (SFAS) 2 requires R&D expenditures to be expensed. SFAS 86 allows software firms to capitalize software development costs after technological feasibility is established, and is an exception to SFAS 2.
Statement of Financial Accounting Standards (SFAS) 142 requires costs of internally developed intangible assets that are not specifically identifiable or have an indefinite life to be expensed.
In this study value relevance is defined as the magnitude and the level of statistical significance of the regression coefficient attached to the variable of interest and incremental information content is defined as the portion of the valuation regression model’s R2 that can be specifically attributed to the variable of interest.
Indeed, as shown in Table 4, the median value of the return on common equity of profitable firms that trade at a discount is only 6.6 %, which is likely to be less than the cost of equity capital for these firms.
Because advertising expenditures are known to generate intangible assets with short useful lives (Ravenscraft and Scherer 1982; Bublitz and Ettredge 1989), they are likely to convey information on future earnings. Advertising expenditures are also associated with lower cost of capital (Huang and Wei 2012), which is likely to positively affect the firm’s value.
In contrast with the highly asymmetric and skewed distributions of regression variables which are scaled by single-variable deflators, scaling by the composite deflator renders close-to-normal frequency distributions. The use of the composite deflator makes the regression parameters less sensitive to the impact of outliers (results not reported but available upon request). It also results in less skewed and more symmetrically distributed regression error term. In short, the composite deflator mitigates the possible violations in our OLS model.
For each year of the sample period we eliminate firm-years in the top and bottom one percentile of scale-deflated variables in Model (1).
Several indicators point to this: the highest median price-to-book (2.3) and price-to-sales (2.0) ratios, smallest size in terms of median value of assets ($76 million), sales ($44 million) and book value of equity ($32 million), lowest median asset turnover (0.7), highest percentage of R&D firms (66 %), the lowest percentage of dividend paying firms (7 %), and the highest percentage NASDAQ firms (77 %).
DP firms have much lower median ROE (6.6 %), ROA (3.2 %) and net profit margin (3.2 %) than those of PP firms.
In other words, it is the expensing of R&D that drives losses for a substantial percentage of PL firms. Indeed, there is a negative correlation between the reported losses and R&D expenditures in PL firms (Pearson’s correlation = −0.55, significant at 1 %).
Table 4 shows that only 38.8, 32.1, 7.3 and 12.7 % of firms in PP, DP, PL and DL contexts, respectively, pay dividends.
The market value of common equity is used as a proxy for information environment/size.
For PP firms the triciles include firms with, respectively high ROE, medium ROE, and low ROE while, for PL firms the triciles include firms with large negative ROE, medium negative ROE and small negative ROE. Similarly, for DP firms the triciles include firms with, respectively high ROE, medium ROE, and low ROE while, for DL firms the triciles include firms with large negative ROE, medium negative ROE and small negative ROE.
We further test whether our main findings are an industry-driven phenomenon. We replicate the tests reported in Table 5 for the six largest industry sectors with the Standard Industrial Classification codes starting with 1, 2, 3, 4, 5 and 7. The results show that our principal findings remain unaffected by firms’ industrial affiliation. We also test whether our main findings vary across years by estimating yearly regressions for the four contexts, and find only insignificant changes in the coefficients and incremental contributions associated with earnings and book values. Therefore, it can be concluded that the discovered valuation effects of the premium/discount condition are not driven by the industry membership and yearly effects. These results are not reported in the paper, but available upon request by the readers.
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Acknowledgments
The authors would like to thank Cheng-Few Lee (the editor) and the anonymous referees for helpful comments. We also appreciate helpful comments from Jo Danbolt, John Holland, Karen Lin, Clairmont Carter, Erhan Mergen, Bill Stevenson, Monty Carter, the seminar participants at the Rochester Institute of Technology, the participants at the 2010 American Accounting Association National Meeting, San Francisco, USA; the 2009 British Accounting Association, Dundee, UK; and the 2006 European Accounting Association Congress, Dublin, Ireland.
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Aleksanyan, M., Karim, K. Searching for value relevance of book value and earnings: a case of premium versus discount firms. Rev Quant Finan Acc 41, 489–511 (2013). https://doi.org/10.1007/s11156-012-0318-8
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DOI: https://doi.org/10.1007/s11156-012-0318-8