This study examines whether investors’ familiarity bias affects their earnings-based equity valuation. Building on theoretical and empirical findings from prior studies, we hypothesize that familiarity bias may reduce the earnings-based equity valuation of foreign firms. We also hypothesize that the perceived link between current earnings surprises and future operating cash flows is one channel through which familiarity bias affects earnings-based equity valuation. Using the setting of the earnings announcements of U.S.-listed non-U.S. firms and U.S. firms matched by industry, year, and firm characteristics, we find that U.S. investors discount the earnings response coefficient of non-U.S. firms relative to that of U.S. firms by 46%. Using analysts’ earnings forecast revisions immediately following the earnings announcements as the proxy for the market-perceived link between current earnings surprises and future operating cash flows, we find that analysts significantly discount the link for non-U.S. firms relative to U.S. firms. Both discounts exist only in the subsamples of non-U.S. firms toward which U.S. investors have a higher degree of familiarity bias. Thus, we provide empirical evidence of the effect of the familiarity bias on earnings-based equity valuation and the channel through which it affects equity valuation.
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U.S.-listed non-U.S. firms that do not use U.S. generally accepted accounting principles (GAAP) to prepare their financial statements are required to file a form 20-F to provide accounting information that is substantially similar to financial statements that comply with U.S. GAAP. Starting in the fiscal years ending after November 15, 2007, U.S.-listed non-U.S. firms that use International Financial Reporting Standards as adopted by the International Accounting Standards Board to prepare their financial statements were no longer required to file 20-F forms.
This procedure automatically excludes firms traded over the counter and on the “Pink Sheets.” Such firms are not subject to the SEC’s disclosure regulations, and are not required to adhere to U.S. GAAP in their financial reporting.
Our results are robust to the inclusion of firm-year observations in which losses are reported.
In our study, we control for the potential issue of the cross-sectional dependence of the estimation of abnormal returns by adopting the market model to estimate abnormal returns (Brown and Warner 1985).
There are four principal components, of which two have an eigenvalue greater than 1. We use the principal component with the largest eigenvalue (1.332), which captures 62 percent of the variance in the geographical distance measure, 58 percent of the variance in the industry ranking correlation measure, 50 percent of the variance in the exports to the U.S. measure, and 16 percent of the variance in the measure of language.
We hand-checked the websites of firms with headquarters in the Bahamas, Bermuda, the British Virgin Islands, the Cayman Islands, the Marshall Islands, and Papua New Guinea to confirm their countries of domicile.
DeFond and Park (2001) use dummy variables for firm size, the market-to-book value of equity, and the number of analysts following. Collins and Kothari (1989) use a dummy variable to control for systematic risk in the ERC regression and argue that the continuous value of systematic risk may be affected by estimation error. Using raw data for these three variables does not change either the sign or the significance of the coefficients.
Incorporating foreign firms in the market index may lead to noisy expected return estimates from the factor model (market returns of the Fama–French three-factor model). We have checked the WRDS data manual and can confirm that the market returns retrieved from the CRSP exclude ADR firms, which are the main type of cross-listing firms.
We also match non-U.S. firms with U.S. firms by the percentage of institutional holding and bid-ask spread to control for the risk related to investor base and liquidity, two important determinants of the cost of capital. Consistent with the findings from the sample matched by implied cost of capital, non-U.S. firms are subject to a significant ERC discount, although the magnitude of the discount is smaller than that documented in the main test.
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We thank conference participants at the 2014 American Accounting Association (AAA) Annual meeting, and workshop participants at The Chinese University of Hong Kong, Tsinghua University for helpful comments. Yashu Dong acknowledges the financial support from the MOE project of Key Research Institute of Humanities and Social Science in University (No. 18JJD790010).
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Dong, Y., Young, D. & Zhang, Y. Familiarity bias and earnings-based equity valuation. Rev Quant Finan Acc (2021). https://doi.org/10.1007/s11156-020-00949-y
- Familiarity bias
- Earnings-based equity valuation
- Earnings response coefficients
- Analyst earnings forecast revisions