Knowledge that Transforms

This study tests predictions that pricing multiples on and incremental explanatory power of equity book value (net income) increase (decrease) as financial health decreases. Tests using a sample of 396 bankrupt firms and tests using a larger, pooled sample both yield inferences consistent with predictions. Findings are robust to inclusion of controls for industry, size, return-on-equity, and volatility of equity returns. Equity book value and net income multiples and incremental explanatory power vary predictably across three illustrative industries, selected based on the likely extent of unrecognized intangible assets.

We examine the effect of underwriting relationships on analysts' earnings forecasts and recommendations. Lead and co-underwriter analysts' growth forecasts and recommendations are significantly more favorable than those made by unaffiliated analysts, although their earnings forecasts are not generally greater. Investors respond similarly to lead underwriter and unaffiliated `Strong buy' and `Buy' recommendations, but three-day returns to lead underwriter `Hold' recommendations are significantly more negative than those to unaffiliated `Hold' recommendations. The findings suggest investors expect lead analysts are more likely to recommend `Hold' when `Sell' is warranted. The post-announcement returns following affiliated and unaffiliated analysts' recommendations are not significantly different.

A cross-sectional analysis of cash compensation paid to CEOs of 713 US firms reveals that the sensitivity of compensation to earnings varies directly with earnings persistence. Additional analysis indicates that this sensitivity is greater for cases where executives are approaching retirement. Such evidence suggests the use of earnings persistence to counterbalance adverse consequences of earnings-based contracting with managers who face finite decision horizons.

A model of earnings, cash flows and accruals is developed assuming a random walk sales process, variable and fixed costs, and that the only accruals are accounts receivable and payable, and inventory. The model implies earnings better predict future operating cash flows than current operating cash flows and the difference varies with the operating cash cycle. Also, the model is used to predict serial and cross-correlations of each firm's series. The implications and predictions are tested on a 1337 firm sample over 1963–1992. Both earnings and cash flow forecast implications and correlation predictions are generally consistent with the data.

We show that a model of undifferentiated price competition closely predicts US audit market concentration. Contracting practices, client size distributions and differences in auditor productivity jointly determine audit firms' market shares. In contrast to prior literature, neither quality differences nor economies of scale for larger firms are necessary in our model to explain audit market concentration.

This study examines the usefulness of an analyst-based valuation model in predicting cross-sectional stock returns. We estimate firms' fundamental values (V) using I/B/E/S consensus forecasts and a residual income model. We find that V is highly correlated with contemporaneous stock price, and that the V/P ratio is a good predictor of long-term cross-sectional returns. This effect is not explained by a firm's market beta, B/P ratio, or total market capitalization. In addition, we find errors in consensus analyst earnings forecasts are predictable, and that the predictive power of V/P can be improved by incorporating these errors.

The price-earnings relation can be characterized as a system of simultaneous equations. Earnings and prices can behave as if they are both endogenously determined because they are jointly affected by information that is difficult to specify explicitly. Specification tests provide evidence that both earnings changes and price changes are endogenous. The price and earnings coefficients increase from OLS to joint estimation and, under a restrictive set of assumptions, provide increasingly similar estimates of the permanent component of earnings. The evidence is consistent with the contention that a portion of the single-equation bias can be mitigated via joint estimation.

We demonstrate the value-relevance of foreign earnings for US multinational firms by examining the associations between annual abnormal stock performance and changes in firms′ domestic and foreign incomes. For 2570 tirm-year observations between 1985 and 1993, both foreign and domestic earnings changes have significant positive associations with annual excess return measures: however, the association coefficient on foreign income is significantly larger than the association coefficient on domestic income. We demonstrate this larger association coefficient for foreign income is consistent with differences in growth opportunities between domestic and foreign operations.

Pre-announcement information is private information gathered in anticipation of a public disclosure. Event-period information is private information useful in conjunction with the announcement itself. Typically rational models of trade are based exclusively on one type of information. Such models are less descriptive of real market settings and misspecified empirically. Therefore, we introduce a model of rational trade with both features and discuss its implications.