Analyzes three separate disclosures of changing default risks for information about future bank cash flows and examines how investors impound this information in bank stock prices. Impact of bank loan portfolio cash flows and default risks on bank stock market values; Commercial bank loan loss accounting; Set of cash flow prediction tests.
This study examines the extent to which parsimonious and general cross‐sectional valuation models, restricted to include only publicly available historical accounting information, explain share prices in the cross section, identify periods when market mispricing may be more pervasive, and also identify which shares within those cross sections are more likely to be mispriced. Our model simply includes historical book value, earnings, dividends, and growth, but it explains on average over 60 percent of the cross‐sectional variation in share prices in annual estimations across 1975–2011. We also examine the extent to which the residuals indicate mispricing. The quintile of stocks picked by our model as most likely underpriced outperform the quintile of stocks picked as most likely overpriced by an average of 9.9 percent over the following 12 months, after controlling for size. We also predict and find that value residuals are better predictors of future abnormal returns: (i) among firms that are not covered by analysts; (ii) among firms that face fewer accounting measurement challenges; and (iii) when we estimate value model parameters by industry/year. We also predict and find our approach works better in periods when the mapping of fundamentals into prices is weaker. This study contributes a novel and straightforward approach to map accounting fundamentals into share prices in order to identify mispricing in time‐series and in the cross section.
Empirical accounting research provides surprisingly little evidence on whether accounting earnings numbers capture cross-sectional differences in risk that are associated with cross-sectional differences in share prices. We address two questions regarding the risk-relevance of accounting numbers: (1) Are accounting-related risk measures (i.e., the systematic risk and total volatility in a firm's time-series of residual return on equity) associated with the market's assessment and pricing of equity risk? (2) If so, then are these accounting-related risk measures incrementally associated with the market's assessment and pricing of equity risk beyond other observable factors, such as those in the Fama and French (1992) three-factor model? We develop an accounting-fundamentals-based measure of the market's pricing of risk—the difference between actual share price and a residual income valuation model estimate of share value using risk-free rates of return. Our results show that both systematic risk and total volatility in residual return on equity partially explain this pricing differential, and that the explanatory power of total volatility is incremental to the Fama and French (1992) factors—market beta, firm size, and the market-to-book ratio.
We examine how fair-value-income measurement affects commercial bank equity analysts' risk and value judgments. Normatively, holding information and other underlying economics constant, bank analysts' risk and valuation assessments should distinguish between banks with different risks, but should not depend on how banks measure income. In our experiment, we vary income measurement—full-fair-value (all fair-value changes recognized in income) versus piecemeal-fair-value (some fair-value changes recognized in income, others disclosed in the notes). We also vary interest-rate-risk exposure (exposed versus hedged). We find that bank analysts' risk and value judgments distinguish banks' exposure to interest-rate risk only under full-fair-value-income measurement. Our evidence contributes to research concerned with financial performance reporting, risk, and fair-value accounting by demonstrating that differences in income measurement affect fundamental judgments of specialist analysts. Our findings are striking because they: (1) point toward an important role for measurement and recognition of fair-value gains and losses in income, and (2) suggest that note disclosure is not a substitute for financial-statement recognition (even for professional analysts specializing in banks and working in a context that involves assessment of core operations of a bank). These results should be of interest to accounting standard setters as they evaluate whether to require full-fair-value-income measurement.
Prior research has found that loan loss provisions are positively associated with bank stock returns and future cash flows, conditional on less discretionary information about loan default. We find that these positive valuation implications obtain only for loan loss provisions for low regulatory capital banks in the fourth fiscal quarter. Our regulatory capital-based tests are motivated by the idea that increased discretionary loan loss provisions are plausibly good news only for banks which appear to have loan default risk problems based on prior information. Our fiscal quarter tests are motivated by findings in prior literature that suggest that managers have incentives to delay income decreasing accruals until the fourth quarter when the audit occurs, implying that income decreasing accruals are more likely, and therefore more expected, in the fourth quarter than in other fiscal quarters (Mendenhall and Nichols 1988; Boyd et al. 1994).