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Review of Accounting Studies

Erschienen in:

01.12.2010

Asymmetric valuation of sustained growth by bond- and equity-holders

verfasst von: John A. Elliott, Aloke Ghosh, Doocheol Moon

Erschienen in: Review of Accounting Studies | Ausgabe 4/2010

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Abstract

Viewing equity as a call option on the firm’s assets with a strike price equal to contractual debt obligations yields an asymmetric prediction on how debt and equity markets view sustained growth. Debt holders are expected to benefit from sustained growth when the default risk is high, while equity holders value such growth when risk is low. Using Altman’s z-score and debt ratings as alternative proxies for the default risk, we document a negative association between bond yield spreads and sustained growth in earnings for firms with high risk only. In sharp contrast, using earnings multiples from returns-earnings regressions as a proxy for equity market rewards, we find that earnings multiples are larger when earnings growth is sustained for the low risk sample only. Decomposing earnings growth into revenue and nonrevenue growth, we find that the debt market rewards for firms with revenue growth are confined to the high risk sample only, while nonrevenue growth firms are not rewarded for either sample. Equity investors value revenue-led earnings growth for low and high risk samples while nonrevenue growth is rewarded for the low risk sample only. Our study adds to our understanding of how changes in firm value from sustained earnings and revenue growth are divided between key providers of capital and how default risk plays an instrumental role in this valuation process.

Vorheriger Artikel The use of advertising activities to meet earnings benchmarks: evidence from monthly data

Nächster Artikel Within-industry timing of earnings warnings: do managers herd?

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For example, net issuance (new issues less retirements) of corporate equity was $47 billion in 2002. In contrast, net issuance of corporate debt was $465 billion (Federal Reserve System, 2005, Flow of Funds Accounts). Thus, the issuance of debt is about 10 times as large as that of equity.

Consistent with this notion, several studies document a nonlinear relation between stock returns and earnings (Hayn 1995; Das and Lev 1994; Freeman and Tse 1992). In particular, the stock market reactions to a percentage increase in profits are much larger than to a percentage increase in losses.

Several studies examine whether the relationship between valuation and earnings is affected by the default risk, going concern status, or losses (e.g., Hayn 1995; Subramanyam and Wild 1996; Dhaliwal and Reynolds 1994). However, these studies do not consider debt markets. Moreover, they do not factor the role of sustained growth.

The economic intuition underlying our hypotheses is not new to the literature. For instance, the linkages between reported earnings and bond/equity prices are formalized in Fischer and Verrecchia (1997) using limited liability as a key explanation. They predict that bond prices are more (less) sensitive to reported earnings as default risk increases (decreases).

Anecdotal evidence suggests that earnings restatements and SEC actions against firms most frequently involve revenue recognition issues. This does not suggest that revenue manipulation is the most prevalent vehicle for earnings management. Greater SEC intervention and restatements related to revenue recognition may simply be an indication that revenue manipulations are easier to detect ex-post. Nelson et al. (2002) document a higher frequency of earnings management via excessive reserves and other expense based devices than via revenue management.

A firm is included if it has at least six consecutive years of accounting data. Strings of variables are calculated starting from 1980 to ensure that a firm has a long enough earnings and revenue history by 1985.

For brevity, we do not report the results of the control variables.

We thank an anonymous referee for suggesting this additional but insightful test.

Though not tabulated for brevity, as in Barth et al. (1999) and Ghosh et al. (2005), we find that the coefficient on the interaction between sustained earnings growth (E _UP) and changes in earnings (ΔNI) is positive and significant for the full sample. When earnings growth is decomposed into revenue and non-revenue based earnings growth, the coefficient on ER _UP × ΔNI is positive and significant while that on ENR _UP × ΔNI is insignificant. These results confirm prior results and extend them to later periods.

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Titel: Asymmetric valuation of sustained growth by bond- and equity-holders
verfasst von: John A. Elliott
Aloke Ghosh
Doocheol Moon
Publikationsdatum: 01.12.2010
Verlag: Springer US
Erschienen in: Review of Accounting Studies / Ausgabe 4/2010
Print ISSN: 1380-6653
Elektronische ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-009-9110-y

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