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Review of Accounting Studies

11-03-2023

Going digital: implications for firm value and performance

Authors: Wilbur Chen, Suraj Srinivasan

Published in: Review of Accounting Studies

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Abstract

We examine firm value and performance implications of the growing trend of nontechnology companies engaging in activities relating to digital technologies. We measure digital activities in firms based on the disclosure of digital words in the business description section of 10-Ks. Digital activities are associated with a market-to-book ratio 8%–26% higher than industry peers, and only 25% of the differences in market-to-book is explained by accounting capitalization restrictions. To control for selection bias, we implement lagged dependent variable and IV regressions, and our market-to-book findings are robust to these specifications. Portfolios formed on digital activity disclosure earn a Daniel et al. The Journal of Finance 52 (3): 1035–1058 (1997)-adjusted return of 30% over a three-year horizon and a monthly alpha of 44-basis-points. On the other hand, we find weak evidence of near-term, positive improvements in fundamental performance, as we find some evidence of interim productivity increases but declines in sales growth conditional on digital activities.

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All dollar figures are denominated in US dollars.

We define the digital terms in Appendix Table 11.

Appendix Table 12 presents the list of industry codes that are used to identify Tech firms.

We use the digital-related patent search terms provided in Bloom et al. (2018) and Webb (2020).

In the rest of the text, we use the same methodology to compute the economic ranges.

As a measure of technology exposure, this instrument proxies for industries that are more likely to benefit from AI, technologies and thus firms within these industries should exhibit a greater likelihood of adoption digital technologies. Consistent with this conjecture, our first-stage regressions show that the measure of AI technology overlap correlates strongly with higher values of the digital score. Moreover, we argue that the assignment of industries that are more exposed to AI technology is fairly exogenous, as many of the patents are filed in universities and other nonprofit organizations.

We study the SRC, as the valuation of sales, unlike book equity and earnings, is not confounded by capitalization restrictions. Thus examining the effects of digital activities on the SRC is a relatively clean way of studying whether digital activities do indeed increase firm valuations.

Abnormal returns are estimated by deducting the firm’s raw returns from the corresponding firm’s size, book-to-market and momentum quintile portfolio returns, following Daniel et al. (1997).

These portfolios hold firms that are in the top tercile of digital disclosers in the long position and firms that do not disclose digital terms in the short position.

Results are also similar without risk factor controls.

The long-short portfolios also yield a significant unadjusted return of 47 basis points.

In our determinants analysis (Table 4), we find that past sales growth and stock returns relate negatively to digital activities.

For example, better reward-punishment practices, performance evaluations.

For NAICS industries, we use the 2017 industry classification and convert industries defined in past versions via the NAICS crosswalks. We also drop firms that do not have at least a four-digit NAICS code. For GICS industries, we define the technology industries based on current (2018 version) and historical GICS codes.

We outline the specific words within these topic groups in Appendix Table 11.

The construction of these variables is detailed in Appendix Table 13.

We report the sample statistics of the tech firms in Table A.1 in the internet appendix.

In Appendix 4, we provide some examples of how these digital terms are used in the firms’ disclosures.

We link the patent data to our dataset with the CRSP-patent link table provided by Kogan et al. (2017), which covers patent data from calendar years 1925–2019 (September). Thus we examine the patent data for a subsample of firm-year observations from fiscal years 2010–2018: 16,315.

We measure the proportion of IT workers from Revelio Labs, which covers a subsample of firms in our sample (11,671 firm-year observations).

The tech portfolio consists of all tech firms classified based on Appendix Table 12. The returns within the portfolio are value-weighted, and we re-balance portfolio weights at the daily-level. The nontech portfolio is defined similarly but consists of firms that are classified as nontech. To reduce the effects of low liquidity stocks from inducing measurement error in the return regressions, we drop penny stock entries with less than $5 in price. Also, to reduce measurement error, betas estimated with less than 200 observations are dropped. Due to these sample restrictions, the analysis is based on a subsample of 17,008 firm-year observations.

For the initial activity sample, we drop all observations of subsequent digital activity, which leads the sample size to drop from 20,450 to 16,497. Note that this regression compares first disclosers to nondisclosers who form the majority of the sample. (There are only 548 first disclosers.) This suggests that the majority of the disclosed digital activity is subsequent disclosure, which aligns with the fact that digital disclosure is highly persistent.

We do find that lagged ROA is positively associated with a higher digital score in the full sample. But we do not find a statistically significant effect in the initial activity sample with industry fixed effects, suggesting that this finding is driven by the increase in ROA after digital disclosure is initiated (and this is corroborated in Panel A of Table 9).

We use common equity in Compustat to measure book equity (following, Doyle et al. 2003, Soliman 2008, Frankel et al. 2011, and Lundholm et al. 2017).

We compare ratios relative to industry peers, as investors commonly benchmark accounting and valuation ratios relative to industry peers.

We also examine the valuation effects of digital activity in the cross-section in Table A.5 in the IA. We find firms that are larger, expend more on SG&A, CapEx and in high digital adoption industries, receive higher valuations.

This estimate could be viewed as conservative, as the controls for intangibles also absorb the effects that digital investments may have on future investment opportunities and growth.

In an untabulated analysis of the lagged dependent variable specification, we also find that continuing disclosers tend to exhibit higher market-to-book, relative to those that do not continue to disclose after initial disclosure of digital activities.

This approach corrects for accounting conservatism by first estimating the conservatism correction factor, which is the ratio of the capitalized tangible and intangible assets (via the cost accounting method over the estimated useful life of assets) to capitalized tangible assets (via the straight-line depreciation method over the estimated useful life of assets). Market-to-book is then adjusted by dividing by this ratio. See Section 2 of the internet appendix for more details on the methodology and theory behind the computation of this conservatism correction factor.

As the conservatism-adjustment drops firms with insufficient investment histories, we conduct the analysis on a small subsample of firms. We also follow McNichols et al. (2014) in dropping financial firms (SIC 6000–6779), firms with assets of less than $4 million and a net PPE-to-asset ratio of less than 0.1, as the conservatism correction is less suited for these firms. Consequently, our sample for this analysis consists of 7352 firm-year observations.

This is based on the average market-to-book of this subsample reported in Table A.2 in the internet appendix.

See Table A.2 in the internet appendix for more details on the sample statistics of the conservatism-corrected market-to-book.

For more details on the methodology, please see Section 3 in the internet appendix.

The logic underlying the valuation interpretation of the ERC stems from an accounting literature that views the ERC coefficient as capturing the market’s expectation of the capitalization rate of earnings (Easton and Zmijewski 1989; Collins and Kothari 1989; Dechow et al. 2014).

We chose this return window as the 99th percentile of the lag between earnings announcement and 10-K filing date is 39 days. We drop observations where the lag is greater than 40 days.

Abnormal daily returns are calculated by taking the raw return minus the Fama-French/Carhart four-factor expected returns (Carhart 1997), where the expected returns are estimated with the β’s of the four-factor model that are estimated in a (−280,−60) window.

We remove consensus forecasts that are more than 100 days old at the time of the announcement and remove forecasts in which the price at the end of the fiscal period is less than one dollar and unexpected earnings is greater than the price.

This analysis is conducted on a subsample of firms that are covered by analysts in the IBES and satisfy our forecast filtering requirements. Thus our sample size drops from 20,839 in the market-to-book analysis to 14,361 in the ERC analysis.

To further control for firm-level heterogeneity in the unexpected earnings and returns relationship, we also examine an alternative specification with grouped firm fixed effects based on 10 by 10 size and beta portfolios in Table A.3 in the internet appendix. We find similar results.

We also examine the fitted ERC curves for digital and nondigital firms using fractional polynomials to model ERC nonlinearities. Our results, presented in Figure A.1 of the internet appendix, show that digital firms tend to exhibit greater return reactions to both positive and negative unexpected earnings (albeit at the more extreme end for negative earnings), consistent with these firms exhibiting a higher ERC coefficient.

Similarly, we remove consensus forecasts that are more than 100 days old at the time of earnings announcement and remove forecasts in which the price at the end of the fiscal period is less than one dollar and unexpected sales greater than the price.

We also examine the robustness of the SRC results by implementing SRC regressions with grouped fixed effects and by examining the fitted SRC using fractional polynomials in Table A.3 and Figure A.2 of the internet appendix. The inferences from both sets of analysis corroborate the main results presented above.

Furthermore, in an untabulated analysis, we show that continuing disclosers tend to exhibit higher SRCs, relative to those that do not continue to disclose after the initial disclosure of digital activities.

We assume 10-K information to be publicly available by four months after the fiscal year-end.

Following Shumway (1997) and Shumway and Warther (1999), we code the delisting return as −30% and − 55% if the firm delists for performance reasons from NYSE and NASDAQ respectively.

Additionally, to further account for low liquidity and high transactions costs in penny stocks, we also remove stocks with prices below $5 at the portfolio formation date.

We also examine the returns without controls for risk factors and find that the results are relatively unchanged.

The monthly returns on an unadjusted basis is 47 basis points and are statistically significant.

To be clear, we code the continuing and noncontinuing digital disclosure in the following way. For continuing disclosures, we recode the Digital_{i, t} variable in equation 6 as 0 for firms that do not make top-tercile disclosure continuously in the return window, and vice versa for noncontinuing disclosures.

Consistent with managerial expertise playing a key role in digital adoption, in Table A.6 in the internet appendix, we also show that firms with digital activity and tech-related top executives yield higher ROA to peers with digital activity.

In support of this conjecture, we also find that gross margins (defined as revenues minus cost of goods sold, scaled by sales) is lower in firms with digital activity, compared to peers (see Table A.4 in the internet appendix), which suggests competitive price pressures that are eroding margins.

We report these analyses in Tables A.7 and A.8 in the internet appendix.

We caution the reader that real-time profits are likely to be lower than the returns reported in this study, as trading frictions could impose additional costs for the investors.

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Title: Going digital: implications for firm value and performance
Authors: Wilbur Chen
Suraj Srinivasan
Publication date: 11-03-2023
Publisher: Springer US
Published in: Review of Accounting Studies
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-023-09753-0