Equity Valuation and Negative Earnings: The Role of Book Value of Equity

Abstract

This study provides an explanation for the anomalous significantly negative price-earnings relation using the simple earnings capitalization model for firms that report losses. We hypothesize and find that including book value of equity in the valuation specification eliminates the negative relation. This suggests that the simple earnings capitalization model is misspecified and the negative coefficient on earnings for loss firms is a manifestation of that misspecification. Furthermore, we provide evidence on three competing explanations for the role that book value of equity plays in valuing loss firms. Specifically, we investigate whether the importance of book value in cross-sectional valuation models stems from its role as (1) a control for scale differences (Barth and Kallapur 1996), (2) a proxy for expected future normal earnings (Ohlson 1995; Penman 1992), or (3) a proxy for loss firms' abandonment option (Berger et al. 1996; Barth et al. 1996; Burgstahler and Dichev 1997). Our results do not support the conjecture that the importance of book value in cross-sectional valuation stems primarily from its role as a control for scale differences. Rather, the results are consistent with book value serving as a value-relevant proxy for expected future normal earnings for loss firms in general, and as a proxy for abandonment option for loss firms most likely to cease operations and liquidate.

Small-sized companies' earnings management: evidence from Italy

“…Baber and Kang, 2002;Beatty, Ke and Petroni, 2002;Brown and Caylor, 2004;Burgstahler et al, 2006;Collins, Pincus and Xie, 1999;Coppens and Peek, 2005;Daske et al, 2006;Easton, 1999;Hamdi and Zarai, 2012;Hayn, 1995;Holland and Ramsay, 2003;Jacob and Jorgensen, 2007;Kerstein and Rai, 2007;Phillips et al, 2004;Revsine et al, 2009). In this case, the companies' frequency distribution of earnings shows a discontinuity between the first negative earnings interval to the left of zero (which is significantly under-represented) and the first positive earnings interval to the right of zero (which is significantly over-represented).…”

Do Ownership Structure Characteristics Affect Italian Private Companies’ Propensity to Engage in the Practices of “Earnings Minimization” and “Earnings Change Minimization”?

“…Beaver, McNichols, & Nelson, 2007;Dechow, Richardson, & Tuna, 2003;Durtschi & Easton, 2005, 2009Holland, 2004;Lahr, 2014;McNichols, 2003), it has been widely used to detect the presence of earnings management practices (e.g. Baber & Kang, 2002;Beatty, Ke, & Petroni, 2002;Brown & Caylor, 2004;Burgstahler & Dichev, 1997;Collins, Pincus, & Xie, 1999;Coppens & Peek, 2005;Daske, Gebhardt, & McLeay, 2006;Degeorge, Patel, & Zeckhauser, 1999;Easton, 1999;Gore, Pope, & Singh, 2007;Hamdi & Zarai, 2012;Hayn, 1995;Holland & Ramsay, 2003;Jacob & Jorgensen, 2007;Kerstein & Rai, 2007;Marques et al, 2011;Moreira, 2006;Phillips, Pincus, Rego, & Wan, 2004;Poli, 2013aPoli, , 2013bRevsine, Collins, Johnson, & Mittelstaedt, 2009). According to this approach, we assume that a company practices EM if the reported earnings of a fiscal year, scaled to total assets of the previous fiscal year, assumes a value between 0 and 0.005 (0 is included, 0.005 is excluded) and that a company practices ECM if the reported earnings change of a fiscal year (determined as the difference between the reported earnings of a fiscal year and the reported earnings of the previous fiscal year), scaled to total assets of the second previous fiscal year, assumes a value between -0.0025 and 0.0025 (-0.0025 is included, 0.0025 is excluded).…”

Analysis of the Relevance of Information Content of the Value Added Statement in the Brazilian Capital Markets

“…Other studies to be mentioned include: Foster (1977); Board and Walker (1990); Strong and Walker (1993); Harris, Lang, and Moller (1994) ;Collins, Pincus, and Xie (1999); Francis and Schipper (1999) ;Dhaliwal, Subramanyam, and Trezevant (1999);Sarlo Neto (2004); Costa and Lopes (2007) ;Lopes, Sant' Anna, and Costa (2007); Galdi and Lopes (2008) ;Bastos, Nakamura, David, andRotta (2009), Malacrida (2009) and Zanini, Cañibano, and Zani (2010).…”