The Predictive Value of Expenses Excluded from 'Pro Forma' Earnings

Abstract

We investigate the informational properties of pro forma earnings. This increasingly popular measure of earnings excludes certain expenses that the company deems non-recurring, non-cash, or otherwise unimportant for understanding the future value of the firm. We find, however, that these expenses are far from unimportant. Higher levels of exclusions lead to predictably lower future cash flows. We also find that investors do not fully appreciate the lower cash flow implications at the time of the earnings announcement. A trading strategy based on the excluded expenses yields a large positive abnormal return in the years following the announcement, and persists after controlling for various risk factors and other anomalies.

Limited attention and the earnings announcement returns of past stock market winners

“…On an annualized basis, the returns we document are much larger than those generated by the postannouncement drift. (Doyle et al 2003), the price impact of Friday earnings releases (Dellavigna and Pollet 2009), observed investor over-optimism with respect to firms with high levels of net operating assets (Hirshleifer et al 2004), and the abnormally high levels of individual investor share purchases around the time of earnings announcements (Lee 1992;Barber and Odean 2008).…”

Do managers use earnings guidance to influence street earnings exclusions?

“…This result is intuitive because street earnings remove the transitory components of earnings (which are not very useful in predicting future earnings) and capture an earnings number that is predictive of future earnings (Francis et al 1996;Ramakrishnan and Thomas 1998 Brown and Sivakumar (2003) find that investors use street earnings in equity valuation to a larger extent than Compustat's version of core earnings, suggesting that street earnings should be the number on which managers focus if they are interested in favorable valuations of their stocks. Analysts appear to exercise substantial discretion in arriving at the street earnings number and their exclusion decisions are often firm-specific (Doyle et al 2003;Barth et al 2009). For example, Doyle et al (2003, p. 148) state, ''What gets excluded in a particular firm's definition of pro forma earnings varies greatly across companies, and the variation cuts across line items on the income statement and categories of accruals.''…”

“…Yet, prior research finds that managers frequently exclude recurring items in calculating pro forma earnings (Black and Christensen 2009). Doyle et al (2003) and Gu and Chen (2004) imply that analysts may inappropriately exclude some recurring expenses from street earnings.…”

“…503 component of analysts' total exclusions because they are generally recurring items, such as research and development expense, depreciation and amortization, stockbased compensation, and interest-or tax-related items. For example, Doyle et al (2003) report that incremental exclusions are almost as predictive of future cash flows as the street earnings number itself, suggesting that incremental exclusions are essentially composed of recurring items. Because of the recurring nature of these items, analysts are unlikely to exclude them from their forecasts absent management intervention.…”

An investigation on how to estimate future cash flows: Evidence from Tehran Stock Exchange

“…One of the primary concerns on investment strategies is to study the quality of earnings and methods for predicting the future cash flow and there are several studies associated with this issue (Collins & Hribar, 2000;Doyle et al, 2003;Francis et al, 2005;Hribar & Craig Nichols, 2007). Dechow and Dichev (2002) recommended a new method for measuring the quality of working capital accruals and earnings.…”