Accounting Losses and Investors’ Growth Expectations MINNA MARTIKAINEN This study provides new evidence on the relationship between market-to-book and earnings-to-book equity ratios in the NYSE in 1975.1990. By investigating this relationship, it is possible to study how current profit- ability is reflected in investors’ cash flow expectations. The results suggest that the two ratios are not signifi- cantly positively related if accounting earnings are negative. For positive earnings, however, the positive relationship exists for the largest and least levered firms. These findings support the hypothesis that investors regard accounting losses as temporary, not reflecting future cash flow expectations. Profits are considered more persistent, especially for large and least levered firms. I. INTRODUCTION The market-to-book (MTB) equity ratio measuring market’s growth expectations has become very popular in financial analysis in recent years. This is because the results of various empir- ical studies indicate that the ratio can be used to explain and predict stock returns. For instance, Fama and French (1992, 1993) suggest that the MTB ratio and market value capture much of the cross-section of average stock returns. They also report that these factors are incrementally important in explaining average returns over those explained by the market portfolio. The importance of the MTB ratio in explaining stock returns is also highlighted by Rosenberg, Reid and Lanstein (1985), DeBondt and Thaler (1987), Chan, Hamao and Lakon- ishok (1991) Lakonishok, Schleifer and Vishny (1994), Davis (1994) and Frankel and Lee (1995), among others. Recently, the economic fundamentals of the MTB ratio have received increasing attention by researchers (see e.g., Fama & French, 1995; Kothari, Shanken, & Sloan, 1995 for a discus- sion). Most notably, Fama and French (1995) investigate the relationship between the MTB ratio and profitability measured by the earnings-to-book (ETB) ratio. By using a simple ratio- nal pricing model, they show that the MTB ratio should be positively related to persistent profitability. This theoretic result is also verified empirically, when the profitability of six portfolios based on the MTB ratios is studied. Fama and French (1995) report that high MTB stocks appear more profitable than low MTB stocks for four years before and at least five years after ranking dates. Fama and French (I 995) do not investigate, however, whether cer- tain types of earnings are more temporary and affect investors’ growth expectations less than Minna Martikainen * Helsinski Center for Business Research, Hietaniemenkatu 2, 00100 Helsinki, Finland. Fax: +3589408417. International Review of Financial Analysis, Vol. 6, No. 2, 1997, pp. 97-105 Copyright 0 1997 by JAI PRESS Inc., All rights of reproduction in any form reserved. ISSN: 1057~5219
Transcript
Accounting Losses and Investors’ Growth
Expectations
MINNA MARTIKAINEN
This study provides new evidence on the relationship between market-to-book and earnings-to-book equity
ratios in the NYSE in 1975.1990. By investigating this relationship, it is possible to study how current profit-
ability is reflected in investors’ cash flow expectations. The results suggest that the two ratios are not signifi-
cantly positively related if accounting earnings are negative. For positive earnings, however, the positive
relationship exists for the largest and least levered firms. These findings support the hypothesis that investors
regard accounting losses as temporary, not reflecting future cash flow expectations. Profits are considered
more persistent, especially for large and least levered firms.
I. INTRODUCTION
The market-to-book (MTB) equity ratio measuring market’s growth expectations has become
very popular in financial analysis in recent years. This is because the results of various empir-
ical studies indicate that the ratio can be used to explain and predict stock returns. For
instance, Fama and French (1992, 1993) suggest that the MTB ratio and market value capture
much of the cross-section of average stock returns. They also report that these factors are
incrementally important in explaining average returns over those explained by the market
portfolio. The importance of the MTB ratio in explaining stock returns is also highlighted by
Rosenberg, Reid and Lanstein (1985), DeBondt and Thaler (1987), Chan, Hamao and Lakon-
ishok (1991) Lakonishok, Schleifer and Vishny (1994), Davis (1994) and Frankel and Lee
(1995), among others.
Recently, the economic fundamentals of the MTB ratio have received increasing attention
by researchers (see e.g., Fama & French, 1995; Kothari, Shanken, & Sloan, 1995 for a discus-
sion). Most notably, Fama and French (1995) investigate the relationship between the MTB
ratio and profitability measured by the earnings-to-book (ETB) ratio. By using a simple ratio-
nal pricing model, they show that the MTB ratio should be positively related to persistent
profitability. This theoretic result is also verified empirically, when the profitability of six
portfolios based on the MTB ratios is studied. Fama and French (1995) report that high MTB
stocks appear more profitable than low MTB stocks for four years before and at least five
years after ranking dates. Fama and French (I 995) do not investigate, however, whether cer-
tain types of earnings are more temporary and affect investors’ growth expectations less than
Minna Martikainen * Helsinski Center for Business Research, Hietaniemenkatu 2, 00100 Helsinki, Finland. Fax: +3589408417.
International Review of Financial Analysis, Vol. 6, No. 2, 1997, pp. 97-105 Copyright 0 1997 by JAI PRESS Inc., All rights of reproduction in any form reserved.
ISSN: 1057~5219
98 INTERNATIONAL REVIEW OF FINANCIAL ANALYSIS / Vol. 6(2)
the others. Neither do they investigate whether the relation varies across different types of
firms.
The main purpose of this study is to investigate the relationship between the MTB ratio and
profitability for firms reporting accounting losses and profits. The study delineates between
profits and losses, because considerable accounting literature suggests that accounting eam-
ings used to measure profitability include temporary components (see e.g., Beaver, Lambert
& Morse, 1980; Beaver, Lambert & Ryan, 1987; Ohlson 1989, 1990). Most importantly, with
respect to this paper, Hayn (1995) and Martikainen (1997) suggest that accounting losses, i.e.
negative earnings, can be regraded as temporary by nature. This is because shareholders have
a liquidation (put) option on the future cash flows of the firm, i.e., they have the opportunity
to sell their shares at a price equal to the net asset assets of the firm. Assuming that accounting
losses are temporary and are not reflected in cash flow expectations, there should not exist a
positive relationship between the MTB and ETB ratios if earnings are negative. On the other
hand, the positive relationship should exist if earnings are positive, assuming that profits are
reflected in investors’ cash flow expectations. The investigation is carried out in market value
and financial leverage portfolios. This is because previous empirical evidence suggests that
the earnings of large firms are typically more persistent than the earnings of small firms (see
e.g., Brown, 1993, and the literature cited there). Financial leverage portfolios are also stud-
ied, because leverage decreases the persistence of accounting earnings.
The current study contributes to the existing literature in three main respects. First, it
extends Fama and French (1995), who do not delineate between profits and losses when
investigating the relationship between the MTB ratio and profitability. Second, the current
article contributes to Fama and French (1995) by studying the relationship between the MTB
and ETB ratios in market value and financial leverage portfolios. Third, it extends Hayn
(1995) and Martikainen (1997) by investigating how accounting losses dampen the ability of
profitability to explain the cross-sectional variation of the MTB ratio.
The remainder of this article is organized as follows. Section 2 provides the theoretical
background for the paper. The third section describes the data and provides the empirical anal-
ysis comparing accounting losses and profits as determinants of the MTB ratios. Section 4
concludes the paper.
II. THEORETICAL BACKGROUND
Fama and French (1995) provide a straightforward model to explain the relationship between
MTB and ETB ratios as well as growth expectations. Assume an all equity-firm that finances
its investments solely with retained earnings. In this case dividends for year t, D,, are
D, = EI, + DP, - I,, (1)
where El, equals equity income, depreciation is noted with , and investment outlays with 1,
Let us further assume that at time t expected depreciation and investment for any year t + i are
proportional to expected future equity income, that is,
EtDt + i = Et [El* + i + DP, + i - It + il = E, EIt + i (1 + k, - k2)> (2)
Accounting Losses and Investors’ Growth Expectations 99
where kl and k2 are the proportionality factors. If the discount rate, r, is constant, the market value of equity for year t, ME,, equals
- EtE’t+i ME, = (l+kl-k2) C 7.
i= 1 (i+r)’
Consequently, the MTB ratio, ME, / BE,, is
m EtEIr+ /BE, MTB, = (l+k,-k,) C .
i= 1 (i+ r)’
Equation 4 shows that the MTB ratio can be interpreted as a measure for market’s expecta- tions for growth opportunities. This is because the MTB ratio increases with the expectations on equity income.
Equations 3 and 4 suggest that the MTB ratio is positively related to persistent earnings, while temporarily high or low earnings do not have significant effect on the MTB ratio. As noted by Hayn (1995) and Martikainen (1997), among others, it can be hypothesized that
accounting losses are temporary and, therefore, less weighted than accounting profits when investors are forming their cash flow expectations. This is because the equity holders have a put option on the future cash flows of the firm. Consequently, they have the opportunity to sell their shares at the price of the market value of the net assets of the firm. Based on this put option, accounting losses cannot be expected to continue infinitely. The notion of liquidation option adding to the firm value is also discussed, for instance, by Robichek and VanHome (1967), Myers and Majd (1990) and Berger, Ofek and Swary (1996).
The analysis in Equations l-4 further suggests that the MTB ratio is negatively related to the required rate of equity return. Therefore, the ratio should be inversely related to leverage, which is generally regarded as a determinant for the required rate of return (see e.g., Hamada, 1972, for a theoretical discussion). It can also be assumed that financial leverage decreases the persistence of accounting earnings. This is because levered firms’ earnings are more sensitive to economic changes because of the fixed nature of debt payments.
Equation 4 reveals that the relationship between growth opportunities and profitability may also be dependent on firm size. This is because it is commonly accepted that accountants smooth income to decrease the variability of accounting income. Moses (1987), among others, suggests that income smoothing is more common for large than for small firms. This increases the persistence of large firms’ earnings with respect to that of small firms. Moreover, large firms are typically more diversified than the small firms, which is also likely to increase their earnings persistence. Therefore, it can be assumed that the relationship between MTB and ETB ratios is stronger for large than for small firms.
III. EMPIRICAL RESULTS
A. Data description The sample consists of all NYSE firms from the Compustat Industrial Annual and the Com-
pustat Research Annual tapes with a December 31 fiscal year-end and a minimum of three years of earnings data during the time period from 1975 to 1990 (a total of 16 years). Market values to calculate the MTB ratios are retrieved from the CRSP database. The MTB is calcu- lated by dividing the market value of equity by the book value of equity at the same time. The
100 ~TERNATIONAL REVIEW OF FINANCIAL ANALYSIS I Vol. 6(2)
Table 1 Sample Statistics for Market Value and Financial Leverage Portfolios
All LOWeSt 2Lowest Medium 2. Highest Highest
Panel A. Market value portfolios
MTB 1.619 1.292 1.328 1.883 I .762 1.831
ETB 0.132 0.030 0.129 0.155 0.167 0.181
Frequency
of losses 0.063 0.174 0.064 0.043 0.023 0.011
Panel B. Financial leverage portfolios
MTB 1.619 2.069 1.730 1.452 1.351 1.497
ETB 0.132 0.185 0.139 0.151 0.116 0.071
Frequency
of losses 0.063 0.034 0.023 0.028 0.059 0.169
Notes: ‘All’ represents all 8,005 firm-year observations pooled. In the other columns of Panel A stocks are divided
annually into five portfolios based on the market value at the end of the fiscal year. In Panel B stocks are
divided annually into five portfolios based on the ratio of long-term debt to the market value of equity at
the end of the fiscal year. MTB refers to the market value of equity divided by the book value of equity at
the same time. ETB ratios are measured as annual earnings per share before ex~ordin~ items and dis-
continued operations in the fiscal year divided by book value of equity at the beginning of year. ‘Frequency
of losses’ is the proportion of losses of the firm-year observations in the portfolio in question.
ETB for year f is measured as primary annual earnings before extraordinary items in year t
divided by book value of equity at the beginning of year t.
Because several studies suggest that the MTB and ETB ratios are related to market value and earnings persistence may be related to firm size, the analysis is performed by dividing the
8,005 firm-year observations into five market value portfolios based on the market value at
the end of the fiscal year. Panel A of Table 1 provides the basic statistics for these portfolios.
These descriptive statistics are consistent with the findings by Fama and French (1995) sug- gesting that size is related to profitability, small stocks tending to have lower earnings on book
than do big stocks. Moreover, as noted also by Hayn (1995), losses are considerably more
common for small than for large firms. While 17.4 percent of the firm-year observations are losses for small firms, the respective figure for large firms is only 1.1 percent.
The basic statistics for the financial leverage portfolios based on the ratio of long term debt to the market value of equity at the end of the fiscal year are provided in Panel B of Table 1.
The results support the assumption on the inverse relation between the MTB ratio and finan-
cial leverage. For the least levered firms, the MTB ratio equals 2.069, while the respective fig- ure for the most levered firms is 1.497. This finding is consistent with the hypothesis that the
MTB ratio is negatively related to the required rate of equity return. Not surprisingly, the most
levered firms have considerably more losses than the least levered ones. This is consistent with the assumption that leverage decreases earnings persistence.
B. The relationship between market-to-book and earnings-to-book ratios To investigate the relationship between the MTB ratios and profitability for firms reporting
accounting losses and profits in different market value and financial leverage portfolios, the following regression is estimated:
5 5
MTB,, = ao+ ETBi, C ajDPji,+ c bjDLjit + eit , (5)
j=l j= 1
Accounting Lasses and Investors’ Growth Expectations 101
Table 2 The Relationship Between MTB and ETB Ratios in Market Value Portfolios
Relationship between Relationship between Restriction that the MTB and ETB Ratios MTB and ETB Ratios Relationship Equals
Portfolio when Earnings are Positive when Earnings are Negative between Profits and Losses
Notes: The analysis includes 8,005 firm-year observations pooled. The analysis is based on the regression:
5 5
z ajDP,,f + C bjDL,,, + eit 1 ,=l ,=I 1 where MTB, is the market-to-book ratio for stock i in April following the end of year t and ETB, is the
earnings-to-book ratio (earnings for year t divided by the book value of equity at the beginning of year
t) of the same stock. Firms are classified on an annual basis into five portfolios based on market value,
j representing the number of the portfolio in this classification. Portfolio (PF) 1 represents the smallest
and PF5 the largest firms in this classification. DPji, and DLjit are dummy variables having a value of
one in case firm i’s are positive and negative, respectively. The terms aO, aj bj and e,, are estimated
regression parameters. The restricted models are used to test whether the parameter estimates are dif-
ferent for positive and negative earnings in different portfolios. The null hypothesis tested is that there
is no difference in the estimates in a given portfolio. The null hypothesis is rejected when the restric-
tion parameter is significant. White’s (1980) heteroskedasticity consistent covariance matrix is used to
calculate standard errors and r-statistics. The latter are provided in parentheses. *, **, *** refer to sig-
nificance levels of 0.05, 0.01 and 0.001, respectively.
where MTBi, is the market-to-book ratio for stock i in the following April after the end of year t. April figures are used because firms’ book value and earnings figures for year tare typically reported by April in year t + 1. ETB, is the earnings-to-book ratio (earnings for year t divided by the book value of equity at the beginning of year t) of the same stock. Firms are classified on an annual basis into five portfolios based on market value or financial leverage, j represent- ing the number of portfolio in this classification. The terms DPjir and Digit are dummy vari- ables having a value of one in case firm i’s earnings are positive and negative, respectively.
The terms ag, a) bj and eit are estimated regression parameters. TO take into account the esti- mation bias caused by heteroskedasticity in the estimated residuals, White’s (1980) heterosk- edasticity consistent covariance matrix is used to calculate standard errors and t-statistics.
Table 2 presents the regression results for market value portfolios. For profits, the positive relationship between the MTB and ETB ratios holds for four of the five portfolios (PF2-PF5). For the smallest firms (PFl), the relationship remains insignificant. This is consistent with the hypothesis that small firms’ earnings are less persistent than those of large firms. The negative relation between earnings persistence and firm size is also confirmed by the slope coefficients
102 INTERNATIONAL REVIEW OF FINANCIAL ANALYSIS / Vol. 6(2)
between the MTB ratio and positive earnings, which tend to increase with the number of the
portfolio. For the largest firms (PF5), the slope is 4.042, while the respective figure for the
smallest firms (PFl) is only 0.057.
Restricted models (see e.g., Judge et al., 1988) are used separately for each portfolio to
study whether the parameter estimates are different for positive and negative earnings in
portfolios. The null hypothesis tested is that there is no difference in the estimates in a given
portfolio. The null hypothesis is rejected when the restriction parameter is significant, i.e., in
this case for the four portfolios of largest firms (PF2- PF5). This supports the assumption
that investors tend to regard losses as more temporary than profits. As a matter of fact,
losses are significantly negatively related to the MTB ratios for portfolios 2 and 3. The nega-
tive relation may indicate that investors expect considerably increased cash flows for firms
that have reported biggest losses. This again highlights the temporary nature of negative
earnings.
The regression results for financial leverage portfolios are provided in Table 3. For firms
reporting a profit, a significantly positive relationship between the MTB and ETB is observed
Table 3 The Relationship Between MTB and ETB Ratios in Financial Leverage Portfolios
Portfolio
PFl
PF2
PF3
PF4
PF5
Relationship between Relationship between
MTB and ETB Ratios MTB and ETB Ratios
when Earnings are Positive when Earnings are Negative
3.705 -3.590
(3.288)** (-3.157)**
2.630 -2.753
(3.117)** (-6.615)***
0.613 -4.523
(1.288) (-2.467)*
0.654 -4.294
(1.261) (-2.412)*
-0.057 0.67 1
(0.134) (0.404)
Restriction that the
Relationship Equals
between Projirs and Losses
120.401
(13.478)***
68.707
(8.804)***
38.481
(6.450)***
45.276
(6.865)***
-8.822
(-1.166)
a,,= 1.294 R*= 0.050 F-value 42.185***
(15.360)***
Notes: The analysis includes 8,005 firm-year observations pooled. The analysis is based on the regression:
5 5
x ajDP,i, + c bjDL,,t + eir 7 j=l j=l I
where MTB,, is the market-to-book ratio for stock i in April following the end of year 1 and ETBj, is the
earnings-to-book ratio (earnings for year 1 divided by the book value of equity at the beginning of year t) of the same stock. Firms are classified on an annual basis into five portfolios based on market value,
j representing the number of the portfolio in this classification. Portfolio (PF) 1 represents the smallest
and PF5 the largest firms in this classification. DPji, and DLji, are dummy variables having a value of one in case firm i’s are positive and negative, respectively. The terms aO, a) bj and eir are estimated
regression parameters. The restricted models are used to test whether the parameter estimates are dif-
ferent for positive and negative earnings in different portfolios. The null hypothesis tested is that there
is no difference in the estimates in a given portfolio. The null hypothesis is rejected when the restric-
tion parameter is significant. White’s (1980) heteroskedasticity consistent covariance matrix is used to
calculate standard errors and t-statistics. The latter are provided in parentheses. *, **, *** refer to sig-
nificance levels of 0.05,O.Ol and 0.001, respectively.
Accounting Losses and Investors’ Growth Expectations 103
for the two portfolios including the least levered firms (PFl and PF2). For the other three port-
folios (PF3-PF5), the relationship remains insignificant. This is consistent with the hypothesis
that the earnings of least levered firms are more persistent than those of the most levered
firms. In the cases where firms report a loss, the relationship between the MTB and ETB ratios
is usually significantly negative, supporting the hypothesis on the temporary nature of
accounting losses.
The restrictions in Table 3 show that the parameter estimates are different for positive and
negative earnings in different financial leverage portfolios. An exception is portfolio 5 for the
most levered firms, for which the null hypothesis is not rejected and the restriction parameter
remains insignificant. This suggests that for the most levered firms both profits and losses are
regarded as temporary by investors. In general, the results support the assumption that finan-
cial leverage decreases earnings persistence.
IV. CONCLUDING REMARKS
This paper extends the recent empirical study of Fama and French (1995) by providing fur-
ther evidence on the relationship between the MTB ratio and accounting profitability.
Because the recent empirical results by Hayn (1995) and Martikainen (1997) suggest that
accounting losses do not have information content when explaining stock returns, losses and
profits are studied separately in this study. The current paper finds out that the relation
between the growth opportunities measured by the MTB ratio and accounting profitability
measured by the ETB ratio is significantly different for firms reporting accounting losses
than for those reporting profits. The results suggest that the two ratios are not significantly
positively related if accounting earnings are negative. For positive earnings, however, the
positive relationship exists for largest and least levered firms. These findings support the
assumption that investors regard accounting losses as temporary, not reflecting future cash
flow expectations. Profits are considered more persistent, especially for large and least
levered firms. The variation of the results between firms is expected, because the earnings of
levered and small firms are likely to be less persistent than the earnings of less levered and
large firms.
In general, the results support the earlier studies that accounting losses dampen the observed
relationship between stock prices and accounting earnings. This is obviously because inves-
tors consider losses as temporary. Since the loss patterns vary considerably among firms, it
should be noted that the temporary components of their earnings may vary. Therefore, when
financial analysts are analyzing MTB ratios and comparing these ratios to accounting rate of
return, they should take into account this observation.
ACKNOWLEDGMENTS
This research was undertaken when I was visiting Louisiana State University. I appreciate the
generous financial support from the Finnish Academy of Sciences, Jenny & Antti Wihurin
Rahasto, Suomen Kulttuurirahasto, Helsingin Sanomain lOO-vuotissaatio, Paulon Saatio and
Saastopankkien Tutkimussaatio.
104 INTERNATIONAL REVIEW OF FINANCIAL ANALYSIS / Vol. 6(2)
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