Assessing the usefulness of accounting earnings to foreign investors.

Author:Lamport, Matthew

    Accounting information is one of the most significant sources of financial information for analysis especially when it comes to establishing the intrinsic value of the firm against which active portfolio managers would compare the market price to initiate buy, sell or hold decisions. If accounting information is an important component of intrinsic value determination, we would expect accounting earnings and share prices to be closely connected. Furthermore, accounting fundamentals (book values and earnings) purport to measure value (i.e. capital) and changes in value (i.e. profit) of the firm. Similarly, the price of a share at one point in time also reflects value (i.e. market capitalisation) and the change in price from one point in time to another, the return to investors. In so far as accounting profits and share returns attempt to measure the same characteristic, the change in wealth of the firm, there should be some association between accounting earnings and share prices. If this is the case, then earnings, as reported by companies, should be useful to investors, especially foreign investors, in predicting the return on shares. Indeed, because foreign investors may not be physically present in the investee country, they may not be fully aware of all information, especially non-earnings related information, which may be circulated in the local market and which may have an impact on share prices. These foreign investors will probably, due to their geographical distance, have to rely on published or reported earnings to assess the earnings potential of a particular firm. A review of the literature shows that there that been a scant amount of literature on the accounting earnings-foreign investors hypothesis. In fact the pioneering work stems from Ball and Brown (1968) who studied the usefulness of accounting earnings as an explanatory variable for explaining stock returns or change in share prices. Since then relatively few studies have followed among which features Beaver et al. (1980), Hopwood and McKeown(), Lustgarden and Lev(), Brief-Zarowin ()

    The objective of this paper is therefore to assess the extent of the usefulness of accounting earnings to foreign investors by examining the significance of the correlation between earnings and share prices. If earnings can explain a reasonable proportion of the change in share prices, then earnings will have some value relevance in predicting future securities returns. This work is believed to supplement the literature which has so far only scantly dealt with the accounting earnings-foreign investors hypothetised link.

  2. Methodology and Analysis: Many of the studies have regressed stock price revisions on unexpected earnings. However, this method to evaluate the value relevance of accounting earnings in explaining stock return depends entirely on the proper measurement of expected earnings. It was also pointed out by Lev ()that unexpected earnings may only convey a small part of the information in earnings and that total earnings might be a better variable as it would capture the impact of the entire information set about earnings that is released throughout the year. Studies by Ohlson and Brief and Zarowin have established the pairing of earnings and book value to explain stock market values. This study proposes to assess the value relevance of earnings to foreign investors using two key independent variables, namely, the level of earnings and the change in earnings, following Ohlson (1991)


    Ohlson arrived at a model which expresses price as weighted average of book value and total earnings. The weighting attached to book value at time t, [y.sub.t] is [1- [alpha] (R-1)]. The weighting attached to total earnings is [alpha] (R-I). Total earnings are represented by the term [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] i-e. total earnings is arrived at by multiplying clean surplus earnings, [X.sub.t] by a multiple, [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] and subsequently deducting the current dividend, [d.sub.t]. Ohlson's above earnings valuation model shows that the relevance of book value and total earnings depend on the magnitude of the w term which captures the extent to which the current level of residual income is likely to persist in the future.

    Modelling the relation between returns and earnings

    Having established the relationship between earnings and market value according to Ohlson's earnings valuation model, we can now turn to modelling the relationship between earnings and changes in market value. Since the relevance of earnings in explaining market value depends on the term w, which reflects the extent to which current level of residual income is likely to persist in the future, i.e. on the degree to which earnings follow a permanent or transitory process, it seems logical to keep the same distinction when modelling the relationship between earnings and return.

    Modelling earnings as a transitory process If earnings follow a transitory process, w is deemed to be zero and market value would equal book value. In other words, the market to book value ratio would be equal to one. If we represent [V.sub.jt] as the value of firm j at the end of...

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