Non‐operating earnings and firm risk*

• Published date: 01 January 2021
• Date: 01 January 2021
• Author: Thanh Ngo,Hongxia Wang,Surendranath Jory
• DOI: http://doi.org/10.1002/rfe.1111

Rev Financ Econ. 2021;39:95–123. wileyonlinelibrary.com/journal/rfe

|

95

© 2020 University of New Orleans

1

|

INTRODUCTION

Reported earnings are composed of operating earnings and non-operating earnings. While investors, analysts, and academics

closely follow operating earnings, non-operating earnings are growing in importance. Non-operating income and expenses are

defined as income and expense items resulting from secondary business-related activities in COMPUSTAT.1 Firms establish non-

core business units to diversify their business exposure and hence reduce their risk. According to the 2015 McKinsey Global

Survey by McKinsey & Company,2 most companies seek growth outside their core business and 75% of the respondents have

pursued at least one non-core activity while an additional 15% planned to do so between 2010 and 2015. A third of the respondents

state that they generate more than 10% of their annual revenues from non-core operations. Participants in the survey report that they

engage in non-core activities to diversify risk, increase profit pools, and strengthen their existing business. Our sample shows that

operating earnings-to-asset ratio from 1990 to 2016 in the US averages 3.8%, while non-operating-earnings-to-asset ratio averages

0.8%, indicating that non-operating earnings are as significant as about one-fifth of operating earnings. Given the growing use of

non-operating activities, we examine the effects of non-operating earnings on the volatility of total earnings, stock price volatility,

idiosyncratic risk, and stock price crash risk after controlling for the effects of operating earnings and other firm characteristics.

Treating a firm as a portfolio of revenue streams with operating revenue representing its core income, we propose that

non-operating revenues from non-core undertakings benefit a firm to the extent that the revenues exceed the associated costs.

Non-core revenues reduce a firm's susceptibility to downturns in its core business and, consequently, reduce its vulnerabil-

ity to economic shocks (also see Curtis, McVay, & Whipple,2014; Eldenburg, Gunny, Hee, & Soderstrom,2011; Singh &

Song,2013). Besides, firms pursue non-operating activities to support rather than replace some of their core business by ac-

quiring skills lacking in their core business, learning critical technology or research and development (R&D), seeking new av-

enues of short-term profit (2015 McKinsey Global Survey), among others. Decomposing a firm's non-operating activities from

operating activities also improves firm transparency, reduces uncertainty and risk, and helps the firm stabilize its market value.

Received: 17 February 2020

|

Revised: 4 May 2020

|

Accepted: 6 May 2020

DOI: 10.1002/rfe.1111

ORIGINAL ARTICLE

Non-operating earnings and firm risk*

SurendranathJory1

|

ThanhNgo2

|

HongxiaWang3

*We thank the Editor, Dr. Tarun Mukherjee, and two anonymous reviewers for their reviews and constructive feedback and suggestions. All remaining

errors are ours.

1Department of Finance, University of

Southampton, Southampton, UK

2East Carolina University, Greenville, NC,

USA

3E. Craig Wall Sr. College of Business

Administration, Coastal Carolina

University, Conway, SC, USA

Correspondence

Hongxia Wang, E. Craig Wall Sr. College of

Business Administration, Coastal Carolina

University, Conway, SC 29528, USA.

Email: hwang3@coastal.edu

Abstract

We find that non-operating earnings reduce total earnings volatility, stock price vola-

tility, idiosyncratic risk, and crash risk. The risk-reducing effects of non-operating

earnings are higher than those of operating earnings for risk measures based on

stock market data. Non-operating earnings serve to mitigate risks among firms with

operating losses, high financial leverage, high growth uncertainty, and low-ability

managers.

KEYWORDS

non-operating earnings, earnings volatility, stock price volatility, stock price crash risk

JEL CLASSIFICATION

G30; G32

96

|

JORY et al.

At the other end, engaging in non-operating activities is not all advantageous if it distracts the business from its core mission.

Diverting resources to non-core businesses adversely affects the resource pool available to core operations. A lack of expertise

in non-core operations may lead to projects that destroy shareholders’ wealth. Consequently, there are both benefits and draw-

backs in pursuing non-core activities. Empirical tests would assist corporations in understanding the impacts of non-operating

earnings, and the current study considers the risk effects of non-operating earnings.

Based on a sample of 72,100 firm-year observations representing 9,659 U.S. publicly traded non-financial and non-utility

firms over the sample period 1990–2016, we document strong and consistent evidence that return on asset (ROA) volatility,

stock price volatility, idiosyncratic risk, and stock price crash risk are inversely related to the ratio of non-operating earn-

ings-to-total assets. Our findings are robust to the effects of operating earnings, several firm characteristics, classification

shifting, and model specifications.

Based on our empirical findings, the risk-reducing effect of non-operating earnings on the volatility of ROAs is half the

effect of operating earnings. Specifically, a 1% increase in non-operating earnings reduces ROA volatility by 0.059%, while

a 1% increase in operating earnings reduces ROA volatility by 0.119%. The impact of non-operating earnings on stock price

volatility is of a greater magnitude than the impact of operating earnings. A 1% increase in non-operating earnings (operating

earnings) is associated with a 0.376% (0.374%) decrease in stock price total volatility. Likewise, a 1% increase in non-operating

earnings (operating earnings) reduces stock price idiosyncratic risk by 0.435% (0.355%). Lastly, a 1% increase in non-operat-

ing earnings (operating earnings) reduces stock price crash risk by 0.697% (0.197%). We find that the risk-reducing effects of

non-operating income are more pronounced in firms with operating losses, growth uncertainty, high financial leverage, and/or

low-ability managers.

We contribute to the emerging literature on non-operating earnings as well as the literature on equity volatility and crash

risk. The empirical findings bear important implications for both investors and managers. Factoring non-operating earnings

allows a comprehensive assessment of the overall riskiness of the portfolio of operations. Non-core operating units that com-

plement existing business operations and provide the firm with an additional revenue stream to counter cyclical effects on the

core operations are valuable. Finally, analyzing the effects of non-operating earnings distinct from operating earnings increases

transparency in the firm operations.

The remainder of the paper is organized as follows. Section 2 reviews the literature and develops the hypotheses. Section 3

describes the sample and methodology. Section 4 presents and discusses the empirical findings, and Section 5 concludes the

paper.

2

|

LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

2.1

|

Earnings components and firm valuation

Non-operating earnings are a function of exceptional activities as well as short- and long-term engagements in operations that

fall outside the firms' core activities. Dissecting earnings into various components improves both managers' and investors' under-

standing of the value effects of earnings (Bowen,1981; Sloan,1996). Agnes Cheng, Cheung, and Gopalakrishnan (1993) find

that non-operating credits or charges contain incremental information, and decomposing earnings into operating and non-operat-

ing ones reduces specification errors in return-earnings equations. Fairfield, Sweeney, and Yohn (1996) illustrate how the disag-

gregation of earnings into operating earnings, non-operating earnings, and special items improves forecasts of return on equity.

Existing studies have documented consistent value-relevant evidence of non-operating earnings. Using a sample of electric

utility firms from 1962 to 1975, Bowen (1981) finds that non-operating earnings contribute positively to firm value. Bao and

Bao (2004) find that Taiwanese firms have a higher proportion of non-operating earnings than their U.S. and U.K. counterparts,

which illustrates the importance of such income avenues in Taiwan. Managers and analysts provide estimates of both operat-

ing and non-operating earnings; their actions underline the informative and value-relevant aspects of non-operating earnings

(Brown & Sivakumar,2003). Taken together, the evidence suggests that non-operating earnings play a contributing role along-

side operating earnings in determining value.

2.2

|

Non-operating earnings, total earnings volatility, and firm risk

Differentiating a firm's core operations from its non-core activities improves the accuracy of prediction models of its future

earnings, hence the stock price. Cheng and Hollie (2008) find that disaggregating cash flows from operations into core and