Doron Nissim

Ratio Analysis and Equity Valuation: From Research to Practice

Financial statement analysis has traditionally been seen as part of thefundamental analysis required for equity valuation. But the analysis has typicallybeen ad hoc. Drawing on recent research on accounting-based valuation, this paperoutlines a financial statement analysis for use in equity valuation. Standardprofitability analysis is incorporated, and extended, and is complemented with ananalysis of growth. An analysis of operating activities is distinguished from theanalysis of financing activities. The perspective is one of forecasting payoffs to equities. So financial statement analysis is presented as a matter of pro formaanalysis of the future, with forecasted ratios viewed as building blocks offorecasts of payoffs. The analysis of current financial statements is then seen asa matter of identifying current ratios as predictors of the future ratios thatdetermine equity payoffs. The financial statement analysis is hierarchical, withratios lower in the ordering identified as finer information about those higher up.To provide historical benchmarks for forecasting, typical values for ratios aredocumented for the period 1963–1999, along with their cross-sectionalvariation and correlation. And, again with a view to forecasting, the time seriesbehavior of many of the ratios is also described and their typical “long-run,steady-state” levels are documented.

The Persistence of the Accruals Anomaly

The accruals anomaly - the negative relationship between accounting accruals and subsequent stock returns - has been well documented in the academic and practitioner literatures for almost a decade. To the extent that this anomaly represents market inefficiency, one would expect sophisticated investors to learn about it and arbitrage the anomaly away. Yet, we show that the accruals anomaly still persists and its magnitude has not declined over time. While we find that institutional investors react promptly to accruals information, it is clear that their reaction is rather weak and is primarily characteristic of active investors who constitute a minority of institutions. The main reason: Extreme accruals firms have characteristics which are unattractive to most institutional investors. Individual investors are by and large unable to profit from trading on accruals information due to the high transaction and information costs associated with implementing a consistently profitable accruals strategy. Consequently, the accruals anomaly persists, and will probably endure.

Valuation of the Debt-Tax Shield

In this study, we use cross-sectional regressions to estimate the value of the debt-tax shield. Recognizing that debt is correlated with the value of operations along nontax dimensions, we estimate reverse regressions in which we regress future profitability on firm value and debt rather than regressing firm value on debt and profitability. Reversing the regressions mitigates bias and facilitates the use of market information to control for differences in risk and expected growth. Our estimated value for the debt-tax shield is approximately 40 percent (ten percent) of debt balances (firm value), net of the personal tax disadvantage of debt. In addition, our estimates for the debt-tax shield vary across tax regimes and across firms in a predictable manner.

Is Cash Flow King in Valuations

Contrary to the common perception that operating cash flows are better than accounting earnings at explaining equity valuations, recent studies suggest that valuations derived from industry multiples based on reported earnings are closer to traded prices than those based on reported operating cash flows. The question addressed in the article is whether the balance tilts in favor of cash flows when the following are considered: (1) forecasts rather than reported numbers, (2) dividends rather than operating cash flows, (3) individual industries rather than all industries combined, and (4) companies in non-U.S. markets. In all cases studied, earnings dominated operating cash flows and dividends. Even though many finance academics and practitioners believe that operating cash flows are better than accounting earnings at explaining equity valuations, the evidence from recent studies suggests the opposite. For example, we previously investigated the performance of industry multiples based on a comprehensive list of value drivers for a sample of U.S. companies. Performance was measured as the ability of valuations derived from industry multiples to approach traded prices, and the value drivers considered included forward earnings; reported earnings; book value of equity; sales; earnings before interest, taxes, depreciation, and amortization; and various cash flow measures. Our results suggested that earnings clearly outperform other value drivers. In this study, we focused on a comparison of cash flows and earnings because of the prominence of these two measures in practice but we expanded our analysis in four directions to see whether cash flows outperform earnings in other contexts. First, we considered forecasts of cash flows in addition to reported numbers. Because analysts exclude in their forecasts the one-time items that tend to blur the relationship between reported numbers and value, moving from reported numbers to forecasts should improve the performance for both cash flows and earnings. The open question was whether the improvement in performance for cash flow forecasts would be large enough to overcome the initial performance gap between reported earnings and cash flows. Second, we broadened the definition of cash flows to consider both dividends and operating cash flows. Even though many companies do not pay dividends, we considered that dividends might outperform earnings for the subset of dividend-paying companies. Third, we compared the performance of earnings with the performance of cash flows within industries to determine whether for a subset of industries, dividends or operating cash flows would outperform earnings. Fourth, we considered nine markets in addition to the United States: Australia, Canada, France, Germany, Hong Kong, Japan, South Africa, Taiwan, and the United Kingdom. To the extent that factors such as accounting rules and the informativeness of dividends vary across markets, that variation could result in across-market variation in the performance of earnings, operating cash flows, and dividends. Our main finding is that valuations based on industry multiples using earnings forecasts are remarkably accurate. About half the companies had valuations that were within 20 percent of traded prices for the three markets where earnings forecasts performed well (Australia, the United Kingdom, and the United States) and were within 30 percent of traded prices for the three markets where earnings forecasts were the least informative (Germany, Japan, and Taiwan). In effect, the lead that reported earnings exhibit over reported operating cash flows and dividends increased when we considered forecasts. Although the earnings multiple was outperformed by operating cash flows or dividends in some industries—and in one market (Japan), where the performance of dividends approached that of earnings—the dominance of earnings multiples was very evident. Overall, our results suggest that proponents of using cash flow multiples consider using earnings multiples instead, especially if earnings forecasts are available.

The Association between Changes in Interest Rates, Earnings, and Equity Values

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Line-Item Analysis of Earnings Quality

In this paper, we discuss earnings quality and the related concept of earnings management, focusing on the primary financial accounts. For each key line-item from the financial statements, we summarize accounting and economic considerations applicable to that item, discuss implications for earnings quality, evaluate the susceptibility of the item to manipulation, and identify potential red flags. The red flags and specific issues discussed for the individual line-items provide a framework for fundamental and contextual analysis by academic researchers and practitioners.

Debt Issue Costs and Issue Characteristics in the Market for U.S. Dollar Denominated International Bonds

This paper analyzes the issue costs and initial pricing of bonds in the international market. In particular, we investigate the determinants of three components of issue costs: underwriter fee, underwriter spread (the difference between the offering price and the guaranteed price to the issuer), and underpricing (the difference between the market price and the offering price). Total underwriter compensation increases with the bonds’ credit risk and maturity, but it is insignificantly related to issue size. Interestingly, underwriters appear to price some issue characteristics directly (by adjusting the fee) and other characteristics indirectly (by setting the guaranteed price). The two compensation components (fee and spread) are negatively related to each other. We provide evidence that this trade-off is consistent with income tax considerations, as well as with two-tier pricing by underwriters. We find no evidence of underpricing. JEL classification codes: G12; G15; G24; G30

Discussion—Reactions to Dividend Changes Conditional on Earnings Quality

Corporate disclosures are an important source of information for investors. Many studies have documented strong price reactions to earnings, dividends, and other corporate announcements. For dividend announcements, the price implications appear straightforward: price is the present value of expected future dividends. Hence, to the extent that future dividends are related to current dividends, dividend changes should trigger price responses. Other corporate disclosures, such as earnings, may also be viewed as proxies for future dividends. The price reaction to a particular disclosure should increase in the difference between the implied equity value based on that disclosure and price prior to the disclosure. The magnitude of price reaction should also increase in the precision of the disclosure and decrease in the precision of all prior price-related information (see, e.g., Holthausen and Verrecchia [1988]). Mikhail, Walther, and Willis (2003, MWW) test this precision effect focusing on dividend disclosures and using “earnings quality” (the association between future cash flow and past earnings) as a proxy for the precision of prior information. In particular, MWW test whether the magnitude of price reactions to dividend change announcements is negatively related to earnings quality. They also use revisions in analysts’ earnings forecasts as an alternative proxy for the change in expected cash flows triggered by the dividend change announcement. For dividend increases, MWW find that the magnitudes of both price reactions and revisions in analysts’ earnings forecasts are negatively related to earnings quality. For dividend decreases, however, they find insignificant results. The hypothesis that MWW test is simple, intuitive, and well established in the analytical literature. Their focus on dividend change announcements is also justified. Analytically, dividends are linked directly to stock prices, and empirically, dividend changes appear to convey relevant information to investors, as is evident by the significant price reactions (e.g., Aharony and Swary [1980]; Asquith and Mullins [1983]) and by the change in expected future earnings (e.g., Ofer and Siegel [1987]; Nissim and Ziv [2001]). Therefore, the research question is relevant. As discussed below, however, I have some concerns regarding the analysis, pri-

Accounting’s Role in the Reporting, Creation, and Avoidance of Systemic Risk in Financial Institutions

The financial crisis that erupted in late 2007 has resurfaced debates about the role of accounting and external financial reporting by financial institutions in helping detect or mask systemic risks and in exacerbating or mitigating such risks. The debate has largely focused on the role of fair value accounting, securitization and special purpose entities, off-balance sheet reporting and pro-cyclicality. We consider these and other issues using a single company’s published accounts. We explain the role, purpose and limitations of external financial reporting and suggest that there are aspects of the current accounting system that may help provide early warnings of and help mitigate potential systemic risks and others that may mask and exacerbate these risks. We offer some ideas on how the accounting might be adjusted to mitigate the latter. Our arguments lead to several conclusions the most important of which include: that credit-related crises are at least partly induced by not requiring financial institutions to take credit valuation adjustments on loans based on expected losses, and that disclosures would have to change significantly to allow an investor or regulator to make a realistic attempt at measuring a firm’s risk and even more so any potential systemic risk. But there is no way that an accounting system that is based on measurements at a single point can serve to fully identify and capture the uncertainty and risks. We believe that to be able to assess systemic risk even for a single firm we would need massive amounts of detailed data that few market participants would be able to utilize and interpret. At best the system can provide more disclosures to facilitate the understanding of such risks.

Synthetic Credit Ratings and the Inefficiency of Agency Ratings

This study develops and evaluates a model that generates synthetic credit ratings using accounting and market based information. The model performs very well in explaining agency ratings, suggesting that fitted values for unrated companies are likely to be reasonably precise. In addition, the synthetic credit ratings help explain cross sectional differences in CDS spreads, even after controlling for contemporaneous agency ratings. The incremental information provided by agency ratings relative to the synthetic ratings has declined substantially in recent years, possibly due to new SEC regulation that limits rating agencies’ ability to obtain confidential information from rated companies. Consistent with the finding that agency ratings do not fully impound the information in the synthetic credit ratings, differences between the synthetic and agency ratings predict changes in agency ratings in subsequent months, especially for small companies. This relationship is very significant, both statistically and economically, and while it monotonically declines over the forecasting horizon, the difference between the synthetic and agency ratings predicts changes in agency ratings as far as 24 months later. There is no evidence of substantial improvement over the last thirty years in the timeliness of agency ratings with respect to the information in synthetic ratings. Investors, in contrast, appear to process the synthetic rating information in a timely fashion, as the difference between the synthetic and agency ratings does not predict changes in CDS spreads or in stock prices.