Eti Einhorn

Extracting Sustainable Earnings from Profit Margins

Revenues and expenses are fundamentally proportional to one another, but are likely to be disproportionally affected by transitory items or economic shocks. We build on this observation and propose a new measure of sustainable earnings based on deviations from normal profit margins. While some other sustainable earnings metrics attempt to identify transitory components on a line-by-line basis, our measure, referred to as the intensity of core earnings (ICE), uses ratio analysis to extract the transitory portion of earnings from all line items. We find that the ICE, as measured here, is positively associated with earnings persistence, better earnings predictability, and stronger market reaction to unexpected earnings. We also find that our measure is positively associated with post-earnings announcement excess stock returns. Comparing our measure with an accrual-based measure of earnings quality, we find that, in general, the two metrics provide distinct incremental information relative to one another and in some instances our measure is better than an accrual-based measure in assessing earnings quality.

Cross-Firm Real Earnings Management

Our analysis is rooted in the notion that stockholders can learn about the fundamental value of any particular firm from observing the earnings reports of its rivals. We argue that such intra-industry information transfers, which have been broadly documented in the empirical literature, may motivate managers to alter stockholders’ beliefs about the value of their firm not only by manipulating their own earnings report but also by influencing the earnings reports of rival firms. Managers obviously do not have access to the accounting system of peer firms, but they can nevertheless influence the earnings reports of rival firms by distorting real transactions that relate to the product market competition. We demonstrate such managerial behavior, which we refer to as cross-firm real earnings management, and explore its potential consequences and its interrelation with the practice of accounting-based earnings management within an industry setting with imperfect (non-proprietary) accounting information.

Under-Weighting of Private Information by Top Analysts*

It is conventionally perceived in the literature that weak analysts are likely to under weight their private information and strategically bias their announcements in the direction of the public beliefs to avoid scenarios where their private information turns out to be wrong, whereas strong analysts tend to adopt an opposite strategy of over weighting their private information and shifting their announcements away from the public beliefs in an attempt to stand out from the crowd. Analyzing a reporting game between two financial analysts, who are compensated based on their relative forecast accuracy, we demonstrate that it could be the other way around. An investigation of the equilibrium in our game suggests that, contrary to the common perception, analysts who benefit from information advantage may strategically choose to understate their exclusive private information and bias their announcements toward the public beliefs, while exhibiting the opposite behavior of overstating their private information when they estimate that their peers are likely to be equally informed.