Stephen H. Penman

Financial statement analysis and the prediction of stock returns

Abstract This paper performs a financial statement analysis that combines a large set of financial statement items into one summary measure which indicates the direction of one-year-ahead earnings changes. Positions are taken in stocks on the basis of this measure during the period 1973–1983, which involve canceling long and short positions with zero net investment. The two-year holding-period return to the long and short positions is in the order of 12.5%. After adjustment for ‘size effects’ the return is about 7.0%. These returns cannot be explained by nominated firm risk characteristics.

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.

Financial reporting quality: is fair value a plus or a minus?

Recent deliberations by both the International Accounting Standards Board (IASB) and the Financial Accounting Standard Board (FASB) in the United States have focused on how fair values of assets and liabilities should be measured. The issue of when, rather than how, fair value measurement should be applied is still far from resolved, however. Fair values have been mandated for some assets and liabilities under both IASB and FASB standards, but it is fair to say that principles governing the applicability of fair values have yet to be articulated: when is fair value accounting appropriate and when is it not? Or, in terms of my charge for this paper, under what circumstances is fair value a plus or a minus? To prepare for my task, I made a survey of public statements made for and against fair value accounting by a variety of standard setters, regulators, analysts, and preparers. The stated ‘minuses’ typically point to the dangers of fair value estimates from marking to model rather than marking to market, concerns about introducing ‘excess volatility’ into earnings, and feedback effects (on banks’ lending practices, for example) that could damage a business and, indeed, heighten systematic risk. A few antagonists question whether fair values (for bank assets and liabilities, for example) really capture the economics of a business (in fostering core deposits and making loans). In counterpoint, the proponents of fair value argue that fair value is a superior economic measure to historical cost. Consider the following arguments, often advanced as ‘pluses’:

Accounting Measurement, Price Earnings Ratio, And The Information-Content Of Security Prices

A number of papers (for example, Beaver, Lambert, and Morse [1980], Beaver, Lambert, and Ryan [1987], Collins, Kothari, and Rayburn [1987], and Freeman [1987]) have documented that stock prices lead accounting earnings. These investigations have led to the conclusions that prices provide information about earnings ahead of time and that earnings capture events that affect security prices with a lag. The study of P/E ratios has supported those conclusions and also produced additional insights. Beaver and Morse [1978] have shown that PIE ratios not only predict future earnings changes but they also identify transitory aspects of current earnings. Investors utilize other information in setting prices which provides both a prediction of future earnings and an indication of whether current earnings are representative of future earnings. Thus a comparison of price to earnings in a P/E calculation can indicate the extent to which current earnings are transitory.1 In this paper we show that information in prices that leads (future) earnings is contained in financial statements. While accrual accounting

Volatility increases subsequent to stock splits: An empirical aberration

Abstract This paper analyzes the empirical behavior of stock-return volatilities prior to and subsequent to the ex-dates of stock splits. The evidence demonstrates rather unambiguously that there is, on the average, an approximately 30% ‘arbitrary’ increase in the return standard deviations following the ex-date. The increase holds for both daily and weekly data, and it is not temporary. No explanatory confounding variables, such as institutional frictions affecting price observations, have been identified. We view the findings as being essentially inconsistent with the notion of ‘rational pricing’.

The distribution of earnings news over time and seasonalities in aggregate stock returns

Abstract Over the past 55 years returns on stock market indexes have on average been higher during the first half-month of calendar quarters 2 through 4 than at other times. Coincidentally, aggregate corporate earnings news arriving at the market during these half-month periods tends to be good, whereas earnings reports arriving later are more likely to convey bad news. In addition firms tend to publish bad-news earnings reports on Mondays, coincident with negative Monday effects in stock returns. The coincidence of earnings news arrival and market seasonalities leads to conjectures about informational reasons for observed seasonalities.

Return to Fundamentals

Up to 25 years ago, fundamental analysis was the primary focus of research in investment analysis. Correspondingly, financial accounting research embraced a measurement perspective. Fundamental analysis involves the determination of the value of securities from available information, with a particular focus on accounting information. The measurement approach in accounting evaluates accounting concepts as determinants of asset values that are measures of investment worth. Both endeavors are directed toward a basic, practical question: How does one assess how much to pay for a stock and what is the role of accounting in that assessment? During the past 25 years, research in academia has been otherwise directed. Both traditional fundamental analysis and accounting measurement theory have been judged as ad hoc and lacking the theoretical foundations required of rigorous economic analysis. “Modern finance” established those foundations but has not brought the theory to the question of fundamental analysis. Rather, it has been preoccupied with relative pricing, an understanding of relationships between the prices of financial assets under conditions of no arbitrage. Asset pricing models recognize that prices covary, and this has implications for the way they are priced. The prices of derivative securities are evaluated from the price of the relevant fundamental security. This is technical analysis, albeit quite different from the technical analysis of the chartists, because it deals only with price data.’ The characterization of the price of securities in terms of expected payoffs is well established, of course, but expressions for pricing the fundamental security have not advanced much beyond the dividend discount formula. The current valuation technology is discounted cash flow analysis but, as will be explained, this has critical conceptual and practical deficiencies. Modern financial accounting research has not produced insights into fundamental analysis either. “Capital markets research” in the tradition of Ball and Brown (1968) has the appearance of being involved in valuation analysis because it documents relationships between prices and accounting numbers. It has, indeed, produced a set of empirical descriptions. However it embraces a perspectivs-the “information perspective’ ’-that differs so

An Evaluation of Accounting Rate-of-return:

where the first two components (profit margin and turnover ratio) are further decomposed by line-item components of the income statement and balance sheet. However, how one utilizes this ratio in a financial statement analysis that elicits investment value (price) is not understood. This paper examines what ROE means for the pricing of stocks. Investment analysis can be characterized as discovering two types of (accounting) information which together yield the price of a stock. First, there is information that provides indications of future earnings (profitability) and, second, information that provides an indication of the rate at which those expected future earnings are discounted (that is, risk). ’ In traditional ratio analysis, ROE is nominated as a profitability measure. However, there are vague notions that it also reflects expected rate-of-return (risk) and certainly one can see from ( I ) that it is related to (book) leverage which presumably is related to risk. The paper evaluates ROE as an indicator of profitability and as an indicator of risk. The analysis of ROE as a measure of risk is described in Section 4 of the paper and the analysis of ROE as a measure of expected profitability is described in Section 5 . Section 2 describes the data and Section 3 provides

Disaggregated Accounting Data as Explanatory Variables for Returns

Modem market-based accounting research rarely refers to the elaborate concepts dictating the preparation of financial reports. The research does not explicate the reasons for the relevance of accounting data in valuation, and it depends only on the broad notion of “accounting data facilitates investors’ assessments of firms’ future cash flows. ” The popular construct of unexpected earnings, which researchers employ to explain returns, by contrast, is irrelevant to the practicing accountant who implements accounting principles. A more traditional way of looking at accounting recognizes the process as one of measurement. That is, the analysis of transactions leads to line items in the financial statements, which in turn aggregate into the “bottom line” numbers: (net) earnings and book value (net worth). These two summary measures achieve preeminent status by serving as primary indicators of a firm’s value. However, the disclosures of the line items clearly suggest that the accountant is aware of the insufficiency of earnings and book values as determinants of values. This paper incorporates a measurement perspective in addition to an information perspective to understand how accounting data relate to security returns.’ Earnings (and book values) derive from line items, and these line items may have differential valuation implications because investors perceive differential measurement errors. Hence, aggregation is not generally satisfied unless the measurement errors in the line items are relatively insignificant. The latter could occur for long reporting periods, as is suggested by the notion that a firm’s lifetime earnings are measured without error. In any event, the language of accounting provides some straightforward hypotheses concerning the realizations of line items and returns. Revenues are ‘‘good,’’ whereas expenses are “bad,” and returns should respond accordingly. More-

Abnormal returns to investment strategies based on the timing of earnings reports

Abstract This paper adds to recent evidence on market inefficiency in processing information in earnings reports. It documents that short positions taken in sample stocks which did not report earnings by the date expected during the sample period, 1971–1976, would have been abnormally profitable, before transaction costs. This is because late reports, on average, revealed bad news which was not anticipated in market prices prior to the report date. The magnitude of the average abnormal returns is in the order of 1.0% over 20 days but is larger for smaller firms in the sample and positively related to the length of the reporting delay. The paper also documents that long positions taken in stocks reporting early with good news would have generated abnormal returns of approximately 1.0% on average over a 20-day holding period.