RESEARCH CORNER

Practice vs. theory - which is right?

Last month's column discussed research which provided strong evidence that CFOs attach great importance to both reported earnings and meeting earnings targets. Conventional finance theory suggests that such beliefs are not justified-that, in fact, executives should focus on maximizing discounted future cash flows, not profits. So there is an apparent conflict between practice and theory: Either management is systematically believing (and doing) something wrong, or the theory itself must be wrong!

One way to resolve this conflict is to consider the "denominator effect" of the discount rate rather than the "numerator effect" of future cash flows. In other words, does meeting an earnings target help lower perceived risk and thereby lower the cost of capital? My colleagues and I are currently exploring this exact question.*

Now, measuring the cost of capital is not an easy task. In fact, it's one of the most perplexing measurement issues for researchers. Because of this difficulty, we instead examine an indirect measure that is related to the cost of capital: the degree of information asymmetry among investors. The more uneven the investment playing field, the higher the risk premium demanded by investors (see the February/March 2006 issue of Beyond Numbers for more on this measure).

We've found strong evidence that information asymmetry declines appreciably after companies report earnings that meet analysts' expectations-on average by about l/50th each quarter. Furthermore, asymmetry continues to decline with the number of quarters during which a company is able to meet expectations, albeit at a declining rate. This levelling of the investment playing field occurs because meeting earnings targets gives investors more assurance that they will not be surprised by a bad earnings report in the future, and that no one else has advance knowledge of this bad news. In turn, higher investor confidence leads to a lower risk premium and a lower cost of capital.

This evidence validates the beliefs of many financial executives: Meeting earnings targets and reporting smooth earnings does build credibility with the investment community and reduces perceived risk.

© 2006 Institute of Chartered Accountants of British Columbia Provided by ProQuest LLC. All Rights Reserved.