Earnings Quality and Firm Valuation: A “New” Perspective Deriving From the Literature

Earnings Quality and Firm Valuation: A “New” Perspective Deriving From the Literature

Liliana Marques Pimentel (University of Coimbra, Portugal) and Susana Margarida Faustino Jorge (University of Coimbra, Portugal)
DOI: 10.4018/978-1-5225-7817-8.ch001

Abstract

The quality of earnings is a summary metric in firm performance evaluation and a focal question to assess the quality of accounting information. A high-quality earnings figure will reflect a firm's current operating performance, being a good indicator of future operating performance; it also accurately annuitizes the intrinsic value of the firm. The multidimensional nature of the earnings quality (EQ) concept has given form to a multiplicity of constructs and measures. This chapter offers a systematic literature review on EQ and its implication on firm value. On the one hand, it discusses the different existent definitions of EQ and the multidimensional nature of the concept; on the other hand, it highlights a “new” EQ perspective taking into account the virtuosities of the residual income model. An empirical model is proposed that reinterprets rebuilding the linear information dynamics in relation to market value added and captures, in a composite measure, the three-dimensional facet of the EQ concept: persistence, predictability, and informativeness of earnings.
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2. Defining Earnings Quality

The subject of EQ is a complex area of research. So far, theoretical literature and empirical studies have not been able to provide a consensual definition of EQ, neither to find an adequate measure for it.

In what concerns the definition, some of the most important definitions, constructs and measures of EQ relate with persistence, predictability and variability (time-series properties) of earnings. Another stream of knowledge relates EQ with the relationship between income, accruals and cash, taking the view that earnings that map more closely into cash are more desirable (e.g. Penman, 2001). Others, in turn, consider that EQ is “conditional on the decision-relevance of the information”, hence considering that EQ is defined only in the context of a specific decision model (Dechow et al., 2010: 344).

Many studies give a definition on EQ. All of them agree that the concept is complex and nebulous, there is not a unique definition, neither an adequate measure for it. Although the concept is of common use, there is no consensus between academics and practitioners on its content, that is, there is no single definition of EQ. In fact, as mentioned, namely, by Bernstein (1996: 749) “virtually, there is no general agreement as regard to the definitions or assumptions on this term (earnings quality)”. Or, as stated by Ghosh et al. (2005: 34) “the earnings quality is a nebulous concept”.

Key Terms in this Chapter

Firm Valuation: To assess and to evaluate the firm’ value. There are different methodological approaches to evaluate companies. This work highlights that earnings are important for firm evaluation effects. Investors recognize earnings management as relevant for their assessment and decisions; accordingly, firm valuation models based on earnings, and based on book value, have been developed.

Market Value Added: The excess of the intrinsic value (market value of equity) in relation to the accounting value (book value of equity). It is also known as “unrecorded goodwill.” In these terms, the goodwill presents itself as a measure for the abnormal earnings generation. As such, the goodwill captures all the “hidden assets,” as well as the difference between the sum of the cost value of the assets shown on the balance sheet, individually considered, and their market value or the intrinsic value.

Earnings Quality (EQ): A complex and nebulous concept with a multidimensional nature. EQ is a summary measure in firm performance evaluation and a crucial issue to assess the quality of accounting information. A high-quality earnings figure will reflect firm’s current operating performance, being a good indicator of future operating performance; it also accurately annuitizes the intrinsic value of the firm. The multidimensional nature of the EQ concept has given form to a multiplicity of constructs and measures.

Abnormal Earnings: Current earnings minus the risk-free rate, times the book value at the beginning of period (i.e., earnings minus a charge for the use of capital). Abnormal earnings are defined to equal reported earnings minus the risk-free interest rate times the book value of the firm’s equity. The accounting literature typically refers to it as “residual income,” excess earnings, or super-profits.

Residual Income Model: Is an approach to equity valuation that formally accounts for the cost of equity capital. Here, “residual” means in excess of any opportunity costs measured relative to the book value of shareholders' equity; residual income is then the income generated by a firm after accounting for the true cost of capital.

Other Information Variable: A variable that captures important events in terms of informative content, which affect the market prices (market value of equity), but that are not yet reflected in the financial statements. This variable captures the extent to which the accounting variables do not explain the market value of equity.

Linear Information Model: Determining the value of the company using accounting and financial variables in a framework of nonlinear relationships.

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