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Earnings Volatility and Market Valuation: An Empirical Investigation *+ Ronnie Barnes London Business School Sussex Place, Regents Park London NW1 4SA email: [email protected] Tel: +44 (0) 20 7262 5050 First Draft: 23 October, 1999 This Draft: 8 January, 2001 * Preliminary: comments welcome. This work has been partially funded by a scholarship from the Institute of Chartered Accountants in England and Wales. + This work constitutes part of my dissertation at LBS. Thanks are due to my supervisor Henri Servaes and the other members of my transfer committee (Shiva Shivakumar and Michel Habib). I have also benefited from discussions with Dennis Oswald, Dick Brealey and Jan Mahrt-Smith and from the comments of workshop participants at the LBS Institute of Finance and Accounting seminar, the EIASM Workshop on Performance Measurement, University of Iowa, Tulane University, Yale University, University of California at Irvine, University of California at Davis, Insead and the 2000 American Accounting Association meetings. The usual disclaimer applies.

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Page 1: Earnings Volatility and Market Valuation: An …facultyresearch.london.edu/docs/ACCT019.pdfEarnings Volatility and Market Valuation: An Empirical Investigation*+ Ronnie Barnes London

Earnings Volatility and Market Valuation:

An Empirical Investigation *+

Ronnie Barnes

London Business School

Sussex Place, Regents Park

London

NW1 4SA

email: [email protected]

Tel: +44 (0) 20 7262 5050

First Draft: 23 October, 1999

This Draft: 8 January, 2001

* Preliminary: comments welcome. This work has been partially funded by a scholarship from the Institute ofChartered Accountants in England and Wales.+ This work constitutes part of my dissertation at LBS. Thanks are due to my supervisor Henri Servaes and the othermembers of my transfer committee (Shiva Shivakumar and Michel Habib). I have also benefited from discussions withDennis Oswald, Dick Brealey and Jan Mahrt-Smith and from the comments of workshop participants at the LBSInstitute of Finance and Accounting seminar, the EIASM Workshop on Performance Measurement, University ofIowa, Tulane University, Yale University, University of California at Irvine, University of California at Davis, Inseadand the 2000 American Accounting Association meetings. The usual disclaimer applies.

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Abstract

This study investigates whether there is a systematic relationship between a firm’s market value (as

measured by its market to book ratio) and the variability of its quarterly earnings stream. Using data

from the Compustat full coverage, industrial and research quarterly files from 1973 to 1998 inclusive

I find that, after controlling for firm size, leverage, current profitability, the level of current

investment and sales growth, there is a significantly negative relationship between the market to

book ratio and earnings volatility (defined as the coefficient of variation of various earnings

measures). I further find that this negative relationship remains even after controlling for operating

cash flow volatility, indicating that “accounting-driven” earnings volatility does indeed have an

economic impact as has long been claimed. My results are robust to various specifications (including

fixed effects, the inclusion of industry dummies, the inclusion of year-quarter dummies and adjusting

all variables relative to the relevant industry year median) and to the inclusion of additional control

variables such as future cash flow volatility and future profitability. In addition to being statistically

significant, my results also have economic significance. For example, there is on average a 0.04

difference in market to book ratios between a firm whose earnings volatility is in the 5th percentile

and one in the 95th percentile. If we compare the 1st and 99th percentiles, we obtain a difference in

market to book ratios of 0.23, approximately 15% of the median.

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1. Introduction and Motivation

This study is motivated primarily by extensive anecdotal evidence that corporate managers believe

there to be a systematic negative relationship between the volatility of a firm’s earnings stream and

its market valuation. Consider, as an example, the recent debate in the United States concerning the

appropriate method of accounting for derivatives. The release in June 1998 by the Financial

Accounting Standards Board of SFAS 133: Accounting for Derivative Instruments and Hedging

Activities represented the culmination of a six year program on the part of the board to unify the

accounting and disclosure requirements in this area and came a full two years after the first

appearance of the Exposure Draft which preceded the final standard. The relatively long gestation

period for the standard reflects the intense and often heated debate that surrounded the project.

Much of this debate concerned the impact of the (then) proposed Standard on volatility; some 44%

of the over 250 comment letters received noted that balance sheet volatility would increase, whilst

61% noted an increase in earnings volatility. The following comments were typical (see Smithson

(1997)):

“The proposal’s introduction of unnecessary financial statement volatility will cause some

companies to avoid effective risk management strategies and potentially erode shareholder value”

[Eli Lilly]

“Given the focus on earnings by analysts and shareholders, the earnings volatility potential

presented by fair value hedge accounting, as proposed, may have a material impact on market

valuation as well”

[Providian Bancorp]

“We do not believe that appropriate consideration has been given to the negative impact of

financial statement volatility on regulated industries”

[CoBank]

Since these comments were made within the context of a particular accounting issue, it might be

argued that the concerns expressed are specific to that issue and are not indicative of a more

widespread desire to minimise earnings volatility. Similarly, it might also be argued that a company

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which submits a comment letter arguing against a particular accounting treatment is, almost by

definition, one whose management has a vested interest (perhaps because of compensation

considerations) in doing so and that these comments should therefore not be interpreted as

representative of the views of the corporate population in general. However, a casual review of the

business press would suggest that these arguments are of little merit and that delivering a steadily

increasing pattern of earnings growth is indeed an important objective for managers. For example,

the “Heard on the Street” column in the April 16-17, 1999 edition of the Wall Street Journal Europe

includes the following quote: ‘Here’s an exercise to give some CEOs a panic attack: Imagine what

would happen if you didn’t “manage,” or smooth out, your quarterly earnings.’ (McGough (1999)).

Consequently, the question as to whether or not a negative relationship between earnings volatility

and market value actually exists is one of considerable practical importance. The quote from Eli Lilly

suggests that, in the context of SFAS 133, companies may choose to forego potentially value-

enhancing risk management strategies in order to avoid the perceived drag on value that the resulting

increase in earnings volatility would create. If, however, such a relationship does not exist and the

market is indifferent to this increased volatility, then adoption of sub-optimal risk management

policies would needlessly destroy shareholder value.

In addition to this anecdotal evidence, the academic literature contains a large number of studies

which take as a given the fact that corporate managers dislike earnings volatility. The aim of these

studies is to rationalise this aversion and the resulting practice of income smoothing (loosely defined

as the adoption of operating strategies or accounting policies which minimise some measure of

earnings volatility). My paper differs from this line of research in that, rather than assuming that

earnings volatility has a negative valuation impact and attempting to explain the source of this

impact, I investigate whether such an impact does in fact exist. Additionally, I am not concerned

with the question of whether the earnings stream whose volatility we are measuring does or does not

reflect the effect of any income smoothing. In other words, I assume that if the motivation and

opportunity for income smoothing exist, these opportunities will be exercised by corporate

managements in an optimal manner and that the earnings volatility which remains is in some sense

“inherent” – it is the economic impact of this inherent volatility in which I am interested.

The remainder of the paper is structured as follows. A detailed review of the related literature is

contained in Section 2 whilst in Section 3, I provide a description of my hypotheses, research design,

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sample selection and data. Section 4 contains a description of my methodology and empirical results

and I summarise and conclude in Section 5.

2. Review of Related Literature

This paper is related to two lines of existing research. As noted above, the papers in the first of these

areas take as a given a managerial aversion to earnings volatility and attempt to rationalise this

aversion and the resulting practice of income smoothing. For example, Hepworth (1953) claims that

rather than reporting the maximum level of profit possible, management’s objective might well be to

smooth reported profits over a number of years since owners will feel more confident toward a

company that reports stable earnings. Gordon (1964) suggests that, as far as the accounting rules

permit, management will smooth reported income since investors believe that this will permit a

higher dividend rate and lead to a higher stock price. Similarly, Beidleman (1973) suggests that by

smoothing, management are able to create a stable earnings stream which is “capable of supporting a

higher level of dividends than a more variable earnings prospect (p654)”1 whilst Barnea, Ronen and

Sadan (1975) hypothesise that management may smooth income in an attempt to enhance investors’

ability to predict future cash flows.

A potential link between earnings volatility and cost of capital has also been considered as an

explanation for income smoothing. Badrinath, Gay and Kale (1989) argue that institutional investors

normally avoid companies that experience large variations in earnings or firms that are perceived as

risky and tend to prefer companies with smoother earnings streams. If this reluctance of institutional

investors to invest in stocks with volatile earnings streams leads to a reduction in liquidity and a

consequent increase in the cost of capital, this motivation for income smoothing may indeed be well-

founded. Similarly, Bricker et al. (1995) present evidence that analysts associate earnings quality

with the ability of a company’s managers to manage earnings so as to avoid negative earnings

surprises, suggesting that a company’s analyst following is affected by its earnings volatility and that

income smoothing may be motivated by a desire to increase this following. This is certainly plausible

– the Wall Street Journal Europe article referred to earlier (McGough (1999)) contains the following

quote from an analyst in connection with a company which quite publicly declines to smooth its

1 If the level of dividends is used (as suggested in Miller and Rock (1985) by management as a means of signallingtheir inside information regarding the future prospects of the firm, it may well be the case that a high degree ofearnings variability prevents management from utilising this signalling mechanism in the most optimal way.

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earnings: “I’m getting more nervous as the day gets closer. It’s like taking a final exam. Did I pass or

did I fail?” As above, if a reduced analyst following and the resulting increase in informational

asymmetry leads to an increase in the firm’s cost of capital, income smoothing may be a value-

maximising strategy. Finally, it is possible that if investors are able to estimate a firm’s cost of capital

only with error and that such estimates are based in part on the volatility of the firm’s earnings, an

increase in volatility may lead to an increase in the estimated cost of capital and a consequent loss of

value. Whilst there is evidence (see, for example, Beaver, Kettler and Scholes (1970), Rosenberg and

McKibben (1973), Lev and Kunitsky (1974) and Bowman (1979)) that earnings variability and

equity betas are positively related, it is questionable as to whether there is a causal link. For example,

in the context of SFAS 133, the disclosures required by the standard will enable investors to “strip

out” the source of any increased earnings volatility. If investors estimate the cost of capital using all

available information, these disclosures should guarantee that this increase in volatility does not in

fact lead to any increase in the estimated cost of capital.

Whilst related, the current paper has a somewhat different focus from that of these earlier studies,

and is more closely related to the line of research that addresses the general question of whether

earnings volatility has real economic effects. Among the earliest papers to address this question were

several ‘economic consequences studies’ that examined the stock price reactions to announcements

of accounting regulations. Specifically, these papers (which include Leftwich (1981) on accounting

for business combinations and Lev (1979), Collins, Rozeff and Dhaliwal (1981) and Lys (1984) on

oil and gas accounting)2 investigate whether the magnitude of the reaction of a particular firm’s

stock price to a mandated change in accounting policy that would potentially increase earnings

volatility is related to the perceived impact of the change on the probability that accounting-based

bond covenants will be violated and costs of financial distress (either direct or indirect) incurred.

Although the results of these studies (which typically use the debt to equity ratio as a proxy for the

extent to which such covenants are binding) appear to support this hypothesis, others have

questioned their interpretation (see, for example, Frost and Bernard (1989)). Nonetheless, these

studies are at least suggestive of a negative stock price reaction to anticipated increases in earnings

volatility that increase the likelihood that bond covenants will be violated. Similarly, Bartov (1993)

and Imhoff and Thomas (1988) provide evidence that firms adjust their real activities to avoid

2 See also Beattie et al. (1994)

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volatility, and that the extent of these adjustments varies cross-sectionally with firms’ debt

constraints.

My paper also investigates the relationship between market valuation and earnings volatility and the

extent to which the strength of this relationship (if any) is affected by leverage. However, the

approach I adopt is considerably different and, I believe, has a number of advantages. In particular,

the economic consequences literature relies heavily on the event-study approach and, as a result,

suffers from certain methodological problems of which identification of the event date and

controlling for confounding events are perhaps the most significant. Further, this line of research

focuses on anticipated increases in earnings volatility resulting from a single source. However,

reported earnings (and the volatility thereof) result from the interaction of real operating decisions,

accounting regulations in their totality and managerial discretion in applying those regulations.

Consequently, I choose to estimate the association between market valuation and realised earnings

volatility (as a proxy for investors’ expectations of future volatility) within a multivariate regression

framework.

More recently, Minton and Schrand (1999) investigate the links between cash flow volatility,

discretionary investment and the costs of external financing. They find that “cash flow volatility is

associated with lower levels of investment in capital expenditures, R&D and advertising. Thus, firms

do not turn to external capital markets to fully cover cash flow short-falls (p423).” They further find

that this sensitivity of investment to cash flow volatility is more pronounced for firms which have

higher costs of accessing external capital markets (as proxied by debt YTM, S&P bond rating, equity

beta, stock price volatility, analyst following and dividend payout ratio). Finally, they provide

evidence that these proxies are positively3 related to earnings and cash flow volatility although the

relationships are often weak4.

Their interpretation of these results is that it is investors’ expectations of future cash flow volatility

that is important in determining the costs of accessing external capital markets and that historical

earnings volatility is relevant only in that it is a better predictor of this future cash flow volatility than

3 In the sense that firms with higher earnings and/or cash flow volatility have higher costs of accessing the debt andequity markets.4Specifically, S&P bond ratings and analyst following are significantly related to cash flow but not earnings volatility,the reverse is true for equity beta and dividend payout ratios whilst stock price volatility is significantly related to both.

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is historical cash flow volatility5. However, they also note that the relationship between dividend

payout ratios and earnings volatility is consistent with the evidence in Smith and Warner (1979) who

observe that dividend restrictions in debt covenants are frequently based on accounting earnings

realisations.

Implicit in this last observation is the hypothesis that high earnings volatility can have economic

consequences, even when not accompanied by a correspondingly high cash flow volatility. This is of

particular interest when considering the implications of SFAS 133. If, as firms claim, derivatives are

primarily used for hedging purposes then an expected effect of SFAS 133 will be to cause cash flow

volatility decreasing transactions to generate an increase in earnings volatility6. Suppose that, as

Minton and Schrand suggest, current earnings volatility is important only as a predictor of future

cash flow volatility. Then, since the disclosure requirements of the standard are sufficiently detailed

that investors will be able to deduce that the increased earnings volatility has no negative

implications for cash flow volatility, the managerial concerns described above are invalid.

The results of Minton and Schrand indicate that both cash flow volatility and earnings volatility are

negatively related to the level of discretionary expenditure and positively related to the costs of

accessing external capital markets. In this paper, I examine whether these relationships translate into

a negative relationship between cash flow and earnings volatility and market valuations. Such a

relationship is not an automatic corollary of the Minton and Schrand results – it is not implausible

that since capital for discretionary investment is more readily available for firms with lower volatility,

such firms are more likely to invest in negative NPV projects.

Other papers which have explicitly considered the link between market values and earnings volatility

are Hunt, Moyer and Shevlin (1997) and Barth, Elliott and Finn (1999) (hereafter HMS and BEF

respectively). HMS hypothesise that in a regression of the market value of equity on net income, the

slope coefficient will be affected by the variability of net income, the variability of cash flow from

operations and the extent to which net income has been smoothed via non-discretionary and

5 In a footnote to their paper, Minton and Schrand describe results which suggest that this is in fact the case over shorthorizons but that for horizons beyond six years, the two predictors are essentially indistinguishable.6 This assumes that firms hedge cash flows rather than earnings. It might be interesting to investigate whether there isany systematic relationship between a firm’s use of derivatives and these two measures of volatility and for which therelationship (if any) is more pronounced. However, the inadequacy of pre-SFAS 133 disclosures may well make thisstudy difficult to implement.

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discretionary accruals. They find that, in general, firms which smooth their income stream using

accruals have higher market values of equity (in the sense that the coefficient on net income is

higher) than do firms which do not undertake such smoothing; further, the impact is greater when

the smoothing is achieved using discretionary, rather than non-discretionary, accruals. They also find

that the coefficient is higher for firms with lower earnings and operating cash flow volatilities.

By contrast, BEF are primarily interested in whether the market values more highly firms which

deliver a steadily increasing stream of earnings. They also regress the market value of equity against

net income (and also the book value of equity) and, on the basis that earnings volatility is a proxy for

operating risk, hypothesise that the coefficient on net income will be decreasing in earnings volatility

– this is indeed the case.

Whilst similar in spirit, my study differs from these papers in terms of the research design employed.

Both HMS and BEF rely on specific valuation models (Modigliani and Miller (1966) and Ohlson

(1995)) which are valid only in extremely limited circumstances. For example, expressing the market

value of equity as a linear combination of current net income and book value is valid only if the

assumption of linear information dynamics without other information is valid. Moreover, there is

nothing within the theoretical development of these models which leads to a role for earnings

volatility. Consequently, neither HMS nor BEF are able to identify whether their empirical results

with respect to earnings volatility arise because such volatility is in itself important or because

earnings volatility is correlated with some relevant omitted variable. By contrast, my research design

(which uses a dependent variable which is widely accepted as a measure of firm value and then,

based on the results from prior research and economic reasoning, controls for other factors which

are likely to be associated with this variable) does allow me to address such issues.

Finally, using a similar research design to the one in the current paper, Shin and Stulz (2000)

investigate the relationship between firm value and risk. They find that firm value (as measured by

the market to book ratio) increases with systematic equity risk and falls with both unsystematic and

total equity risk.

Whereas the current study investigates the link between earnings volatility and market value, a

number of papers examine the relationship between this volatility and stock returns. For example,

Billings (1999) finds that a strategy of investing in stocks with low earnings volatility and financing

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these positions by short selling high earnings volatility stocks generates consistently large, positive

returns.

Michelson et al (1995) divide a sample of S&P 500 firms into “smoothers” and “nonsmoothers and

find that the mean annualised continuously compounded return of smoothers over the 1982-1991

period is significantly lower than that of nonsmoothers. They also find that this result becomes

stronger as the criteria which a company has to satisfy to be classified as a smoother become stricter.

Finally, they find that smoothers have, on average, significantly lower equity betas (a result which is

consistent with Beaver, Kettler and Scholes (1970)) but are larger. They interpret this last result as

support for the hypothesis that larger firms have a greater incentive to smooth income than do

smaller firms since the former are subject to greater scrutiny by the government and general public; it

is also consistent with the observation that large firms are more likely to be followed by large

numbers of analysts who prefer to follow firms with stable earnings streams. However, in Michelson

et al (1999), the same authors find that when they use cumulative average abnormal returns

(measured against a market model benchmark), their principal result is reversed i.e. the cumulative

average abnormal return of smoothers is significantly higher than that of nonsmoothers and that this

result again becomes stronger as the criteria which a company has to satisfy to be classified as a

smoother become stricter.

The results of Billings (1999) and Michelson et al. (1995, 1999) appear to have two possible

interpretations. Firstly, earnings volatility is a risk factor (or is highly correlated with some other risk

factor) which is priced in equilibrium so that investors’ required returns are increasing in the level of

earnings volatility. Alternatively, the results may be suggestive of market inefficiency in that earnings

volatility is a firm-specific, fully diversifiable risk which investors incorrectly interpret as a priced,

systematic risk. However, care should be taken when interpreting these results. The fact that the

results of Michelson et al. (1995) are completely reversed when changing their dependent variable

from unadjusted to market-adjusted returns has to cast doubt on the robustness of the research

design, whilst there are several unexplained anomalies in the results of Billings (1999) – for example,

the relationship between equity beta and stock returns is indeterminate whilst the “size effect” (see,

for example, Fama and French (1992)) is reversed7.

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3. Research Design and Sample Selection

The basic hypothesis that we wish to test in this paper is that there is a systematic negative

relationship between the volatility of a firm’s earnings stream and its market value. We choose to

address this question within a multivariate regression framework; specifically, we regress a measure

of market value against a measure of earnings volatility and a number of control variables which

prior research has found to be related to market value. In determining the details of the research

design, we faced three major issues: (i) measure of market value (ii) measure of earnings volatility

(iii) choice of control variables.

3.1 Measure of market value

In determining an appropriate measure of market value to use as our dependent variable, we were

motivated by the desire to find a measure which is directly comparable across firms without a need

for risk adjustment or normalisation. The obvious candidate was Tobin’s q, defined as the firm’s

market value (as a proxy for the present value of its future cash flows) divided by the replacement

cost of its tangible assets. Within the existing corporate finance literature, there are many examples

of studies which investigate the relationship between market value and some characteristic(s) of

interest using Tobin’s q as the dependent variable in a multivariate regression (for example, Lang and

Stulz (1994)8 and Servaes (1996) on corporate diversification, Allayannis and Weston (2000) on the

use of foreign currency derivatives and Hall et al. (2000) on patent citations). The intuition behind

the use of Tobin’s q in this way is as follows. Assuming that financial markets are efficient and that a

firm’s market value is therefore an unbiased estimate of the present value of its future cash flows, the

ratio of market value to the replacement cost of assets is a measure of the extent to which a firm’s

market value is derived from its intangible assets (for example, its investment opportunities or real

options). Now suppose, for example, that a high level of earnings variability increases the cost to a

particular firm of accessing external capital markets. It is then highly plausible that this will lead to

the firm being unable to exploit valuable investment opportunities and, as a direct corollary, a lower

market value. In this situation, we would expect there to be the hypothesised systematic negative

relationship between Tobin’s q and earnings volatility. Similarly, we would expect to find such a

7 Whilst beyond the scope of the current paper, an investigation of whether there is indeed a relationship betweenaverage realised stock returns and earnings volatility is an interesting topic for future research.8 On which the following discussion of the use and drawbacks of Tobin’s q draws heavily.

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relationship if one or more of the other rationales for income smoothing discussed in Section 2 were

valid.

However, the major drawback to using Tobin’s q is that its calculation is computationally complex

and requires several detailed assumptions concerning, for example, the pattern of a firm’s future

acquisitions of plant and machinery, its depreciation policies, the difference between book value and

replacement cost in some “base year”, general changes in price levels, and the replacement cost of

inventories. Moreover, as Lang and Stulz (1994) and Perfect and Wiles (1994) (among others) have

shown, the results from regressions using the market to book ratio as the dependent variable are

often qualitatively very similar to those from regressions using Tobin’s q. For these reasons, we

choose to use the firm’s market to book ratio as the dependent variable in all of our regressions.

More specifically, the version of the market to book ratio we use is one which is based on the

“corporate finance” view of a firm as a set of net operating assets (including net working capital but

excluding cash) on which there are various claims (common stock, preference shares, minority

interests and long- and short-term debt (net of cash)). In view of the difficulty in obtaining market

values for most of these claims, we adopt a pragmatic approach (which is consistent with much of

the prior literature) and define the market to book ratio in terms of a numerator which is the sum of

the market value of common stock and the book values of preference shares, minority interests,

long-term debt, and debt in current liabilities, net of cash and short-term investments and a

denominator which is identical except that the market value of common stock is replaced by its book

value9.

3.2 Measure of earnings variability

9 It may be argued that the ratio should be computed using a lagged market value to reflect the fact that the book valueinformation relating to a particular date is not publicly available (and cannot therefore be impounded into shareprices) until some time later. However, there is a high degree of correlation between our chosen version of the ratioand an alternative version which does indeed use lagged market values. There is also a high degree of correlationbetween both of these versions and two other versions (one using contemporaneous market values, the other usinglagged market values) which are based on a view that liabilities such as accounts payable, income taxes payable anddeferred taxes are in fact elements of the firm’s financing. Further, the results from estimating our basic regression(see equation (1) in Section 4.1) using these alternative versions of the market to book ratio are qualitatively very closeto those from estimating the regression using our chosen version and are therefore not reported.Similarly, earlier studies (for example, Krishnan et al. (1999)) have used the market equity to book equity ratio as thedependent variable in regressions of this type. Given that we are using the market to book ratio as a proxy for Tobin’sq and for the reasons outlined in our discussion of Hunt, Moyer and Shevlin (1997) in Section 2, we feel that thisspecification would be inappropriate. However, when we estimate our regression using the market equity to bookequity ratio (which exhibits a correlation of around 60% with our chosen version of the market to book ratio) as thedependent variable, we obtain qualitatively similar results.

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Consistent with Minton and Schrand (1999), we measure earnings volatility as the coefficient of

variation10 of some measure of earnings (net income, pretax income or income before extraordinary

items) over either the four or eight quarters preceding the end of the quarter at which we measure

the dependent variable. As discussed in more detail below, we exclude any firm-quarters for which

four or eight (as appropriate) contiguous observations of the relevant earnings variable are not

available.

3.3 Control variables

In addition to a measure of earnings volatility, our regressions also include as explanatory variables

firm size, leverage, current investment, sales growth and current profitability. Firm size is included

since numerous earlier studies have shown it to be related to various market-based variables (see, for

example, Fama and French (1992) for the relationship between size and stock returns) whilst

leverage is included as a proxy for the expected costs of financial distress. The level of current

investment is included as a proxy for the investment opportunity set - since our dependent variable

measures the extent to which a firm’s market value is derived from its investment opportunities or

real options, it is obviously important that we control for such opportunities. Similarly, sales growth

is included since it may capture aspects of the firm’s growth opportunities for which the level of

current investment is an inadequate proxy. Finally, we believe that a high level of current profitability

may indicate a strong competitive position which is value-enhancing.

Additionally, we include a measure of cash flow volatility in order to isolate the impact of

“accounting-driven” earnings volatility. In other words, earnings may vary due to variations in cash

flows or, even where cash flows are relatively stable, due to accruals such as depreciation, increases

in accounts receivable and so on. Since the focus of this study is on whether earnings volatility is

associated with market valuations, it is important that we control for cash flow volatility. Further,

given the results of Shin and Stulz (2000), cash flow volatility also serves as short-term measure of

firm risk.

3.4 Data

10 Defined as the standard deviation scaled by the absolute value of the mean. In addition to Minton and Schrand(1999), other studies which use the coefficient of variation as a measure of earnings (or cash-flow) volatility includeAlbrecht and Richardson (1990) and Michelson et al. (1995, 1999).

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The data for this study is extracted from the Compustat full coverage, industrial and research

quarterly files from 1973 to 1998 inclusive. Additionally, we replace (wherever possible) any missing

value for research and development costs or advertising expenses with a value constructed from the

corresponding annual amount extracted from the relevant Compustat annual file11.

In order to ensure as far as possible the completeness and integrity of the data, we first attempt to

reconstruct any missing items from other, non-missing, items (for example, total current assets as the

sum of cash and short-term instruments, receivables, inventories and other current assets). We then

eliminate any observation for which one or more of the following data items is negative: cash and

short-term investments, accounts receivable, inventories, other current assets, total current assets,

property, plant and equipment, other assets, total assets, debt in current liabilities, accounts payable,

other current liabilities, other liabilities, long-term debt, preferred stock, sales, cost of goods sold,

selling, general and administrative expense, depreciation and amortization. Similarly, we eliminate

any observation for which either or both of total current liabilities and total liabilities is negative and

greater in absolute value than the sum of the absolute value of those component items which are

legitimately negative12. We also eliminate any observation where the difference between an item and

its components or between stockholders’ equity and total assets less total liabilities (which should by

definition be zero) exceeds (in absolute value) $1m. Where the value for capital expenditure,

research and development costs or advertising expenses is negative, we do not eliminate the

observation but treat the item as missing.

Finally, we eliminate any observation relating to a financial services company (SIC codes between

6000 and 6999) or a company which is not publicly traded, any observation with a missing value for

the number of common shares outstanding and/or the end of quarter share price and any observation

for which it was not possible to construct at least one of our measures of both earnings volatility and

cash flow volatility.

11 For example, suppose that a firm reports the following research and development costs: annual - 10m; quarter 1 -$3m; quarters 2,3 – missing; quarter 4 - $4m. We replace each of the missing observations for quarters 2 and 3 by$1/2(10 – 3 – 4)m = $1.5m.12 For example, total current liabilities may be negative because income taxes payable are negative; however, since itsother components are constrained to be non-negative, total current liabilities cannot be “more negative” than incometaxes payable.

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The resulting sample consists of 283,498 observations relating to 11,662 firms; the number of

observations per firm ranged from 1 to 92 with a mean of 43. Descriptive statistics for key financial

statement items for the final sample are contained in Panel A of Table 1. The mean (median) book

value of equity is $298m ($31m) whilst for market value of equity, the corresponding amounts are

$724m and $54m; the mean (median) quarterly net income for the sample is $8m (zero). For all

items, the mean exceeds the median by a considerable margin. In Panel B of Table 1, we present the

time-series distribution of the sample – as expected, the number of firm observations per quarter

increases steadily through time13. There are very few observations until the fourth quarter of 1975 –

this is primarily the result of the difficulty (discussed in more detail below) in constructing a measure

of cash flow volatility.

4. Methodology and Empirical Results

4.1 Variable definition

The basic regression I estimate is

ititititititititit sgrowthinvestprofitlevsizecfvolearnvol q εββββββββ ++++++++= 76543210 (1)

where q denotes Tobin’s q, earnvol and cfvol are measures of the volatility of earnings and cash flow

respectively, size is (the natural logarithm of) total assets, and lev, profit, invest and sgrowth are

measures of leverage, current profitability, the level of current investment and sales growth

respectively. The subscripts i and t are used to denote firms and quarters respectively.

As discussed above, I use as a proxy for Tobin’s q the market to book ratio (MTB). MTB is defined

as the ratio of (a) a numerator which is the sum of the market value of common stock14 and the book

values of preference shares (item #55), minority interests (item #53), long-term debt (item #51), and

debt in current liabilities (item #45), net of cash and short-term investments (item #36) and (b) a

denominator which is identical except that the market value of common stock is replaced by its book

13 The low number of observations for the final three quarters of 1998 reflects the time at which data for the study wascollected.14 The product of the number of common shares outstanding (item #61 from the Compustat quarterly files) and theclosing share price (item #14).

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value (item #59). In order to mitigate the impact of extreme values of the dependent variable on our

results, I winsorize at the 1% and the 99% levels - I then eliminate any observations where the ratio

is negative. Summary statistics on the resulting 269,427 observations are shown in Panel A of Table

2. The mean (median) market to book ratio for the sample is 3.42 (1.51) with a range of essentially

zero (due to rounding) to 55.70. The ratio has been increasing through time – the mean (median)

ratio in 1976 of 1.18 (0.93) increased to 3.27 (1.54) in 1986 and to 5.15 (2.16) in 1998. Similarly,

there is a wide variation across industries – SIC 2-digit code 28 (Chemicals & Allied Products) has a

mean (median) ratio of 8.31 (2.71) whilst that of 2-digit code 12 (Coal Mining) is only 1.13 (1.06).

As noted by Michelson et al. (1995, 1999), there is no consensus within the existing literature as to

which earnings number is the ultimate target of any smoothing activity. Consequently, I estimate my

regressions using three different bases for my measure of earnings volatility, earnvol – pretax income

(item #23), income before extraordinary items (item #8) and net income (item #69). More

specifically, I regress the market to book ratio at the end of quarter t against the coefficient of

variation of one of these earnings measures, calculated over quarter t-n+1 to quarter t inclusive

where n is equal to 4 or 8. i retain only those observations for which n quarters of data are available

for this calculation. Thus, for example, the regression of the market to book ratio against the

coefficient of variation of net income measured over 8 quarters will only include an observation for a

particular firm at the end of 1990 if, inter alia, net income is a non-missing data item for that firm for

each quarter of 1989 and 1990.

For consistency, I use as my measure of cash flow volatility, cfvol, the coefficient of variation of

operating cash flow calculated over the same time frame as earnvol. Since the implementation of

SFAS 95 “Statement of Cash Flows” in 1987, firms have been required to prepare a statement of

cash flows which shows the net cash flow from operating activities (OCF) on the face of the

statement (Compustat quarterly data item #108). Prior to SFAS 95, however, firms had some degree

of discretion over the format in which the statement was presented. In some formats, OCF was not

reported, in which case I adopt the approach of Biddle, Bowen and Wallace (1997) to construct a

measure of operating cash flow. If the firm used the “Cash Statement by Activity” format, funds

from operations – total (data item #82) was used. If either the “Working Capital Statement” or

“Cash Statement by Source and Use of Funds” was used, operating cash flow is estimated as funds

from operations - total, less the change in working capital (where working capital is defined as

current assets (excluding cash and short term investments) less current liabilities (excluding debt in

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current liabilities)). Finally, where funds from operations - total was not available, this was proxied

by net income, adjusted for depreciation and deferred taxes15.

Summary statistics for the various specifications of earnvol and cfvol (after winsorization at the 1%

and the 99% levels) are shown in Panel B of Table 2. Panel C of Table 2 contains summary statistics

for the control variables size, lev, profit and sgrowth. Since size is the natural logarithm of total

assets, issues relating to outliers are less relevant here; hence I do not winsorize this variable since

doing so would leave my results qualitatively unchanged. Lev, my measure of firm leverage, is

defined as the book value of long-term debt divided by the sum of the market value of common

stock and the book values of preference shares, minority interests and long-term debt16. I use three

different versions of profit, my measure of current profitability – return on assets (defined as pretax

income plus interest expense (item #22)17 divided by total assets (item #44) less cash and short-term

investments)18, return on capital (pretax income plus interest expense divided by the denominator in

the market to book ratio) and return on equity (net income divided by the book value of common

stock). In all three cases, I use the denominator computed as at the end of the relevant quarter.

Alternative specifications based on denominators calculated using either start of quarter or the

average of end and start of quarter data are again highly correlated with my chosen specification19.

Finally, sgrowth is defined as the natural logarithm of one plus the percentage change in sales over

the previous 4 or 8 quarters, according to the time frame over which earnvol and cfvol are

calculated. As with size, I do not winsorize sgrowth – however, lev and profit are winsorized at the

1% and 99% levels.

15 As noted by Collins and Hribar (2000), any measure of operating cash flow which requires an estimation of accrualsusing consecutive balance sheets is subject to (potentially severe) estimation error due, for example, to mergers andacquisitions, divestitures and foreign currency translation. Consequently, our measure of cash flow volatility in thepre-1987 period is likely to be measured with error, leading to biased coefficient estimates. However, we haveestimated our basic regression using only the post-1987 sample and obtained qualitatively similar results to thoseobtained using the entire sample. Hence, we believe that any error in measuring operating cash flow has a negligibleimpact on our results.16 Given my definition of the market to book ratio, a more appropriate measure of leverage might be one where short-term debt, net of cash and short-term investments were included within both the numerator and the denominator.However, the correlation between this measure and the one I actually use is 67%; when I estimate my regression usingthis alternative measure, I find that my results are largely unchanged.17 In all of my measures of profitability, I actually multiply the numerator by four in order to annualise the measure.18 I exclude cash and short-term investments from the denominator since the income from these assets is excludedfrom the numerator – in other words, I am really calculating return on operating assets.19 Once again, estimation of alternative specifications of equation (1) confirms that my results are indeed largelyinsensitive to the particular version of profit I use.

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My primary specification of invest is capital expenditure during the quarter although in certain

specifications of the regression I use research and development costs, advertising expenditure or the

sum of capital expenditure, research and development costs and advertising expenditure as

alternative measures. In all cases, I scale by total assets less cash and short-term investments at the

start of the quarter and winsorize at the 1% and 99% levels. Summary statistics for these variables

are shown in Panel D of Table 2.

A review of Panels A to D of Table 2 suggests a significant degree of skewness in a number of the

variables. Most notably, from Panel C, it can be seen that for all three versions of profit the minimum

observation is significantly greater in magnitude than the maximum observation whilst the mean

(which in all three cases is negative) is considerably lower than the median. For example, the

minimum return on assets is –361% whilst the maximum is only 84%; the mean and median

observations are –2% and 9% respectively. This significant negative skewness is consistent with the

positive skewness in the market to book ratio discussed above. Insofar as the measures of earnings

and cash flow volatility are concerned, all of the measures are positively skewed. Both the mean and

median observations are typically higher when the volatility measured is calculated using eight, rather

than four, quarters of data. Additionally, cash flows appear to be more volatile than (any of the

versions of) earnings, providing additional support for the belief that managers do indeed smooth out

earnings. Finally, all three measures of the level of current investment exhibit a moderate degree of

positive skewness, whilst the sales growth measures (as expected) exhibit little or no skewness.

4.2 Results

In Table 3, I present the results from a pooled cross-sectional/time-series OLS estimation of

equation (1) with invest defined as scaled capital expenditures and profit defined as return on assets.

As hypothesized, the coefficients20 on earnvol and cfvol are negative, indicating that higher earnings

and cash flow volatility are indeed associated with a lower market to book ratio. These coefficients

are also statistically significantly (at any reasonable level) different from zero. The coefficients on

size, lev and profit are also negative and statistically significantly different from zero whilst those on

invest and sgrowth are significantly positive. These results are independent of whether earnvol, cfvol

20 In all cases, the reported coefficients on earnvol and cfvol are (in order to aid comprehension of the results) 100times the actual coefficient i.e. a reported coefficient of –4.40 corresponds to an actual coefficient of –0.044.

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and sgrowth are calculated using 4 or 8 quarters of data and of which particular specification of

earnvol is used.

Although the results in Table 3 are supportive of my principal hypothesis, the negative coefficient on

profit is somewhat troubling – it is difficult to construct a plausible explanation of why a higher level

of profitability should be associated with a lower market to book ratio. Based on the negative

skewness of all three measures of profit and the positive skewness of MTB, my conjecture is that

(even after winsorization) this result is driven by a small number of outlying observations with an

abnormally high negative current profitability and a correspondingly high market book ratio.

Consequently, I re-estimate equation (1) using WLS21 - the results are reported in Panel A of Table

4. I find that the coefficients on earnvol and cfvol remain significantly negative, as do those on lev.

However, the coefficients on size and profit are now significantly positive, whilst that on invest

remains significantly positive. These results are supportive of my conjecture that those in Table 3 are

disproportionately affected by a small number of outliers.

To illustrate the economic significance of our results, consider the first row of Panel A of Table 4.

As reported in Panel B of Table 2, the ranges for cvni4 and cvcfo4 are 0.04 to 29.73 and 0.09 to

73.91 respectively – the 5th/95th percentiles are 0.08/6.27 and 0.20/14.79 respectively. Consequently,

holding all else constant, a firm with an earnings volatility (as measured by cvni4) in the 95th

percentile will have a market to book ratio which is 0.04 lower than that of a firm whose earnings

volatility is in the 5th percentile – this represents 2.37% (1.05%) of the median (mean) market to

book ratio. The same analysis performed with respect to cash flow volatility also yields a difference

in the market to book ratio of 0.04. Comparing the 1st and 99th percentiles of cvni4 reveals a

difference in market to book ratios of 0.23, representing approximately 15% of the median.

A further econometric issue with the results reported in Panel A of Table 4 is that I am still

estimating equation (1) on a pooled cross-sectional/time-series basis with the implicit assumption

that the firm-quarter observations are independent. If (as is likely) this assumption is invalid, the

21 Implemented using the rreg (robust regression) procedure in Stata. This procedure begins by estimating theregression using OLS and excluding any observation for which Cook’s D statistic exceeds 1. Thereafter, the procedureoperates iteratively; firstly, it again estimates the regression using OLS on the remaining observations and calculatescase weights based on absolute residuals. It then estimates the regression using WLS with these case weights andcalculates a new set of weights based on the absolute residuals from this WLS regression. The iteration stops when themaximum change in weights falls below some prespecified tolerance level. (See Stata Reference Manual, Release 6,Volume 3, pp 253-58 for further details on the procedure).

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estimated coefficients will be unbiased but the estimated standard errors and t-statistics will be

biased. To overcome this problem, I again estimate equation (1) using WLS but impose the

additional restriction that whilst observations are independent across firms, they are not necessarily

independent within firms22. The results are reported in Panel B of Table 4. As expected, the

additional restriction has the effect of reducing the t-statistics, in some cases considerably. However,

all coefficients remain significantly different from zero at any reasonable level of significance; in

particular, the coefficients on earnvol and cfvol are negative and significantly different from zero

with t-statistics ranging from –11 to –15.

4.3 Robustness

To test the robustness of the results in Table 4, I also estimate various alternative specifications of

equation (1), again using rreg to eliminate outliers and cluster to correct for autocorrelated

residuals. In the regressions reported in Panel A of Table 5, research and development costs and

advertising expenditures are included as separate control variables whereas in Panel B, invest is

defined as the sum of capital expenditures, research and development costs and advertising

expenditures. In both cases, the coefficients on earnvol and cfvol remain negative (and of the same

order of magnitude as in Table 4) with a somewhat lower level of significance due to a large

reduction in the number of observations. The remaining results are largely as expected – the

coefficients on all measures of current investment are positive and highly significant, with the

magnitude of the coefficients on research and development costs and advertising expenses in Panel A

typically higher than that of the coefficient on capital expenditures. This is plausible when I consider

that, although all of these variables are being used as proxies for the firm’s investment opportunity

set, the immediate write off of research and development costs and advertising expenses has the

effect of depressing the denominator in the dependent variable.

I also estimate a series of regressions (results not reported) which are essentially the same as those

reported in Panels A and B of Table 5 except that where research and development costs or

advertising expenditures are missing, I force the value to zero - the results are again qualitatively

unchanged.

22 Implemented using the cluster procedure within Stata (see Stata Reference Manual, Release 6, Volume 3, pp 158,

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As noted earlier, Minton and Schrand (1999) suggest that earnings volatility might be important only

because investors are concerned about future cash flow volatility and this is better predicted using

current earnings volatility rather than current cash flow volatility. To allow for this possibility, I

estimate equation (1) with a measure of future cash flow volatility, futcfvol23, included as an

additional control variable. The results are reported in Table 6 and appear to suggest that earnings

volatility plays a role in the market’s valuation process above and beyond its use as a predictor of

future cash flow volatility. As conjectured, the coefficient on futcfvol is uniformly significantly

negative. However, the coefficients on earnvol and cfvol remain consistently significantly negative,

from which I conclude that earnings volatility is important in its own right and not just as a predictor

of future cash flow volatility.

A further explanation of the negative relationship between the market to book ratio and earnings

volatility is that (as suggested by Stein (1989)) it is higher quality firms which choose to smooth

earnings – in other words, it is not high earnings volatility which depresses the market to book ratio

but rather high quality (with quality proxied by the market to book ratio) which leads firms to

smooth earnings and show low earnings volatility. A plausible alternative proxy for quality is future

profitability; consequently, I estimate equation (1) with a measure of future profitability, futprof24,

included as an additional control variable. The results are shown in Table 7. As expected, the

coefficient on future profitability is significantly positive but, as above, my results with respect to

earnvol remain unchanged – the coefficient on this variable is consistently significantly negative, a

finding which tends to rule out the possibility that the market to book ratio and earnings volatility are

related only because the latter is a proxy for firm quality.

In Table 8, I summarize the results from estimating equation (1) with firm-specific fixed effects.

Once more, I consistently find negative coefficients on earnvol and cfvol which are significantly

different from zero. Other sensitivity checks I perform involve the inclusion of year-quarter dummies

(Table 9, Panel A), the inclusion of industry dummies at the two-digit SIC code level (Table 9, Panel

B) and the estimation of a specification in which all variables are adjusted relative to the relevant

industry-year median. In all of these specifications, although there are some differences in coefficient

estimates, the results are uniformly supportive of my hypothesis that there is a significant negative

178-79 for further details).23 Defined as the coefficient of variation of operating cash flow calculated over the four or eight (as appropriate)quarters starting with t+1.

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association between a firm’s market to book ratio and the volatility of its earnings stream, even after

controlling for the volatility of its operating cash flows.

In Table 11, I present the results from estimating equation (1) with earnvol and cfvol calculated for

any given firm using the entire time-series of data (summary statistics for these specifications of the

two variables after winsorization at the 1% and 99% levels are reported in Table 10). In Panel A, I

treat earnvol and cfvol as intertemporal constants and use the entire panel of data to estimate the

regression whilst in Panel B, I recognise that (when defined in this way), earnvol and cfvol are only

known at the end of the period and so estimate the regression on a purely cross-sectional basis with

the dependent variable equal to the latest available market to book ratio. In all cases, the coefficients

on earnvol and cfvol are negative although the level of significance is considerably lower in the

specifications reported in Panel B. Similarly, the coefficient on cfvol is uniformly significantly

negative in Panel A whilst in Panel B, although still negative, it is insignificant at the 5% level. The

results with respect to the control variables are as expected.

5. Summary and Conclusions

In this study, I investigate whether there is a systematic relationship between a firm’s market value

and the variability of its quarterly earnings stream. Using data from the Compustat full coverage,

industrial and research quarterly files from 1973 to 1998 inclusive I compute firm market to book

ratios. On the grounds that it is a close proxy for Tobin’s q, (generally accepted as a measure of

value which is directly comparable across firms without a need for risk adjustment or normalisation),

I use this ratio as a measure of firm value. I define earnings volatility as the coefficient of variation of

various earnings measures, calculated over the previous 4 or 8 quarters, and find that, after

controlling for firm size, leverage, current profitability, the level of current investment and sales

growth, there is a significantly negative relationship between the market to book ratio and earnings

volatility. I further find that this negative relationship remains even after controlling for operating

cash flow volatility, indicating that “accounting-driven” earnings volatility does indeed have an

economic impact as has long been claimed. My results are robust to various specifications (including

fixed effects, the inclusion of industry dummies, the inclusion of year-quarter dummies and adjusting

24 Defined as the average return on assets calculated over the four or eight (as appropriate) quarters starting with t+1.

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all variables relative to the relevant industry year median). They are also robust to the inclusion of

additional control variables such as future cash flow volatility and future profitability.

In addition to being statistically significant, my results also have economic significance. For example,

there is on average a 0.04 difference in market to book ratios between a firm whose earnings

volatility is in the 5th percentile and one in the 95th percentile. If we compare the 1st and 99th

percentiles, we obtain a difference in market to book ratios of 0.23, some 15% of the median.

Finally, my results have implications for corporate managements and accounting standard setters.

Given that highly volatile earnings streams do indeed translate into lower market values, it appears

that there is an opportunity to increase shareholder value by reducing earnings volatility. However,

whether this is possible is rather questionable. Given that managers have long accepted a negative

association between earnings volatility and market value, it is probable that the realised earnings

which firms report already reflect an “optimal” level of income smoothing and that any further

smoothing is either not simply not possible or, for whatever reason, suboptimal. Insofar as

accounting regulators are concerned, my results suggest that accounting standards (such as SFAS

133) which will increase earnings volatility may well lead managers to (rationally) alter their real

operating decisions in a way which might not, in itself, be shareholder value maximizing. This is not

to claim that regulators should not introduce volatility increasing standards, but rather to point out

that such standards do indeed have genuine economic consequences.

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Discretionary Investment and the Costs of Debt and Equity Financing. Journal of Financial

Economics 54: 432-460

Ohlson, J.A. 1995. Earnings, Book Values, and Dividends in Equity Valuation. Contemporary

Accounting Research 11:661-688

Perfect, S.B. and K.W. Wiles. 1994. Alternative constructions of Tobin's q: An empirical

comparison. Journal Of Empirical Finance 1: 313-341

Rosenberg, B. and W. McKibben. 1973. The Prediction of Systematic and Specific Risk in Common

Stocks. Journal of Financial and Quantitative Analysis 8: 317-333

Servaes, H. 1996. The Value of Diversification During the Conglomerate Merger Wave. Journal of

Finance 51: 1201-1225

Shin, H-H. and R.M. Stulz. 2000. Firm Value, Risk, and Growth Opportunities. NBER Working

Paper Series, No. 7808

Smith, C.W. Jr. and J.B. Warner. 1979. On Financial Contracting: An Analysis of Bond Covenants.

Journal of Financial Economics 7: 117-161

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27

Smithson, C.W. 1997. Managing Financial Risk - 1997 Yearbook: Chapter 7 (Accounting).

Available at http://www.cibcfp.school.com

Stein, J.C. 1989. Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate

Behavior. Quarterly Journal of Economics 104: 655-669

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Table 1

Panel A:

Descriptive Statistics on Sample Firm/Quarter Observations

The sample consists of 283,498 observations extracted from the Compustat full coverage, industrial and research quarterly files from 1973 to 1998

inclusive. An observation is included provided that none of the following items are negative: cash and short-term investments, accounts receivable,

inventories, other current assets, total current assets, property, plant and equipment, other assets, total assets, debt in current liabilities, accounts payable,

other current liabilities, other liabilities, long-term debt, preferred stock, sales, cost of goods sold, selling, general and administrative expense and

depreciation and amortization. Any observation for which either or both of total current liabilities and total liabilities is negative and greater in absolute

value than the sum of the absolute value of those component items which are legitimately negative is eliminated. Any observation where the difference

between an item and its components or between stockholders’ equity and total assets less total liabilities exceeds (in absolute value) $1m is eliminated.

Where the value for capital expenditure, research and development costs or advertising expenses is negative, the item is treated as missing. Any observation

relating to a financial services company (SIC codes between 6000 and 6999) or a company which is not publicly traded, any observation with a missing

value for the number of common shares outstanding and/or the end of quarter share price and any observation for which it was not possible to construct at

least one measure of both earnings volatility and cash flow volatility is eliminated. All amounts are expressed in $m.

Variable No. of

observations

Mean Median Standard

deviation

Minimum Maximum

Total assets 283,490 822 69 5,272 0 318,882

Total liabilities 283,483 524 31 4,131 0 283,297

Book value of equity 283,483 298 31 1,505 (4,822) 65,462

Market value of equity 283,498 724 54 4,173 0 295,679

Pretax income 274,084 14 1 103 (6,948) 5,215

Income before extraordinary items 274,673 8 0 63 (5,463) 2,681

Net income 274,658 8 0 71 (8,672) 3,291

Research and development costs 150,601 8 0 74 0 8,200

Capital expenditures 278,185 35 2 234 0 31,393

Advertising expense 94,163 8 0 38 0 931

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Panel B:

Time-Series Distribution of Sample Firm/Quarter Observations

Quarter

Year 1 2 3 4 Total

1973 - - 1 1 2

1974 - - - 3 3

1975 5 6 9 423 443

1976 363 433 469 1,210 2,475

1977 1,171 1,309 1,408 1,480 5,368

1978 1,405 1,413 1,393 1,444 5,655

1979 1,401 1,410 1,398 1,435 5,644

1980 1,376 1,369 1,319 1,341 5,405

1981 1,159 1,127 1,088 1,174 4,548

1982 1,185 1,238 1,344 2,334 6,101

1983 2,211 2,253 2,225 2,849 9,538

1984 2,844 2,936 3,004 3,495 12,279

1985 3,478 3,519 3,524 3,660 14,181

1986 3,632 3,635 3,616 3,648 14,531

1987 3,662 3,715 3,745 3,811 14,933

1988 3,784 3,846 3,872 3,676 15,178

1989 3,658 3,656 3,664 3,862 14,840

1990 3,851 3,855 3,828 3,931 15,465

1991 3,921 3,915 3,918 3,901 15,655

1992 3,918 3,922 3,943 4,028 15,811

1993 4,092 4,169 4,245 4,310 16,816

1994 4,377 4,475 4,592 4,636 18,080

1995 4,696 4,731 4,704 4,742 18,873

1996 4,842 5,082 5,231 5,410 20,565

1997 5,528 5,671 5,887 5,676 22,762

1998 5,275 2,235 824 13 8,347

Total 283,498

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Table 2

Summary Statistics

Panel A: Dependent Variable

Summary statistics on the dependent variable, MTB. MTB is the market to book ratio defined as the ratio of a numerator which is the sum of the market

value of common stock and the book values of preference shares, minority interests, long-term debt, and debt in current liabilities, net of cash and short-

term investments and a denominator which is identical except that the market value of common stock is replaced by its book value. The variable is

winsorized at the 1% and 99% levels.

Variable No of

observations

Minimum Maximum Mean Median

MTB 269,427 0.00 55.70 3.42 1.51

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Panel B: Measures of Earnings Volatility and Cash Flow Volatility (based on four or eight

quarters of data)

Summary statistics on the independent variables earnvol and cfvol. Earnvol is defined as the coefficient of variation of either net income (ni), pretax

income (ibt) or income before extraordinary items (ibe) calculated over either the preceding 4 or 8 quarters. Cfvol is the coefficient of variation of

operating cash flow calculated over either the preceding 4 or 8 quarters. Operating cash flow is defined as (depending on the statement of cash flows or

changes in financial position format used) either net cash flow from operating activities, funds from operations, funds from operations less changes in

working capital, or net income plus depreciation and deferred taxes less changes in working capital. All variables are winsorized at the 1% and 99% levels.

Variable No of

observations

Minimum Maximum Mean Median

earnvol

ni 4 267,684 0.04 29.73 1.70 0.55

ni 8 216,405 0.09 46.04 2.60 0.81

ibt 4 266,993 0.04 29.36 1.64 0.52

ibt 8 215,757 0.08 43.26 2.42 0.74

ibe 4 267,678 0.04 28.27 1.62 0.52

ibe 8 216,436 0.08 42.43 2.39 0.74

cfvol

4 283,484 0.09 73.91 3.84 1.18

8 229,571 0.17 97.10 4.95 1.51

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Panel C: Control Variables (1)

Summary statistics on the control variables size, lev and profit. Size is the natural logarithm of total assets. Lev is defined as the book value of long-term

debt divided by the sum of the market value of common stock and the book values of preference shares, minority interests and long-term debt. Profit is

defined as either roa – return on assets (pretax income plus interest expense divided by total assets less cash and short-term investments), roc - return on

capital (pretax income plus interest expense divided by the denominator in the market to book ratio) and roe - return on equity (net income divided by the

book value of common stock); in all cases, the numerator is multiplied by four in order to annualise the measure. Lev, profit and sgrowth are winsorized at

the 1% and the 99% levels.

Variable No of

observations

Minimum Maximum Mean Median

size 283,464 -6.91 12.67 4.33 4.23

lev 276,661 0 0.84 0.20 0.13

roa 264,041 -3.61 0.84 -0.02 0.09

roc 254,168 -7.16 3.17 -0.02 0.13

roe 272,680 -4.90 2.99 -0.06 0.09

Panel D: Control Variables (2)

Summary statistics on the control variables invest and sgrowth. Invest is defined as either capex - capital expenditures, R&D – research and development

costs, or advert – advertising expenses, all scaled by total assets less cash and short-term investments. Sgrowth is defined as the log of one plus the

percentage increase in sales over either the preceding 4 or 8 quarters. All variables are winsorized at the 1% and the 99% levels.

Variable No of

observations

Minimum Maximum Mean Median

capex 277,683 0 0.45 0.05 0.03

rd 150,536 0 0.82 0.04 0.01

advert 94,133 0 0.13 0.01 0.01

sgrowth4 212,850 -8.71 8.32 0.09 0.09

sgrowth8 175,963 -9.71 8.58 0.18 0.17

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Table 3

OLS Regressions of Market to Book Ratio on Earnings Volatility, Cash Flow Volatility, Size,

Leverage, Current Profitability, Capital Expenditures and Sales Growth

Estimated coefficients (t-statistics) from OLS regressions of market to book ratio on earnings volatility, cash flow volatility, size, leverage, current

profitability, the level of current investment and sales growth. The model is

itititititititititsgrowthinvestprofitlevsizecfvolearnvol MTB εββββββββ ++++++++= 76543210

where MTBit is the market to book ratio of firm i at the end of quarter t, earnvolit is the coefficient of variation of earnings (either net income (ni), pretax

income (ibt) or income before extraordinary items (ibe)) of firm i calculated over the 4 or 8 quarters ending with quarter t, cfvolit is the coefficient of

variation of operating cash flows (as defined in Table 2, Panel B) of firm i calculated over the 4 or 8 quarters ending with quarter t, sizeit is the natural

logarithm of the total assets of firm i at the end of quarter t, levit is the leverage (as defined in Table 2, Panel C) of firm i at the end of quarter t, profitit is

the return on assets (as defined in Table 2, Panel C) of firm i for quarter t, investit is the capital expenditures of firm i during quarter t (scaled by total assets

less cash and short-term investments at the beginning of the quarter) and sgrowthit is the logarithmic growth in sales of firm i calculated over the 4 or 8

quarters ending with quarter t.

constant earnvol cfvol size lev profit invest sgrowth

ni 4

(187,892)

4.44

(126.40)

-4.40

(-14.31)

-2.03

(-15.88)

-0.07

(-11.02)

-6.13

(-104.89)

-5.36

(-166.17)

7.15

(37.55)

1.23

(46.23)

ni 8

(146,584)

4.26

(109.73)

-2.98

(-14.07)

-1.61

(-14.85)

-0.08

(-10.47)

-5.81

(-92.22)

-5.33

(-141.00)

6.35

(29.41)

1.12

(48.71)

ibt 4

(187,828)

4.44

(126.44)

-4.78

(-15.33)

-2.03

(-15.86)

-0.07

(-11.06)

-6.12

(-104.76)

-5.37

(-166.24)

7.15

(37.52)

1.23

(46.19)

ibt 8

(146,489)

4.27

(109.85)

-3.65

(-16.05)

-1.60

(-14.84)

-0.08

(-10.61)

-5.80

(-91.93)

-5.34

(-141.32)

6.30

(29.17)

1.12

(48.67)

ibe 4

(187,906)

4.44

(126.44)

-4.73

(-14.76)

-2.02

(-15.82)

-0.08

(-11.15)

-6.13

(-104.84)

-5.36

(-166.17)

7.16

(37.59)

1.23

(46.23)

ibe 8

(146,600)

4.26

(109.71)

-3.28

(-14.24)

-1.60

(-14.85)

-0.08

(-10.61)

-5.81

(-92.26)

-5.33

(-141.02)

6.35

(29.44)

1.12

(48.72)

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Table 4

WLS Regressions of Market to Book Ratio on Earnings Volatility, Cash Flow Volatility, Size,

Leverage, Current Profitability, Capital Expenditures and Sales Growth

Estimated coefficients (t-statistics) from WLS regressions of market to book ratio on earnings volatility, cash flow volatility, size, leverage, current

profitability, the level of current investment and sales growth. The model is

itititititititititsgrowthinvestprofitlevsizecfvolearnvol MTB εββββββββ ++++++++= 76543210

where MTBit is the market to book ratio of firm i at the end of quarter t, earnvolit is the coefficient of variation of earnings (either net income (ni), pretax

income (ibt) or income before extraordinary items (ibe)) of firm i calculated over the 4 or 8 quarters ending with quarter t, cfvolit is the coefficient of

variation of operating cash flows (as defined in Table 2, Panel B) of firm i calculated over the 4 or 8 quarters ending with quarter t, sizeit is the natural

logarithm of the total assets of firm i at the end of quarter t, levit is the leverage (as defined in Table 2, Panel C) of firm i at the end of quarter t, profitit is

the return on assets (as defined in Table 2, Panel C) of firm i for quarter t, investit is the capital expenditures of firm i during quarter t (scaled by total assets

less cash and short-term investments at the beginning of the quarter) and sgrowthit is the logarithmic growth in sales of firm i calculated over the 4 or 8

quarters ending with quarter t

.

Panel A

constant earnvol cfvol size lev profit invest sgrowth

ni 4

(187,892)

1.53

(309.75)

-0.76

(-17.66)

-0.28

(-15.55)

0.05

(54.81)

-1.44

(-174.84)

0.16

(34.58)

1.59

(59.09)

0.21

(56.97)

ni 8

(146,584)

1.45

(261.84)

-0.44

(-14.61)

-0.21

(-13.47)

0.06

(56.53)

-1.39

(-154.58)

0.21

(38.04)

1.37

(44.45)

0.22

(67.90)

ibt 4

(187,828)

1.53

(310.03)

-0.87

(-19.75)

-0.28

(-15.46)

0.05

(54.63)

-1.44

(-174.63)

0.15

(34.04)

1.59

(59.21)

0.21

(56.88)

ibt 8

(146,489)

1.45

(261.73)

-0.51

(-15.78)

-0.21

(-13.52)

0.06

(56.26)

-1.39

(-154.41)

0.20

(37.42)

1.37

(44.47)

0.22

(68.01)

ibe 4

(187,906)

1.53

(310.03)

-0.87

(-19.35)

-0.28

(-15.44)

0.05

(54.45)

-1.44

(-174.75)

0.15

(34.05)

1.59

(59.13)

0.21

(57.12)

ibe 8

(146,600)

1.45

(261.80)

-0.50

(-15.23)

-0.21

(-13.46)

0.06

(56.23)

-1.39

(-154.57)

0.20

(37.90)

1.37

(44.46)

0.22

(67.98)

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35

Panel B (Robust Standard Errors)

constant earnvol cfvol size lev profit invest sgrowth

ni 4

(169,852)

1.53

(93.59)

-0.76

(-13.78)

-0.28

(-14.23)

0.05

(16.36)

-1.44

(-62.93)

0.16

(10.54)

1.59

(25.44)

0.21

(30.00)

ni 8

(133,268)

1.45

(80.10)

-0.44

(-11.23)

-0.21

(-11.11)

0.06

(16.82)

-1.39

(-55.80)

0.21

(12.01)

1.37

(19.32)

0.22

(28.85)

ibt 4

(169,802)

1.53

(93.86)

-0.87

(-15.13)

-0.28

(-14.18)

0.05

(16.33)

-1.44

(-62.91)

0.15

(10.38)

1.59

(25.48)

0.21

(29.93)

ibt 8

(133,189)

1.45

(80.39)

-0.51

(-11.80)

-0.21

(-11.20)

0.06

(16.79)

-1.39

(-55.86)

0.20

(11.83)

1.37

(19.30)

0.22

(28.90)

ibe 4

(169,880)

1.53

(93.76)

-0.87

(-14.65)

-0.28

(-14.15)

0.05

(16.28)

-1.44

(-62.89)

0.15

(10.38)

1.59

(25.46)

0.21

(30.06)

ibe 8

(133,278)

1.45

(80.10)

-0.50

(-11.37)

-0.21

(-11.11)

0.06

(16.75)

-1.39

(-55.85)

0.20

(11.98)

1.37

(19.33)

0.22

(28.93)

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Table 5

Panel A

WLS Regressions of Market to Book Ratio on Earnings Volatility, Cash Flow Volatility, Size,

Leverage, Current Profitability, Capital Expenditures, Research and Development Costs,

Advertising Expenses and Sales Growth

Estimated coefficients (t-statistics) from WLS regressions of market to book ratio on earnings volatility, cash flow volatility, size, leverage, current

profitability, the level of current investment and sales growth. The model is

itititititititititititsgrowthinvestinvestinvestprofitlevsizecfvolearnvol MTB εββββββββββ ++++++++++= 9876543210 321

where MTBit is the market to book ratio of firm i at the end of quarter t, earnvolit is the coefficient of variation of earnings (either net income (ni), pretax

income (ibt) or income before extraordinary items (ibe)) of firm i calculated over the 4 or 8 quarters ending with quarter t, cfvolit is the coefficient of

variation of operating cash flows (as defined in Table 2, Panel B) of firm i calculated over the 4 or 8 quarters ending with quarter t, sizeit is the natural

logarithm of the total assets of firm i at the end of quarter t, levit is the leverage (as defined in Table 2, Panel C) of firm i at the end of quarter t, profitit is

the return on assets (as defined in Table 2, Panel C) of firm i for quarter t, invest1it, invest2it and invest3it are (respectively) the capital expenditures, the

research and development costs and the advertising expenses of firm i during quarter t (all scaled by total assets less cash and short-term investments at the

beginning of the quarter) and sgrowthit is the logarithmic growth in sales of firm i calculated over the 4 or 8 quarters ending with quarter t.

constant earnvol cfvol size lev profit invest1 invest2 invest3 sgrowth

ni4

(35,270)

1.40

(37.43)

-0.83

(-6.04)

-0.32

(-7.66)

0.05

(6.94)

-1.43

(-27.23)

0.36

(10.79)

2.59

(17.10)

6.84

(18.93)

3.84

(6.46)

0.31

(13.46)

ni8

(27,275)

1.30

(31.30)

-0.50

(-5.40)

-0.25

(-6.95)

0.06

(8.07)

-1.39

(-24.04)

0.37

(9.59)

2.17

(12.68)

5.56

(13.12)

4.15

(6.40)

0.30

(11.59)

ibt4

(35,265)

1.40

(37.73)

-1.00

(-7.21)

-0.32

(-7.63)

0.05

(6.90)

-1.43

(-27.18)

0.36

(10.64)

2.58

(17.14)

6.81

(18.90)

3.85

(6.49)

0.31

(13.46)

ibt8

(27,245)

1.30

(31.51)

-0.57

(-5.44)

-0.25

(-6.95)

0.06

(8.03)

-1.38

(-24.04)

0.37

(9.58)

2.18

(12.71)

5.56

(13.19)

4.17

(6.43)

0.30

(11.47)

ibe4

(35,282)

1.40

(37.62)

-0.97

(-6.59)

-0.32

(-7.62)

0.05

(6.90)

-1.43

(-27.19)

0.36

(10.69)

2.59

(17.13)

6.83

(18.89)

3.86

(6.49)

0.31

(13.43)

ibe8

(27,287)

1.30

(31.41)

-0.63

(-5.80)

-0.25

(-6.93)

0.06

(8.00)

-1.38

(-24.04)

0.37

(9.54)

2.18

(12.70)

5.55

(13.08)

4.16

(6.41)

0.30

(11.57)

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Panel B

WLS Regressions of Market to Book Ratio on Earnings Volatility, Cash Flow Volatility, Size,

Leverage, Current Profitability, Total Current Investment and Sales Growth

Estimated coefficients (t-statistics) from WLS regressions of market to book ratio on earnings volatility, cash flow volatility, size, leverage, current

profitability and the level of current investment. The model is

itititititititititsgrowthinvestprofitlevsizecfvolearnvol MTB εββββββββ ++++++++= 76543210

where MTBit is the market to book ratio of firm i at the end of quarter t, earnvolit is the coefficient of variation of earnings (either net income (ni), pretax

income (ibt) or income before extraordinary items (ibe)) of firm i calculated over the 4 or 8 quarters ending with quarter t, cfvolit is the coefficient of

variation of operating cash flows (as defined in Table 2, Panel B) of firm i calculated over the 4 or 8 quarters ending with quarter t, sizeit is the natural

logarithm of the total assets of firm i at the end of quarter t, levit is the leverage (as defined in Table 2, Panel C) of firm i at the end of quarter t, profitit is

the return on assets (as defined in Table 2, Panel C) of firm i for quarter t, sgrowthit is the growth in sales of firm i calculated over the 4 or 8 quarters

ending with quarter t, investit is the sum of the capital expenditures, the research and development expenditures and the advertising costs of firm i during

quarter t (scaled by total assets less cash and short-term investments at the beginning of the quarter) and sgrowthit is the logarithmic growth in sales of firm

i calculated over the 4 or 8 quarters ending with quarter t.

constant earnvol cfvol size lev profit invest sgrowth

ni4

(35,228)

1.46

(39.88)

-0.83

(-6.00)

-0.32

(-7.70)

0.05

(6.54)

-1.52

(-28.89)

0.28

(8.53)

3.28

(22.80)

0.31

(13.48)

ni8

(27,262)

1.36

(33.44)

-0.47

(-5.05)

-0.24

(-6.52)

0.06

(7.69)

-1.47

(-25.40)

0.32

(8.33)

2.81

(17.03)

0.30

(11.55)

ibt4

(35,229)

1.46

(40.18)

-1.00

(-7.14)

-0.32

(-7.68)

0.04

(6.50)

-1.52

(-28.83)

0.28

(8.39)

3.28

(22.83)

0.31

(13.48)

ibt8

(27,226)

1.36

(33.61)

-0.53

(-4.91)

-0.24

(-6.52)

0.06

(7.67)

-1.46

(-25.39)

0.32

(8.31)

2.81

(17.09)

0.30

(11.44)

ibe4

(35,244)

1.46

(40.07)

-0.98

(-6.55)

-0.32

(-7.66)

0.04

(6.50)

-1.52

(-28.84)

0.28

(8.43)

3.28

(22.82)

0.31

(13.44)

ibe8

(27,279)

1.36

(33.52)

-0.60

(-5.54)

-0.24

(-6.50)

0.06

(7.62)

-1.46

(-25.38)

0.32

(8.26)

2.81

(17.05)

0.30

(11.55)

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Table 6

WLS Regressions of Market to Book Ratio on Earnings Volatility, Cash Flow Volatility, Size,

Leverage, Current Profitability, Capital Expenditures, Future Cash Flow Volatility and Sales

Growth

Estimated coefficients (t-statistics) from WLS regressions of market to book ratio on earnings volatility, cash flow volatility, size, leverage, current

profitability, the level of current investment, future cash flow volatility and sales growth. The model is

ititititititititititsgrowthfutcfvolinvestprofitlevsizecfvolearnvol MTB εβββββββββ +++++++++= 876543210

where MTBit is the market to book ratio of firm i at the end of quarter t, earnvolit is the coefficient of variation of earnings (either net income (ni), pretax

income (ibt) or income before extraordinary items (ibe)) of firm i calculated over the 4 or 8 quarters ending with quarter t, cfvolit is the coefficient of

variation of operating cash flows (as defined in Table 2, Panel B) of firm i calculated over the 4 or 8 quarters ending with quarter t, sizeit is the natural

logarithm of the total assets of firm i at the end of quarter t, levit is the leverage (as defined in Table 2, Panel C) of firm i at the end of quarter t, profitit is

the return on assets (as defined in Table 2, Panel C) of firm i for quarter t, investit is the capital expenditures of firm i during quarter t (scaled by total assets

less cash and short-term investments at the beginning of the quarter), futcfvolit is the coefficient of variation of operating cash flows (as defined in Table 2,

Panel B) of firm i calculated over the 4 or 8 quarters beginning with quarter t+1 and sgrowthit is the logarithmic growth in sales of firm i calculated over

the 4 or 8 quarters ending with quarter t.

constant earnvol cfvol size lev profit invest futcfvol sgrowth

ni4

(139,167)

1.49

(83.71)

-0.60

(-10.31)

-0.24

(-12.16)

0.05

(15.02)

-1.41

(-57.17)

0.34

(18.32)

1.62

(24.09)

-0.23

(-11.38)

0.24

(28.53)

ni8

(90,139)

1.38

(64.62)

-0.26

(-5.68)

-0.17

(-8.22)

0.06

(14.27)

-1.37

(-46.95)

0.54

(21.19)

1.41

(16.92)

-0.17

(-7.53)

0.24

(24.24)

ibt4

(139,164)

1.49

(83.95)

-0.70

(-11.76)

-0.24

(-12.10)

0.05

(15.00)

-1.41

(-57.14)

0.34

(18.18)

1.62

(24.14)

-0.23

(-11.34)

0.24

(28.56)

ibt8

(90,074)

1.38

(64.63)

-0.30

(-6.01)

-0.17

(-8.36)

0.06

(14.29)

-1.37

(-46.98)

0.54

(21.09)

1.41

(16.90)

-0.17

(-7.54)

0.24

(24.26)

ibe4

(139,186)

1.49

(83.79)

-0.69

(-11.03)

-0.24

(-12.10)

0.05

(14.95)

-1.41

(-57.12)

0.34

(18.18)

1.62

(24.09)

-0.23

(-11.30)

0.24

(28.59)

ibe8

(90,146)

1.38

(64.63)

-0.32

(-6.10)

-0.17

(-8.21)

0.06

(14.23)

-1.37

(-46.95)

0.54

(21.15)

1.41

(16.93)

-0.17

(-7.48)

0.24

(24.28)

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39

Table 7

WLS Regressions of Market to Book Ratio on Earnings Volatility, Cash Flow Volatility, Size,

Leverage, Current Profitability, Capital Expenditure, Future Profitability and Sales Growth

Estimated coefficients (t-statistics) from WLS regressions of market to book ratio on earnings volatility, cash flow volatility, size, leverage, current

profitability, the level of current investment, future profitability and sales growth. The model is

ititititititititititsgrowthfutprofinvestprofitlevsizecfvolearnvol MTB εβββββββββ +++++++++= 876543210

where MTBit is the market to book ratio of firm i at the end of quarter t, earnvolit is the coefficient of variation of earnings (either net income (ni), pretax

income (ibt) or income before extraordinary items (ibe)) of firm i calculated over the 4 or 8 quarters ending with quarter t, cfvolit is the coefficient of

variation of operating cash flows (as defined in Table 2, Panel B) of firm i calculated over the 4 or 8 quarters ending with quarter t, sizeit is the natural

logarithm of the total assets of firm i at the end of quarter t, levit is the leverage (as defined in Table 2, Panel C) of firm i at the end of quarter t, profitit is

the return on assets (as defined in Table 2, Panel C) of firm i for quarter t, sgrowthit is the growth in sales of firm i calculated over the 4 or 8 quarters

ending with quarter t, investit is the capital expenditures of firm i during quarter t (scaled by total assets less cash and short-term investments at the

beginning of the quarter), futprofit is the average return on assets (as defined in Table 2, Panel C) of firm i calculated over the 4 or 8 quarters beginning

with quarter t+1.

constant earnvol cfvol size lev profit invest futprof sgrowth

ni4

(130,091)

1.44

(80.17)

-0.49

(-8.32)

-0.23

(-10.94)

0.05

(13.67)

-1.37

(-55.14)

0.17

(12.30)

1.69

(24.46)

0.55

(21.53)

0.22

(25.58)

ni8

(79,879)

1.31

(59.17)

-0.17

(-3.55)

-0.13

(-5.94)

0.05

(12.45)

-1.30

(-43.92)

0.28

(14.55)

1.52

(17.35)

0.95

(21.02)

0.22

(20.60)

ibt4

(130,115)

1.45

(80.39)

-0.60

(-9.89)

-0.23

(-10.87)

0.05

(13.62)

-1.37

(-55.10)

0.16

(12.05)

1.69

(24.49)

0.55

(21.49)

0.22

(25.61)

ibt8

(79,823)

1.31

(59.15)

-0.21

(-4.01)

-0.13

(-6.00)

0.05

(12.47)

-1.30

(-43.91)

0.28

(14.43)

1.52

(17.35)

0.94

(21.04)

0.22

(20.60)

ibe4

(130,101)

1.45

(80.31)

-0.58

(-9.16)

-0.23

(-10.87)

0.05

(13.62)

-1.37

(-55.10)

0.16

(12.12)

1.69

(24.47)

0.55

(21.56)

0.22

(25.66)

ibe8

(79,890)

1.31

(59.19)

-0.21

(-3.87)

-0.13

(-5.93)

0.05

(12.41)

-1.30

(-43.91)

0.28

(14.53)

1.52

(17.35)

0.94

(20.99)

0.22

(20.63)

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Table 8

WLS Regressions (with firm-specific fixed effects) of Market to Book Ratio on Earnings

Volatility, Cash Flow Volatility, Size, Leverage, Current Profitability, Capital Expenditures

and Sales Growth

Estimated coefficients (t-statistics) from WLS regressions with firm-specific fixed effects of market to book ratio on earnings volatility, cash flow volatility,

size, leverage, current profitability, the level of current investment and sales growth. The model is

itititititititititsgrowthinvestprofitlevsizecfvolearnvol MTB εββββββββ ++++++++= 76543210

where MTBit is the market to book ratio of firm i at the end of quarter t, earnvolit is the coefficient of variation of earnings (either net income (ni), pretax

income (ibt) or income before extraordinary items (ibe)) of firm i calculated over the 4 or 8 quarters ending with quarter t, cfvolit is the coefficient of

variation of operating cash flows (as defined in Table 2, Panel B) of firm i calculated over the 4 or 8 quarters ending with quarter t, sizeit is the natural

logarithm of the total assets of firm i at the end of quarter t, levit is the leverage (as defined in Table 2, Panel C) of firm i at the end of quarter t, profitit is

the return on assets (as defined in Table 2, Panel C) of firm i for quarter t, investit is the capital expenditures of firm i during quarter t (scaled by total assets

less cash and short-term investments at the beginning of the quarter) and sgrowthit is the logarithmic growth in sales of firm i calculated over the 4 or 8

quarters ending with quarter t.

constant earnvol cfvol size lev profit invest sgrowth

ni 4

(169,852)

1.69

(117.32)

-0.64

(-16.16)

-0.13

(-7.74)

0.07

(20.97)

-1.70

(-136.49)

0.23

(30.25)

1.12

(35.64)

0.13

(32.27)

ni 8

(133,268)

1.57

(91.20)

-0.26

(-9.58)

-0.10

(-7.15)

0.08

(22.66)

-1.69

(-121.88)

0.23

(26.99)

1.00

(28.22)

0.13

(34.88)

ibt 4

(169,802)

1.69

(117.37)

-0.72

(-17.73)

-0.13

(-7.66)

0.07

(20.98)

-1.70

(-136.33)

0.23

(30.05)

1.12

(35.65)

0.13

(32.19)

ibt 8

(133,189)

1.56

(91.20)

-0.32

(-10.68)

-0.10

(-7.22)

0.08

(22.75)

-1.69

(-121.78)

0.23

(26.89)

1.00

(28.20)

0.13

(34.58)

ibe 4

(169,880)

1.69

(117.40)

-0.77

(-18.47)

-0.13

(-7.73)

0.07

(21.04)

-1.70

(-136.33)

0.23

(29.97)

1.12

(35.65)

0.13

(32.42)

ibe 8

(133,278)

1.56

(91.18)

-0.34

(-11.13)

-0.10

(-7.27)

0.08

(22.80)

-1.69

(-121.78)

0.23

(26.92)

1.00

(28.14)

0.13

(34.85)

Page 42: Earnings Volatility and Market Valuation: An …facultyresearch.london.edu/docs/ACCT019.pdfEarnings Volatility and Market Valuation: An Empirical Investigation*+ Ronnie Barnes London

41

Table 9

WLS Regressions of Market to Book Ratio on Earnings Volatility, Cash Flow Volatility, Size,

Leverage, Current Profitability, Capital Expenditures and Sales Growth

Estimated coefficients (t-statistics) from WLS regressions of market to book ratio on earnings volatility, cash flow volatility, size, leverage, current

profitability, the level of current investment and sales growth. The model is

itititititititititsgrowthinvestprofitlevsizecfvolearnvol MTB εββββββββ ++++++++= 76543210

where MTBit is the market to book ratio of firm i at the end of quarter t, earnvolit is the coefficient of variation of earnings (either net income (ni), pretax

income (ibt) or income before extraordinary items (ibe)) of firm i calculated over the 4 or 8 quarters ending with quarter t, cfvolit is the coefficient of

variation of operating cash flows (as defined in Table 2, Panel B) of firm i calculated over the 4 or 8 quarters ending with quarter t, sizeit is the natural

logarithm of the total assets of firm i at the end of quarter t, levit is the leverage (as defined in Table 2, Panel C) of firm i at the end of quarter t, profitit is

the return on assets (as defined in Table 2, Panel C) of firm i for quarter t, investit is the capital expenditures of firm i during quarter t (scaled by total assets

less cash and short-term investments at the beginning of the quarter) and sgrowthit is the logarithmic growth in sales of firm i calculated over the 4 or 8

quarters ending with quarter t.

Panel A (year-quarter dummies)

constant earnvol cfvol size lev profit invest sgrowth

ni 4

(169,852)

1.81

(79.94)

-1.25

(-15.83)

-0.38

(-13.80)

0.04

(8.65)

-1.74

(-54.02)

0.18

(8.04)

1.76

(17.48)

0.24

(22.29)

ni 8

(133,268)

1.70

(67.67)

-0.74

(-13.46)

-0.26

(-10.09)

0.05

(10.03)

-1.67

(-47.88)

0.24

(8.94)

1.51

(13.09)

0.25

(21.35)

ibt 4

(169,802)

1.81

(80.19)

-1.36

(-16.98)

-0.37

(-13.72)

0.04

(8.62)

-1.73

(-54.00)

0.18

(7.86)

1.76

(17.48)

0.24

(22.24)

ibt 8

(133,189)

1.70

(67.90)

-0.83

(-13.67)

-0.26

(-10.23)

0.05

(10.01)

-1.67

(-47.85)

0.23

(8.81)

1.52

(13.09)

0.25

(21.31)

ibe 4

(169,880)

1.81

(80.16)

-1.38

(-16.55)

-0.37

(-13.76)

0.04

(8.56)

-1.73

(-54.00)

0.18

(7.86)

1.76

(17.48)

0.24

(22.34)

ibe 8

(133,278)

1.70

(67.74)

-0.84

(-13.63)

-0.26

(-10.14)

0.05

(9.97)

-1.67

(-47.88)

0.24

(8.92)

1.51

(13.12)

0.25

(21.38)

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42

Panel B (industry dummies)

constant earnvol cfvol size lev profit invest sgrowth

ni 4

(169,852)

1.76

(75.52)

-0.97

(-12.41)

-0.31

(-11.41)

0.05

(10.96)

-1.78

(-54.21)

0.13

(6.13)

1.82

(20.58)

0.23

(21.78)

ni 8

(133,268)

1.66

(64.29)

-0.58

(-10.62)

-0.22

(-8.76)

0.06

(11.83)

-1.70

(-47.75)

0.19

(7.47)

1.59

(15.89)

0.24

(21.24)

ibt 4

(169,802)

1.76

(75.73)

-1.10

(-13.65)

-0.31

(-11.36)

0.05

(10.95)

-1.77

(-54.16)

0.13

(5.96)

1.82

(20.59)

0.22

(21.72)

ibt 8

(133,189)

1.66

(64.47)

-0.65

(-10.67)

-0.23

(-8.93)

0.06

(11.85)

-1.70

(-47.68)

0.18

(7.36)

1.59

(15.94)

0.24

(21.19)

ibe 4

(169,880)

1.76

(75.71)

-1.10

(-13.09)

-0.31

(-11.38)

0.05

(10.89)

-1.78

(-54.19)

0.13

(5.95)

1.82

(20.60)

0.23

(21.83)

ibe 8

(133,278)

1.66

(64.33)

-0.66

(-10.63)

-0.23

(-8.82)

0.06

(11.79)

-1.70

(-47.76)

0.18

(7.44)

1.59

(15.93)

0.24

(21.25)

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43

Panel C (adjusted to industry-year median)

constant earnvol cfvol size lev profit invest sgrowth

ni 4

(171,386)

0.04

(6.81)

-1.05

(-17.78)

-0.19

(-9.21)

0.03

(9.85)

-1.34

(-53.05)

0.33

(21.90)

1.41

(22.69)

0.20

(28.06)

ni 8

(134,672)

-0.01

(-1.58)

-0.66

(-15.11)

-0.12

(-6.13)

0.04

(10.64)

-1.33

(-47.25)

0.35

(19.96)

1.33

(18.41)

0.18

(24.57)

ibt 4

(171,396)

0.05

(6.89)

-1.16

(-18.27)

-0.19

(-9.12)

0.03

(9.79)

-1.34

(-53.02)

0.32

(21.77)

1.41

(22.71)

0.20

(28.10)

ibt 8

(134,589)

-0.01

(-1.51)

-0.77

(-15.56)

-0.13

(-6.26)

0.04

(10.60)

-1.33

(-47.16)

0.35

(19.75)

1.33

(18.39)

0.18

(24.53)

ibe 4

(171,390)

0.05

(7.67)

-1.11

(-17.44)

-0.19

(-9.12)

0.03

(9.82)

-1.34

(-53.00)

0.32

(21.80)

1.41

(22.78)

0.20

(28.10)

ibe 8

(134,703)

-0.01

(-1.48)

-0.76

(-15.11)

-0.12

(-6.13)

0.04

(10.52)

-1.33

(-47.20)

0.35

(19.90)

1.33

(18.39)

0.18

(24.63)

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44

Table 10

Summary Statistics: Measures of Earnings Volatility and Cash Flow Volatility (using all

observations)

Summary statistics on the independent variables earnvol and cfvol. Earnvol is defined as the coefficient of variation of either net income (ni), pretax

income (ibt) or income before extraordinary items (ibe) calculated using all available data. Cfvol is the coefficient of variation of operating cash flow

calculated using all available data. Operating cash flow is defined as (depending on the statement of cash flows or changes in financial position format

used) either net cash flow from operating activities, funds from operations, funds from operations less changes in working capital, or net income plus

depreciation and deferred taxes less changes in working capital. All variables are winsorized at the 1% and 99% levels.

Variable No of

observations

Minimum Maximum Mean Median

earnvol

ni 264,580 0.27 111.20 6.33 2.06

ibt 264,580 0.25 99.27 5.23 1.75

ibe 264,580 0.26 98.04 5.46 1.83

cfvol 265,044 0.39 134.82 7.17 2.24

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45

Table 11

WLS Regressions of Market to Book Ratio on Earnings Volatility, Cash Flow Volatility, Size,

Leverage, Current Profitability, Capital Expenditures and Sales Growth

Panel A: Panel Regression

Estimated coefficients (t-statistics) from WLS regressions of market to book ratio on earnings volatility, cash flow volatility, size, leverage, current

profitability, the level of current investment and sales growth. The model is

itititititititititsgrowthinvestprofitlevsizecfvolearnvol MTB εββββββββ ++++++++= 76543210

where MTBit is the market to book ratio of firm i at the end of quarter t, earnvoli is the coefficient of variation of earnings (either net income (ni), pretax

income (ibt) or income before extraordinary items (ibe)) of firm i calculated using all available observations, cfvoli is the coefficient of variation of

operating cash flows (as defined in Table 2, Panel B) of firm i calculated using all available observations, sizeit is the natural logarithm of the total assets of

firm i at the end of quarter t, levit is the leverage (as defined in Table 2, Panel C) of firm i at the end of quarter t, profitit is the return on assets (as defined in

Table 2, Panel C) of firm i for quarter t, investit is the capital expenditures of firm i during quarter t (scaled by total assets less cash and short-term

investments at the beginning of the quarter) and sgrowthit is the logarithmic growth in sales of firm i calculated over the 4 quarters ending with quarter t.

constant earnvol cfvol size lev profit invest sgrowth

ni

(171,556)

1.49

(85.39)

-0.17

(-4.71)

-0.11

(-4.01)

0.06

(16.87)

-1.41

(-60.90)

0.26

(17.04)

1.60

(25.12)

0.22

(30.10)

ibt

(171,544)

1.49

(84.65)

-0.14

(-3.43)

-0.11

(-4.13)

0.06

(16.80)

-1.41

(-61.10)

0.26

(17.06)

1.61

(25.21)

0.22

(30.05)

ibe

(171,559)

1.49

(85.39)

-0.23

(-5.71)

-0.10

(-3.98)

0.05

(16.65)

-1.41

(-61.17)

0.26

(16.92)

1.61

(25.23)

0.22

(30.04)

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46

Panel B: Cross-Sectional Regression

Estimated coefficients (t-statistics) from WLS regressions of market to book ratio on earnings volatility, cash flow volatility, size, leverage, current

profitability, the level of current investment and sales growth. The model is

itititititititititsgrowthinvestprofitlevsizecfvolearnvol MTB εββββββββ ++++++++= 76543210

where MTBit is the market to book ratio of firm i at the end of quarter t, earnvoli is the coefficient of variation of earnings (either net income (ni), pretax

income (ibt) or income before extraordinary items (ibe)) of firm i calculated using all available observations, cfvoli is the coefficient of variation of

operating cash flows (as defined in Table 2, Panel B) of firm i calculated using all available observations, sizeit is the natural logarithm of the total assets of

firm i at the end of quarter t, levit is the leverage (as defined in Table 2, Panel C) of firm i at the end of quarter t, profitit is the return on assets (as defined in

Table 2, Panel C) of firm i for quarter t, investit is the capital expenditures of firm i during quarter t (scaled by total assets less cash and short-term

investments at the beginning of the quarter) and sgrowthit is the logarithmic growth in sales of firm i calculated over the 4 quarters ending with quarter t.

Unless otherwise stated, all variables are calculated for the last quarter for which all the relevant data for firm i is available.

constant earnvol cfvol size lev profit invest sgrowth

ni

(6,181)

1.67

(47.57)

-0.17

(-2.00)

-0.14

(-1.92)

0.09

(12.99)

-1.53

(-26.11)

0.27

(11.13)

1.22

(5.35)

0.17

(7.36)

ibt

(6,181)

1.67

(47.43)

-0.24

(-2.36)

-0.14

(-1.91)

0.09

(12.85)

-1.53

(-26.12)

0.27

(11.09)

1.22

(5.37)

0.17

(7.36)

ibe

(6,181)

1.67

(47.49)

-0.25

(-2.38)

-0.13

(-1.88)

0.09

(12.88)

-1.53

(-26.21)

0.27

(10.94)

1.22

(5.36)

0.17

(7.40)