Which Performance Measures Do Investors around the World Value the Most & Why?

Introduction (Via HLS)

Academics and practitioners have recently begun to move away from proposing “better” measures of earnings to instead focusing on earnings quality attributes—such as persistence, predictability, smoothness, and timeliness—that may make a particular earnings measure more useful in equity valuation, especially if such attributes capture some dimension of information risk about the firm’s future performance.

Our goal in this paper is to develop an empirical description of the underlying constructs reflected in common performance measure attributes, and to generalize that description to multiple performance measures for firms in the global capital market. To this end, we estimate the persistence, predictability, smoothness, contemporaneous and lagged association with operating cash flows, timeliness, and conservatism of eight different summary performance measures for almost 20,000 firms in 46 countries during 1996–2005. Our eight performance measures are sales, EBITDA, operating income, income before income taxes, income before extraordinary items and discontinued operations, net income, total comprehensive income, and operating cash flows.

We find that the performance measures exhibit value relevance that largely follows an inverted U shape, with the lowest value relevance at the top (i.e., sales) and bottom (i.e., total comprehensive income) of the income statement and higher value relevance toward the middle of the income statement (i.e., operating income and EBITDA). No single performance measure clearly dominates all others, but subtotals generally tend to be more value relevant when they include core operating expenses and exclude more transitory items like extraordinary items, gains and losses, and other comprehensive income.

Our results suggest that, when it comes to equity valuation, accounting researchers and standard setters should focus not on what performance measure is “best” at one point in time, but on the underlying attributes that investors find most relevant.

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21. January 2010 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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