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Barth Et Al. - 1990 - Components of Earnings PDF
Barth Et Al. - 1990 - Components of Earnings PDF
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Components
of Earnings and the
Structure of Bank Share
Prices
Empiricalexaminationof the relation betweencommonstock prices and two major
componentsof bankearningsshowsthatearningsbeforesecuritiesgains and lossesplayan
importantrole in explainingbankstockprices.Themarketappearsto assign a significant
multipleto this componentof earnings,judgingfromregressionresultsover the 1968-87
period.
Themarketappearsto pricerealizedsecuritiesgains and lossesdifferently.Themultiple
on securitiesgains and lossesdid not differsignificantlyfromzerooverthe periodstudied.
Theevidencealso suggests that securitiesgains and lossesbehavein a mannerconsistent
with smoothingearnings.That is, investorsapparentlyperceivethat reportedgains and
losses in banks'investmentsecuritiesare timedby bankmanagementsto offsetlossesand
gains in otherearnings.
Thesefindingsholdwhetherearningscomponents
areusedto explainpricelevelsor price
changes.Furthermore,the movementof the coefficienton earningsbeforesecuritiesgains
and lossescorrespondsto majoreconomicchangesthat might be expectedto affectbanks.
Over the 1972-74 period,for example,as financialconditionsgenerallydeclined,the
impliedmultiplefor earningsbeforesecuritiesgains and lossesalso declineddramatically.
C
ONVENTIONAL
VALUATIONMOD- nancial claims, in the form of loans and invest-
book value of common equity) and the percentage changes in marketvalue per share (the first
differences). For the explanatory variables, we
used two basic components of earningssecurities gains and losses (SGL)and earnings
before securities gains and losses (EB). The appendix describes the equations used. The resulting regression coefficients can be viewed as the
weights, or multiples, assigned by investors to
the earnings component.
SGL vs. EB
If the market places a greater emphasis on EB
than on SGLin valuing a firm's common equity,
then our regression analyses should yield a
lower coefficient for SGL than for EB. There are
several reasons why we might expect such a
result.
Earnings before securities gains and losses
(EB)arise primarilyfrom the deposit and lending activities of the bank. The EBcomponent of
earnings varies with the levelsof interest rates
(or interest rate spreads), which are highly correlated over time. Under historicalcost accounting, EBdoes not reflect changes in the market
value of bank assets and liabilities(except with a
time lag that may be considerable).3In particular, EB contains no explicit revaluations of the
loan portfolio or investment securities in the
form of unrealized gains and losses.4
In contrast, securities gains and losses (SGL)
essentially consist of changesin the marketvalue
of investment securities since their purchase
date. Income from investment securities (for
banks, mostly municipal, state and federal government securities) is likely to be more volatile
and transitory than other components of earnings, such as net interest income.
A very simple valuation, then, might consider
EB as consisting entirely of a permanent (i.e.,
recurring)component, carryinga multiple equal
to the reciprocalof the cost of equity capital. By
contrast, if SGL is viewed as nonrecurring, it
would have a dollar-for-dollarimpact on the
market value of common equity and carry a
coefficientof one, reflectingits one-period effect
on earnings.
In a more complex valuation, the importance
of SGL is somewhat more problematic. If all
information relevant to the valuation of securities is fully reflected in their prices, for example,
then future changes in their marketvalue would
be completely anticipated. Thus, under an appropriate amortization schedule, the expected
Year
MarketValueof Equity
Mean
Median
EarningsBeforeSGL
Mean
Median
SecuritiesGains& Losses
Mean
Median
Obs.
1968
1969
1970
1971
1.70
1.51
1.44
1.45
1.60
1.40
1.32
1.30
.120
.128
.132
.124
.121
.126
.130
.122
-.0079
-.0081
-.0038
.0030
-.0065
-.0045
-.0013
.0027
70
76
78
87
1972
1973
1974
1975
1976
1977
1978
1.67
1.27
0.66
0.70
0.86
0.78
0.75
1.47
1.14
0.60
0.62
0.79
0.72
0.73
.124
.128
.121
.112
.108
.114
.128
.123
.126
.122
.116
.111
.117
.132
.0017
-.0021
-.0022
-.0006
.0021
.0005
-.0028
.0009
-.0012
-.0009
.0006
.0005
.0001
-.0017
87
88
95
95
95
99
119
1979
1980
1981
1982
0.72
0.74
0.82
0.81
0.67
0.69
0.75
0.77
.137
.141
.140
.135
.142
.143
.143
.138
-.0041
-.0066
-.0081
-.0059
-.0025
-.0016
-.0042
-.0023
119
122
127
137
1983
0.99
0.96
.125
.129
-.0002
.0002
138
1984
1.00
0.97
.127
.133
.0001
.0003
139
1985
1.28
1.27
.123
.132
.0071
.0044
142
1986
1987
1.26
1.08
1.25
1.03
.119
.110
.128
.116
.0173
.0065
.0075
.0032
147
147
All data are expressed as percentagesof the book value of common equity.
Average Values
Our sample consisted of 150banks whose financial statement data appear on the 1987 Compustat Bank Tape.6 These banks are the largest
publicly traded banks in the United States.
Table I reports the average values of the variables used in the regression of stock price levels.
(MV, EBand SGL are all divided by the book
value of common equity.)
If book value perfectly reflects the value of a
corporation'snet assets, then the ratioof market
value to book value (the market-to-bookratio)
should equal one. Deviations from one can be
viewed as the market's assessment of valuation
errors in net book assets (expressed as a percentage of book value). From1968through 1973,
the average market-to-bookratio exceeded one,
indicating that the capital market was placing a
higher economic value on the banks' common
Year
1969
1970
% Changein MarketValue*
Median
Mean
-.046
-.075
.040
.032
%Changein EarningsBeforeSGLt
Median
Mean
.111
.139
.107
.136
% Changein SGLt
Mean
Median
-.060
-.038
-.012
-.034
Obs.
70
76
1971
.066
.040
.025
.022
79
1972
1973
.246
-.188
.201
-.207
.078
.108
.078
.121
.015
-.017
.006
-.011
87
87
1974
-.401
-.391
.012
.072
-.021
-.009
88
1975
1976
1977
.174
.319
-.013
.143
.308
-.012
.048
.040
.174
.054
.058
.152
-.005
.020
.006
-.019
.004
.001
95
95
95
1978
1979
.055
.128
.044
.052
.286
.197
.221
.171
-.033
- .036
-.023
- .020
99
119
1980
1981
1982
1983
1984
.145
.171
.109
.336
.107
.077
.155
.124
.343
.119
.132
.103
.051
.007
.130
.120
.101
.087
.016
.113
-.066
-.060
-.044
.021
.030
-.012
-.038
-.020
.001
.003
119
122
128
138
139
1985
1986
1987
.409
.052
- .159
.408
.062
- .143
.086
.047
.004
.089
.079
.052
.064
.228
.054
.038
.063
.027
140
142
148
-.004
-.003
Change in marketprice per share expressed as a percentageof previous year's price per share.
t Expressedas a percentageof previous year's earnings(per share)before securitiesgains and losses.
Despite the dramatic decline in market-tobook ratios in 1972-74, the return on equity, as
reflected in EB/BV,remained remarkablystable
at 0.124, 0.128 and 0.121. The ratio of MV/BVto
EB/BVcan be interpreted as a crude estimate of
the average earnings multiplier the market assigns to EB. Because the average MV/BV declined, while the average EB/BVremained essentially constant, the implied multiplier
dropped dramatically from 13.5 times to 5.5
times, a reduction of approximately60 per cent.
(The regression results reported below provide
more direct estimates of the multiplier.)
While the average EB/BVwas positive in every
year, the average SGL/BV fluctuated around
zero. The median SGL was positive in 10 years
and negative in 10 years. This behavior is consistent with the earlier contention that the expected value of SGL is zero.8
Table II reports the average values of the
variables used in the regressions of percentage
changes in market value. The variables are the
percentage change in price per share, the
change in EBper share expressed as a percentage of the previous year's EB and the level of
SGL per share expressed as a percentage of the
previous year's EB.
Not surprisingly, the annual percentage
changes in common stock were quite volatile,
ranging from a low of -0.401 in 1974to a high of
0.409 in 1985. Percentage changes in EB, which
Evidence of Smoothing
Smoothingbehaviorcan be examined by comparing changes in EBwith changes in SGL over
time. The median value of changes in EBwas
0.086, while the median value of changes in SGL
was -0.005. The smoothing argument implies
that when changes in EB are relatively low
(high), SGLcan be expected to be relativelyhigh
(low). Excludingthe years in which SGLand EB
had median values (1975 and 1985, respectively), in 13 of the 17 years when the changes in EB
were below (above) the median, SGLwas above
(below) its median. The null hypothesis (i.e.,
changes in EBand SGLare independent) can be
rejected at the 2 per cent level of significance.9
This behavior accords with the smoothing hypothesis.
13
17.63
12.65
13.79
15.96
21.32
12.59
4.92
5.58
6.39
5.92
3.80
4.00
4.73
5.53
3.74
3.28
5.25
6.06
6.68
5.54
tI
8.4
5.1
6.3
8.1
8.3
4.9
6.1
7.6
7.8
12.7
6.2
6.2
7.5
8.3
7.5
5.4
12.0
8.9
10.7
8.7
2
-1.85
-0.62
-1.14
4.42
-10.49
8.69
-1.55
-1.77
-5.22
2.09
3.49
3.35
1.48
-1.31
-1.99
-1.22
-3.44
1.53
4.29
-1.43
t2
-0.5
-0.2
-0.2
0.7
-0.8
0.8
-0.3
-0.3
-1.0
0.6
0.8
1.0
0.7
-0.8
-1.5
-0.4
-1.0
0.6
1.8
-0.4
R2
.51
.26
.34
.42
.45
.21
.78
.40
.43
.64
.24
.24
.35
.35
.36
.22
.57
.39
.47
.42
Obs.
69
75
78
87
87
87
94
93
92
98
119
119
121
125
135
133
134
137
130
110
+ 132(SGLit/BVit)
+ uit. t1 and t2 are t-valuesassociatedwith f31and R2,respectively.
MVit/BVit= at + 01t(EBit/BVit)
FINANCIALANALYSTSJOURNAL/ MAY-JUNE1990O 57
t2
1.21
0.26
0.58
1.10
0.54
0.43
0.20
0.40
0.22
0.21
0.27
0.68
0.52
0.57
0.29
0.17
0.28
0.49
0.07
19.5
4.5
6.0
6.1
4.7
6.0
4.0
3.7
3.3
4.0
5.7
7.4
5.8
7.9
4.0
3.1
3.9
7.1
2.0
-0.27
-0.21
0.20
-1.04
0.49
-0.19
-0.90
-0.66
0.16
0.21
-0.00
-0.37
-0.12
-0.17
-0.83
-0.26
-0.18
0.15
-0.36
t2
R2
-1.5
-1.2
0.7
-1.8
1.7
-0.4
-0.2
-2.0
0.5
0.7
-0.0
-1.3
-0.7
-0.9
-2.0
-0.7
-0.8
1.2
-1.8
.85
.21
.31
.33
.20
.29
.18
.15
.09
.13
.22
.38
.22
.35
.16
.09
.12
.29
.04
Obs.
69
74
78
87
87
87
93
91
97
97
118
118
118
122
132
128
i29
121
102
3.
4.
5.
6.
59
coefficient would be predicted to be either positive or negative, depending upon how the market views SGL.
13. Concernhas been expressed about positive crosssectional dependency in the regression residuals
when the sample contains industry clustering,as
we have here. While cross-sectional dependencies are mitigated by permitting the intercept
term to vary year-by-year,any remainingpositive
dependence would tend to understate the standard errors and would bias the significancetests
in favor of rejectingthe null hypothesis. In spite
of this potential bias, the null hypothesis that 132
equals zero cannot be rejected at conventional
levels of significance. Departures from independence would affect our interpretationof the tstatistics reported for 131as well, although the
t-values for 31 average 7.8, or nearly five times
that required to achieve conventional significance, when the standard conditions are met.
Note that departures from independence do not
bias the coefficientestimates for ,1 and I32.
14. The ,I1and 132estimates are likely to be correlated
from year to year. This limits our ability to
conduct significance tests on the times-series
differences in 31 and f82. A score of 20 out of 20
would nevertheless appear to be impressive, notwithstanding the time-series dependence.
15. The assumption of a zero mean is not conditioned upon firm-specificor year-specific information other than AEB.The regressionscondition
the expected value of the SGLvariableupon AEB
and hence at least partiallyreflect the potentially
strategic nature of SGL. However, the serial
dependency discussed in footnote 8 would suggest that an alternativespecificationof the unexpected SGL might include prior years' SGL.
16. W. Beaver, R. Lambert and D. Morse, "The
Information Content of Security Prices," journal
of Accountingand Economics,March 1980.
17. Another approachto the time-seriesdependency
in the data is to estimate the regression model
coefficients using a technique known as "seemingly unrelated regressions." This technique incorporatesthe correlationbetween the regression
residuals in differentyears' regressions in a way
that provides more efficient coefficientestimates
and unbiased tests of the significance of those
coefficients. When the coefficients were reestimated using this technique, the results were
essentially the same as those reported here (i.e.,
I31is positive, 12 fluctuatesaround zero, and 12 iS
less than 131).
Appendix
To examine the contributions of different earnings components to bank stock prices, we used
the following equations:
MVit/BVit
= at + 1lt(EBit/BVit)
+ uit
+ I32t(SGLit/BVit)
(Al)
and
APit/Pit-
1 = at + I3t(zEBit/Nlit-
+ 0 2t(SGLit/Mit-1) + uit,
1)
(A2)
where
MVit = the market value of common equity
for firm i at the end of year t,
=
BVit the book value of common equity for
firm i at the end of year t,
APit
Pit
-Pit-,
Glossary
Null Hypothesis: A statement that a certain relationship holds. In this study, the null hypothesis is that
a particularcoefficient is equal to zero. Statistical
tests are conducted to determine the probability
that statement is true, given the observed data. If
the probability(called the level of significance) is
sufficientlysmall, the null hypothesis is rejectedas
false.
Myopic Market: A market where prices are established based only on a portion or subset of all the
relevant informationavailable. An example would
be a market that focuses only on net income and
ignores other relevant information.
Random Walk with a Drift: A process that describes
how a variablechanges over time. For example, if
earnings move as a random walk with a drift, next
period's earnings are expected to be equal to the
most recently reported earnings plus a growth
factor, called a drift.