Essay About Effect Of Transitory Earnings And P Ratios

Xerox: Book-In-Time
Essay Preview: Xerox: Book-In-Time
Report this essay
SNA VIII Solo, 15 – 16 September 2005
THE EFFECT OF TRANSITORY EARNINGS
ON THE USE OF E/P RATIOS IN CORPORATE VALUATION:
EMPIRICAL EVIDENCE FROM INDONESIA
ERNI EKAWATI
Fakultas Ekonomi Universitas Kristen Duta Wacana
ABSTRACT
The purposes of this study are, firstly, to confirm the findings of the previous
study, whether earnings contain transitory components. Secondly, to investigate how E/P
ratios are affected when firms experience transitory earning changes. Thirdly, to examine
whether the differences in E/P ratios across firms due to differences in the magnitude of
transitory earnings will quickly disappear in subsequent years.
Using financial data of companies listed in Jakarta Stock Exchange (JSE) from
the periods of 1993 to 2003, the study finds that earning changes exhibit a transitory
component. Under the condition of transitory earnings, firms E/P ratio is positively
affected by the changes in earnings. Industry-adjusted earning changes variable is shown
to have a high explanatory power in predicting firms E/P ratio. As the variation of firms
E/P ratios are mainly explained by the transitory component of earnings, time series
pattern of E/P ratios reflects transitory deviations due to the transitory component of
earnings changes.
A. INTRODUCTION
Many practitioners subscribe to the view that accounting earnings and earning-toprice
(E/P) ratios are among the most important figures in making investment decisions.
E/P has also drawn much attention from academicians, and has been interpreted in
various ways. Some popular interpretations of E/P ratios have been an earning
capitalization rate (Graham et al., 1962), an indicator of mis-priced stocks (Basu, 1977
and Jaffee et al., 1989), an indicator of transitory earnings (Beaver and Morse, 1978), and
a risk measure (Ball, 1978).
Recent academic evidence documents that changes in earnings and profitability
are to some extent predictable (Lev, 1969; Freeman et al., 1982; Collins and Kothari,
1989; Easton and Zmijewski, 1989; Ou and Penman, 1989; Elgers and Lo, 1994; Basu,
1997; and Fama and French, 2000;). Similar evidence are also found in Indonesia (Assih,
1999; Werdiningsih, 2001; and Febriyanti, 2004). Fama and French (2000) document
that earnings tend to be mean reverting. Large increases in earnings are followed by
subsequent decreases, while large decreases are followed by increases. The changes in
earnings tend to reverse from one year to the next, and large changes of either sign
reverse faster than small changes. They also find that negative changes in earnings
reverse faster than positive changes. Since extreme changes in earnings seem to reverse
faster, it is believed that these changes are due to the transitory component of earnings.
Unlike permanent earning components, transitory components such as
extraordinary gains and losses, changes in earnings due to changes in accounting
standards, and similar items that are not expected to continue in the future, are not
expected to persist for long periods of time. Thus, earnings that contain a large transitory
component lose relevance for making investment decisions (Stunda and Typpo, 2004).
Stock price represented in the denominator of the E/P ratios can deviate from its
value at a given point in time, but it will eventually correct itself to a value that is implied
in some fundamentals such as earnings. As a consequence, time series properties of
earnings have a potentially important implication for corporate valuation using E/P ratio
approach. Should E/P ratios be affected by the transitory component of earnings, the
investment analysts have to adjust the E/P ratios to account for unusual changes in
earnings. Consider a case that a firm has experienced an extreme decline in earnings due
to its poor performance, intuitively, this condition will lead to a higher E/P ratio (lower
P/E ratio). However, if the recent decline in earnings has a transitory component the
SNA VIII Solo, 15 – 16 September 2005
correct adjustment may be to decrease the E/P ratio. Furthermore, as the transitory
component of earnings may cause the E/P ratio of such firms temporarily deviate from its
value, the differences of E/P ratios across firms due to differences of the magnitude of
transitory components will quickly disappear in subsequent years.
The purpose of this study is, firstly, to confirm the findings of the previous study,
using data from companies listed in Jakarta Stock Exchange (JSE), whether earnings
contain transitory components or are mean reverting. Secondly, to investigate how E/P
ratios are affected when firms experience transitory