Earnings Volatility and Market Valuation: An Empirical Investigation

* 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 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 5 th percentile and one in the 95 th percentile. If we compare the 1 st and 99 th percentiles, we obtain a difference in market to book ratios of 0.23, approximately 15% of the median. 2 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 …