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ACCT820 Chapter 13 Valuation Earnings Based Approaches[1]

ACCT820 Chapter 13 Valuation Earnings Based Approaches[1] -...

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Introduction and Overview Reported earnings are the single most widely followed measures of firm performance o Accounting standard setters, along w/the accounting profession & the community of financial statement users, have designed the accrual accounting process to measure earnings as the bottom line of the firm’s profitability each period o As a result, firms’ reported earnings play central roles as the primary value-relevant measures of performance used in the capital markets for share pricing & capital allocation B/c of the demand in the capital market for earnings info, firms usually release quarterly & annual earnings to the public as soon as accountants have prepared & verified them, often weeks before firms release their detailed quarterly & annual financial statements o Analysts often spend enormous amounts of time & effort building (& when new info arrives, revising) forecasts of firms’ upcoming quarterly & annual earnings Sell-side analysts sell their earnings forecasts to interested investors, brokers, & fund managers Commercial firms such as I/B/E/S & First Call have built businesses on compiling & distributing daily data on analysts’ earnings forecasts The financial media provide daily coverage of firms’ earnings announcements o In fact, b/c of the demand for & attention devoted to earnings among capital market participants, US GAAP & IFRS require firms to report earnings scaled on a per-share basis in their financial statements Firms’ share prices usually react quickly to earnings announcements, & the direction & magnitude of the market’s reaction depends on the direction & magnitude of the earnings news relative to the market’s expectations o Firms that announce earnings beating the market’s expectations often experience significant jumps in share price during the day of & the days immediately following the announcement o Likewise, firms that announce earnings falling short of the market’s expectations usually experience a decline in share price - & in some circumstances, severe drops in share price – during the day of & the days immediately following the announcement o Many research studies have shown that firms’ stock returns are positively correlated w/changes in earnings B/c earnings provide such important info to investors & other external stakeholders, earnings also play key roles in decisions that firms make w/regard to internal capital allocation o New project proposals within firms are often evaluated based on the effects they will have on reported earnings o In addition, corporate governance processes commonly reward or punish managers w/comp & bonus plans based on whether firm performance meets certain earnings targets The preceding observations establish the important roles of earnings: o Earnings is the primary measure of firm performance produced by the accrual accounting system o Earnings has a direct impact on the capital markets & the pricing of shares
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