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Valuing Loss Firms

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  • Joos, Peter
  • Plesko, George
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    Abstract

    We hypothesize that when confronted with a loss, investors price earnings conditional on the expected probability of the firm's return to profitability. We show a parsimonious model of one year-ahead loss reversal is useful in predicting the firm's return to profitability. Using the estimated probabilities of loss reversal to define samples of persistent (low probability of reversal) and transitory (high probability of reversal) losses, we show the pricing of losses, as well as their characteristics, varies as a function of their expected probability of reversal. We document a more pronounced stock price response to a transitory loss consistent with investors assessing the likelihood of exercising the abandonment option to be smaller. We also find the market responds negatively to persistent losses, especially in the latter part of the sample period. We also show the results are consistent with investors pricing the components of losses differently depending on the type of loss: they value only the aggregate accruals component of persistent losses and only the aggregate cash flow component of transitory losses. Further analysis shows the result for persistent losses relates to the presence of an increasingly larger R&D component that investors price negatively as if rewarding firms that make larger R&D outlays with larger returns. One consequence of the presence of a growing R&D component implies persistent losses become a weaker indicator of the likelihood of exercising the abandonment option.

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    File URL: http://hdl.handle.net/1721.1/5418
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    Bibliographic Info

    Paper provided by Massachusetts Institute of Technology (MIT), Sloan School of Management in its series Working papers with number 562043.

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    Date of creation: 09 Jul 2004
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    Handle: RePEc:mit:sloanp:5418

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    Postal: MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), SLOAN SCHOOL OF MANAGEMENT, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA
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    Web page: http://mitsloan.mit.edu/
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    Postal: MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), SLOAN SCHOOL OF MANAGEMENT, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA

    Related research

    Keywords: earnings; losses; cash flows; accruals; valuation; persistence;

    References

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    1. Healy, Paul M. & Palepu, Krishna G., 1988. "Earnings information conveyed by dividend initiations and omissions," Journal of Financial Economics, Elsevier, vol. 21(2), pages 149-175, September.
    2. Dechow, Patricia M., 1994. "Accounting earnings and cash flows as measures of firm performance : The role of accounting accruals," Journal of Accounting and Economics, Elsevier, vol. 18(1), pages 3-42, July.
    3. Berger, Philip G. & Ofek, Eli & Swary, Itzhak, 1996. "Investor valuation of the abandonment option," Journal of Financial Economics, Elsevier, vol. 42(2), pages 257-287, October.
    4. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 607-36, May-June.
    5. DeAngelo, Harry & DeAngelo, Linda & Skinner, Douglas J, 1992. " Dividends and Losses," Journal of Finance, American Finance Association, vol. 47(5), pages 1837-63, December.
    6. DeAngelo, Harry & DeAngelo, Linda, 1990. " Dividend Policy and Financial Distress: An Empirical Investigation of Troubled NYSE Firms," Journal of Finance, American Finance Association, vol. 45(5), pages 1415-31, December.
    7. Givoly, Dan & Hayn, Carla, 2000. "The changing time-series properties of earnings, cash flows and accruals: Has financial reporting become more conservative?," Journal of Accounting and Economics, Elsevier, vol. 29(3), pages 287-320, June.
    8. Collins, Daniel W. & Maydew, Edward L. & Weiss, Ira S., 1997. "Changes in the value-relevance of earnings and book values over the past forty years," Journal of Accounting and Economics, Elsevier, vol. 24(1), pages 39-67, December.
    9. David Burgstahler, 2002. "Do Stock Prices Fully Reflect the Implications of Special Items for Future Earnings?," Journal of Accounting Research, Wiley Blackwell, vol. 40(3), pages 585-612, 06.
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    Cited by:
    1. Michelle Hanlon & Terry Shevlin, 2005. "Bank-Tax Conformity for Corporate Income: An Introduction to the Issues," NBER Working Papers 11067, National Bureau of Economic Research, Inc.

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