Firms can smooth their earnings via accounting discretion. Managers seem to prefer a less volatile earnings path. But prior studies do not show a clear relation between smoothness and firm valuation. What do you think about it? Do you know papers devoted to that subject?
SMOOTHING: for purposes of presentation, it may look appealing. However, for decision making, i.e. investors of shareholder reading the report, looking at the "untreated" values would be more practical.
The practical aspect of smoothing comes in handy when we use smoothing for forecasting purpose. Small corrugated ups and down that are statistically non-significant may be lessened and making forecasting more manageable----with proper adjustment for error.
BACK TO FUNDAMENTALS: For practical reading, decision makers (investors) would still have to go to the actual financial statements to analyse firm's earnings.
Thanks you Paul
But decreasing the volatility of earnings may seem to be appealing, for the manager since perceived risk by investors may be reduced. If this statement happens to be correct, with a .constant expected profitability, and a reduced standard deviation of profits,is not firm value supposed to rise?
Dear Patrick
I think that this is depend on some variables. in this kind of studies it is difficult to find more studies concluded the same results. this is depending on the efficiency of the market, relation between investors and managers (agency theory), preferences of mangers and investors, reactions of the market size of transaction costs and so on.
Best Regards
Thanks you Mawih
In assessing smoothness as useful, we consider perhaps that forecasting is easier with an accrual system of accounting (valuation models), but this can also hide or delay the measurement of changes in fundamental performance. Moreover as you said the efficien,cy of the market is at stake.
I agree with all of what has been answered so far, but I though I would offer an alternative view for thought and discussion. There is a view that earnings don't matter much at all anymore. The "market" is often driven by hype and projection. Not the type of projection investment managers use...NPV of forward earnings... but the surmised mental projection of future "value". This is why some firms with no earnings trade at many multiples of zero earnings (risky for sure!). Currently (6/16) the bio-tech industry has many firms flying high with zero earnings. There is nothing to smooth. Most have a few paid research projects ongoing, for small income to the balance sheet, but are mostly venture funded.
This brings us to your question, and again I would differ from the earlier learned discussion for sake of dialogue. In presentations, a good manager or pitch person (either internal or external) can explain the spikes honestly and show the "opportunity" within them. eg. this spike was xyz and we are looking to have another XYZ in about 6 months. This trough is because we finished abc and we are now starting another project to fill in. Etc. This type of story narrative plays well with both institutional and individual investors and even employees. It says hey, we are alive and working hard, which gets back to the idea that people are capable of mental projection of a firms future...sometimes for the better...sometimes for the worse! (remember the Dot Com Alamo):).
HI J Cogliandro!
You are right in the sense that when there is no earnings at all to smooth, that's another story., Anticipations are just at stake. But as soon as there is a simple positive earnings number, things may begin to be different, and perhaps we switch to our previous talk, except if the forecast growth of the bio-tech company is huge!
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