Depreciation and the market's valuation of earnings

✍ Scribed by Richard Powell; Wayne B. Thomas; Ted Bainbridge

• Publisher: Elsevier Science
• Year: 2001
• Tongue: English
• Weight: 692 KB
• Volume: 18
• Category: Article
• ISSN: 0882-6110
• DOI: 10.1016/s0882-6110(01)18012-0

✦ Synopsis

The purpose of this paper is to better understand how financial markets use depreciation information that appears in the financial statements . When computing depreciation expense, a firm has discretion in its choice of depreciation method and this choice can impact the amount of depreciation expense and therefore reported earnings. Ceteris paribus, we claim that a firm which reports a low depreciation ratio (i.e. the ratio of depreciation expense to average gross property, plant, and equipment) tends, on average, to report understated depreciation and therefore overstated earnings, relative to similar firms that report moderate or high depreciation ratios. We expect market participants to adjust such a firm's overstated earnings downward. Accordingly, we hypothesize that firms with low depreciation ratios tend to have low earnings response coefficients (ERCs), where the ERC is the coefficient obtained from regressing a price metric on an earnings metric .

We find significant empirical evidence to support this hypothesis . The results hold while controlling for factors such as risk, expected growth, size, capital intensity, and industry. The results also do not appear to be attributable to differences in earnings persistence . The evidence suggests that financial markets are not fixated on reported earnings ; instead, markets are making adjustments for the various depreciation methods selected by firms.