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Abstract:
In this paper we provide insights into the manner in which (relatively sparse) accounting information, along with measures of internet usage, are employed by the market in the valuation of internet firms. Consistent with those who claim that financial statement information is of very limited use in the valuation of internet stocks, we are unable to detect a significant positive association between bottom-line net income and our sample firms' market prices; in fact, the association is actually negative. However, when we decompose net income into its components, we find gross profits to be positively and significantly associated with prices. In addition, both unique visitors and pageviews, as measures of internet usage, are found in most instances to provide incremental explanatory power (in some cases considerable) for stock prices. We also separately analyze the e-tailers, and the portal and content/community firms (the p/c firms) in our sample. For the e-tailers we find that bottom-line net income generally has a negative association with stock prices (as for the sample as a whole), while a positive and significant association exists for the p/c firms. In this respect, p/c firms' shares behave more like those of non-internet companies. Further, we find for the p/c firms that the incremental explanatory power of pageviews and of unique visitors is approximately the same; in contrast, pageviews has much greater incremental explanatory power for the e-tailers than does unique visitors. This suggests that pages viewed per visitor is an especially important metric for the e-tailers, as compared to the p/c firms.

Abstract:
In light of the importance of revenues in the valuation of internet stocks, this paper examines the roles played by analysts, past revenues, and web usage data (unique visitors, pageviews, and minutes spent at a firm's web sites) in the forecasting of future revenues. In contrast to evidence from other industries, we find that analysts' revenue forecasts almost always underestimate the revenues of internet firms. Historical revenue growth is shown to have incremental predictive power over analysts' forecasts, more so for our sample of portal and content/community firms than for our e-tailer sample. Estimates of web usage growth, on the other hand, generally have significant incremental value for predicting the revenues of the e-tailers, but little predictive power for the revenues of the p/c firms. Finally, we examine whether measures of web traffic have incremental value in the prediction of revenues above time-series forecasts. This issue is especially important when valuing firms with little or no analyst coverage, where there is, of necessity, an increased reliance on historical revenues for forecasting purposes. We find that all three web usage metrics do have significant incremental predictive power.

Abstract:
We investigate the use of a warrant-pricing approach to incorporate employee stock options (ESOs) into equity valuation and to account for the dilutive effect of ESOs in the valuation of option grants for financial reporting purposes. Our valuation approach accounts for the jointly determined nature of ESO and shareholder values. The empirical results show that our stock price estimate exhibits lower prediction errors and higher explanatory powers for actual share price than does the traditional stock price estimate. We use our valuation approach to assess the implications of dilution on the fair-value estimates of ESO grants. We find that the fair value is overstated by 6% if we ignore the dilutive feature of ESOs. Furthermore, this bias is larger for firms that are heavy users of ESOs, small, and R&D intensive, and for firms that have a broad-based ESO compensation plan.

Abstract:
We investigate the use of a warrant-pricing approach to incorporate employee stock options (ESOs) into equity valuation and to account for the dilutive effect of ESOs in the valuation of option grants for financial reporting purposes. Our valuation approach accounts for the jointly determined nature of ESO and shareholder values. The empirical results show that our stock-price estimate exhibits lower prediction errors and higher explanatory powers for actual share price than does the traditional stock-price estimate. We use our valuation approach to assess the implications of dilution on the fair value estimates of ESO grants. We find that the fair value is overstated by six percent if we ignore the dilutive feature of ESOs. Further, this bias is larger for firms that are heavy users of ESOs, small, and R&D intensive, and for firms that have a broad-based ESO compensation plan.

Abstract:
We investigate the use of a warrant-pricing approach to incorporate employee stock options (ESOs) into equity valuation and to account for the dilutive effect of ESOs in the valuation of option grants for financial reporting purposes. Our valuation approach accounts for the jointly determined nature of ESO and shareholder values. The empirical results show that our stock-price estimate exhibits lower prediction errors and higher explanatory powers for actual share price than does the traditional stock-price estimate. We use our valuation approach to assess the implications of dilution on the fair value estimates of ESO grants. We find that the fair value is overstated by six percent if we ignore the dilutive feature of ESOs. Further, this bias is larger for firms that are heavy users of ESOs, small, and R&D intensive, and for firms that have a broad-based ESO compensation plan.

Employee stock options, warrant-pricing model, equity valuation

Abstract:
This paper presents evidence of anomalies in internet firms' stock returns surrounding their quarterly earnings announcements. There is a general runup in prices in the days prior to the earnings announcements, followed by a price reversal lasting for several days. The magnitude of the market-adjusted returns associated with these price movements exceeds 11 percent over a 10-day period. We find little evidence to suggest that these returns can be explained either by the earnings news disclosed or by risk changes. Additional analyses suggest that these return patterns are driven, at least in part, by price pressure.

capital market, internet, stock returns, earnings announcement, price pressure

Abstract:
This paper presents evidence of persistent anomalies in internet firms' stock returns surrounding their quarterly earnings announcements. There is a general run-up in prices in the days prior to the earnings announcement, which extends through the market opening on the day subsequent to the release. This is followed by a price reversal lasting for several days. The magnitude of the market-adjusted returns associated with these price movements exceeds 11 percent over a 10-day period. There is little evidence to suggest that these returns can be explained either by the earnings news disclosed or by changes in risk around the earnings announcements. Additional analyses suggest that these return patterns are driven, at least in part, by price pressure which exists in the days before internet firms' earnings announcements. A trading strategy designed to exploit these price patterns would have generated a daily return of more than 1 percent over the sample period.

Abstract:
SFAS 109 allows firms to use their discretion to set arbitrarily high valuation allowances against deferred tax assets. Firms can then later use these "hidden reserves" to manage earnings. Our evidence indicates that most banks do not record a valuation allowance to manage earnings, but rather to follow the guidelines of SFAS 109. However, if the bank is sufficiently well capitalized to absorb the current-period impact on capital, the amount of the valuation allowance increases with a bank's capital. In later years, bank managers adjust the valuation allowance to smooth earnings. The magnitude of the discretionary adjustment increases with the deviation of unadjusted earnings from the forecast or historical earnings.

Earnings management, deferred taxes, discretion, banks

Abstract:
SFAS 109 allows firms to use their discretion to set arbitrarily high valuation allowances against deferred tax assets. Firms can then later use these "hidden reserves" to manage earnings. Our evidence indicates that most banks do not record a valuation allowance to manage earnings, but rather to follow the guidelines of SFAS 109. However, if the bank is sufficiently well capitalized to absorb the current-period impact on capital, the amount of the valuation allowance increases with a bank's capital. In later years, bank managers adjust the valuation allowance to smooth earnings. The magnitude of the discretionary adjustment increases with the deviation of unadjusted earnings from the forecast or historical earnings.

Earnings management, deferred taxes, discretion, banks

Abstract:
SFAS 109, Accounting for income taxes, was criticized for allowing firms to set arbitrarily high valuation allowances against deferred tax assets at adoption as "hidden reserves" that firms could use in future periods to manage earnings. Consistent with these claims, bank managers make discretionary decreases in the valuation allowance, which represents an increase in earnings, when earnings before adjustment are below the consensus analyst forecast. The magnitude of the discretionary adjustment increases in the deviation from forecast. Abnormal returns around the 10-K filing date suggest that the market attributes value to these discretionary earnings even though they presumably have no direct cash flow implications. However, additional tests indicate that the association between returns and discretionary changes in the valuation allowance are related to reductions in earnings volatility which provide indirect, but real, cash flow benefits in the regulated banking industry.

Abstract:
This paper examines foreign exchange (FX) sensitivity-analysis disclosures, which are provided according to one of the three market-risk reporting formats allowed by the Securities and Exchange Commission's Financial Reporting Release No. 48 (FRR No. 48). We select a sample of FX derivatives users from the 1997 Fortune 500 list and collect their market risk disclosures for the three years 1997-1999. We estimate a Probit selection model to distinguish the sensitivity-analysis reporters from the rest of the FX derivatives users, and use the Heckman two-stage procedure to correct for potential sample selectivity bias, as well as the endogeneity of the market risk disclosures. Our evaluation of the sensitivity-analysis disclosures indicates that the flexibility allowed by FRR No. 48 makes it difficult to compare the disclosures across firms. Nonetheless, we find that loss estimates are usually expressed in fair value when firms conduct the sensitivity analysis at the derivatives-level, and in earnings or cash flows when the analysis is done at the entity-level. We find that entity-level earnings sensitivity disclosure exhibits incremental predictive power for the market-based exchange rate exposure and stock return volatility. However, derivatives-level fair value sensitivity disclosure does not have explanatory power for future market-based risk measures. These results are obtained after controlling for traditional risk measures, the lagged market-based risk measures, and other derivatives-related disclosures.

Derivative financial instruments, SEC market risk disclosures, sensitivity analysis, foreign exchange risk, exchange rate exposure, stock return volatility

Abstract:
This paper examines the implications of managerial optimism for analysts' forecast bias. Using insider trading behavior to capture managerial optimism, we find that the bias in eight-month-ahead analysts' consensus forecasts is negatively related to the level of managerial optimism. Furthermore, the negative relation is weaker for large firms and for firms with extensive analyst followings, a result supporting the idea that managers exert less influence on analysts if the firms operate in a rich information environment. We also document that the more optimistic the managers, the greater the reduction in analysts' forecasts for current year's earnings, but the smaller the reduction in analysts' forecasts for next year's earnings. This result is consistent with implications of the managerial optimism hypothesis: managers remain optimistic about their companies' futures, even when the current year's performance is disappointing. Finally, we find that the stock price reaction to downward forecast revisions is smaller for firms with more optimistic managers, indicating that investors understand the implications of managerial optimism for analysts' forecast bias and subsequent revisions.

Managerial optimism, analyst forecast

Abstract:
From a sample of 910 U.S. firms over the period 1977-1996, we find that structure of the empirical model has significant impacts on resulting estimates of exchange rate exposures from equity returns. While lengthening the return horizon has minimal impact on exposure estimates, the inclusion of a market portfolio in the specification results in significant changes to the exposure estimates. We further demonstrate that different definitions of the market portfolio result in important differences in the overall distribution of exposure estimates and the interpretations of the sign, size, and significance of many firms' exposures. The source of the exposure differences across market portfolios is due to a strong size-exposure relation for U.S. firms. Surprisingly, this size-exposure relation does not appear to be driven by an underlying correlation between size and foreign cash flow position of the firms. An alternative model specification using matched CRSP capital-based size portfolios as controls for market movements in the exposure model produces firm-level exposures with a stronger relation to foreign cash flows and less of a correlation with firm size.

Abstract:
We investigate whether corporate managers' stock repurchase decisions are affected by their incentives to manage diluted earning-per-share (EPS). We find that managers increase the level of their firms' stock repurchases when: (1) the dilutive effect of outstanding employee stock options (ESOs) on diluted EPS increases, and (2) earnings are below the level required to achieve the desired rate of EPS growth. We also find that managers' repurchase decisions are not associated with actual ESO exercises, suggesting that they are driven by incentives to manage diluted but not basic EPS, and strengthening our earnings management interpretation.

earnings dilution, earnings management, earnings-per-share (EPS), employee stock options, stock buybacks, stock repurchases

Abstract:
We show that both return measurement horizon and model specification have noticeable impacts on estimates of exposure from equity prices for US firms. While increases in the return horizon lead to increases in the precision of the estimates, this effect is less significant than the impact of model structure. We demonstrate that the inclusion and of a market return variable and its particular construction has a dramatic influence on the sign and size of the exposures due to a strong relation between firm size and exposure for US firms. We propose using CRSP cap-based portfolios as the control for market factors and show that this produces exposures with stronger relation to foreign cash flows and correlations with firm size.

Abstract:
This study investigates whether the quantitative disclosures about notional amount and fair value of foreign exchange derivatives, required by Statement of Financial Accounting Standards (SFAS) No. 119 and its predecessors are associated with the information used by investors to assess the sensitivity of equity returns to currency fluctuations (currency exposure). I derive the underlying relations of currency risk exposure to notional amount and to fair value disclosures, applying the "delta" risk measure for derivative securities. The analysis shows that derivatives disclosures are potentially useful. I test the hypotheses using the Fortune 500 manufacturing firms over the period 1994-1996. First, I test for an association between currency exposure and derivatives disclosures. Second, I test whether current period derivatives disclosures help predict currency exposures in future periods. The results are mixed and only weakly consistent with my predictions. In particular, the evidence suggests that neither aggregated nor disaggregated fair value disclosures complement notional amount in assessing currency risk exposure.

This study has three implications for increasing the usefulness of derivatives disclosures. First, improving disclosures about firms' inherent business risks will increase the usefulness of derivatives disclosures by providing information about the risks being managed with derivatives. Second, disaggregation of notional amount and fair value information by long and short positions taken, major currency, class of instrument, time to maturity, and leverage would allow users of financial statements to perform a complete exposure assessment. Third, separate disclosure of foreign exchange gains and losses on derivative instruments and the items being hedged will facilitate exposure assessment.

SFAS No. 119, Accounting Disclosures, Notional Amount, Fair Value, Foreign Exchange Risk Exposure, Foreign Exchange Derivatives

Abstract:
This paper investigates whether Statement of Financial Accounting Standards No. 119 (SFAS 119) disclosures are useful for assessing the sensitivity of a firm's equity return to currency fluctuations (currency exposure). First, the study demonstrates how the notional amount and fair value of foreign exchange derivative instruments, separately and jointly, are related to currency exposure. The derived relations provide potential implications for improving the usefulness of these two quantitative disclosures and a framework for analyzing the data. Second, empirical analysis is performed on the 1994 and 1995 disclosures for a sample of U.S. manufacturing firms. The results are mixed, with both aggregated and disaggregated notional amounts significantly associated with currency exposure in 1994, but not in 1995. In contrast, with certain specifications, fair value disclosures are found useful in both years, especially when they are complemented by alternative proxy variables for risk. Moreover, a joint test of these two quantitative disclosures reveals that neither fair value nor notional amount consistently exhibits incremental information about firms' currency exposures over the other.

Abstract:
This paper investigates whether the notional amounts of derivative financial instruments contain relevant information about derivatives risk. The issue is addressed using a derived relation between the sensitivity of equity return to currency fluctuations (hereafter, FX sensitivity) and the notional amounts of foreign exchange (FX) derivatives positions. The derived relation is tested using the 1994 data of a selected sample of the 1990 Fortune 500 manufacturing firms. The empirical results indicate that, in isolation, the notional amounts of long and short FX derivatives positions are significantly associated with FX sensitivity in the expected direction. Notional amounts by class of instrument also exhibit the predicted association with FX sensitivity and, as a group, they are significantly more relevant than their aggregate counterpart. Given the assumption that the model used in this study is correctly specified and implemented, these findings are consistent with notional amounts containing relevant information about derivatives risk. This suggests that notional amounts should be included as a possible source of information, especially when feasible alternative risk measures are not available. Finally, this study does not test the usefulness of notional amounts against alternative risk measures because these measures are not required to be disclosed under the current accounting guidelines. While notional amounts are readily available and objective, the computation of alternative measures is subjective in nature. Therefore, if any alternative measures are mandated, it will be fruitful to examine their usefulness in future research using notional amounts as a benchmark.