What is Behind the Magic of O-Score? An Alternative Interpretation of Dichev's (1998) Bankruptcy Risk Anomaly
54 Pages Posted: 8 Jan 2010 Last revised: 10 Dec 2011
Date Written: December 9, 2011
Using Ohlson’s (1980) measure of bankruptcy risk (O-Score), Dichev (1998, The Journal of Finance 53, 1131−1147) documents a bankruptcy risk anomaly in which firms with high bankruptcy risk earn lower than average returns. This study first demonstrates that the negative association between bankruptcy risk and returns does not generalize to alternative measure of bankruptcy risk. Then, by examining the nine individual components of O-Score, I find that funds from operations (FFO) is the only component that is associated with returns. Furthermore, I show that the return-predictive power of FFO is due to cash flows from operations. Taken as a whole, this study provides evidence that Dichev’s bankruptcy risk anomaly is a manifestation of investors’ under (over)-pricing of cash flows (accrual) component of earnings, i.e., the accrual anomaly documented by Sloan (1996, The Accounting Review 71, 289−316).
Keywords: Market efficiency, Bankruptcy risk, Funds from operations, Cash flows, Accruals
JEL Classification: G14, G33, M41
Suggested Citation: Suggested Citation