The Impact of Earnings Management on the Performance of Earnings-Based Valuation Models

46 Pages Posted: 9 Jan 2011

See all articles by Yao Tian

Yao Tian

San Jose State University

Lucie Courteau

Free University of Bozen-Bolzano - Faculty of Economics and Management

Jennifer L. Kao

Independent

Date Written: January 7, 2011

Abstract

The purpose of this study is to examine empirically how the presence of earnings management may affect firm valuation. We compare the performance of earnings-based (e.g., Residual Income Model, RIM) and non-earnings-based (e.g., Discounted Cash Flow, DCF) valuation models, measured by absolute percentage pricing errors and absolute percentage valuation errors, for two subsets of publicly traded US firms: "Suspect" firms that are likely to have engaged in earnings management and “Normal” firms matched on industry, year and size. When valuation models use only analysts' short-term earnings forecasts as model inputs, results indicate that earnings management adversely affects the RIM model’s ability to estimate a firm’s intrinsic value while leaving that of DCF unchanged. We contribute to the valuation literature by showing that the well-known superiority of the RIM model over DCF does not hold when earnings are managed. By comparison, if the valuation model also includes analysts' long-term target price forecasts, RIM does not enjoy any economically significant accuracy advantage over DCF, with or without the presence of earnings management. Over a longer forecast horizon, financial analysts appear to account for the impact of earnings management on firms’ future values by adjusting their target price forecasts. We extend the earnings management literature by demonstrating that the way analysts react to earnings management over short to long-term forecast horizons has different implications for the estimation ability of RIM vis-à-vis DCF models.

Suggested Citation

Tian, Yao and Courteau, Lucie and Kao, Jennifer L., The Impact of Earnings Management on the Performance of Earnings-Based Valuation Models (January 7, 2011). CAAA Annual Conference 2011, Available at SSRN: https://ssrn.com/abstract=1736346 or http://dx.doi.org/10.2139/ssrn.1736346

Yao Tian (Contact Author)

San Jose State University ( email )

San Jose, CA 95192-0066
United States
6505268206 (Phone)

Lucie Courteau

Free University of Bozen-Bolzano - Faculty of Economics and Management ( email )

Faculty of Economics and Management
Piazza Università 1
39100 Bozen-Bolzano (BZ), Bozen 39100
Italy

Jennifer L. Kao

Independent

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