Valuing Loss Firms

51 Pages Posted: 6 Jul 2004

See all articles by Peter R. Joos

Peter R. Joos

INSEAD

George A. Plesko

University of Connecticut School of Business

Date Written: June 16, 2004

Abstract

We hypothesize that when confronted with a loss, investors price earnings conditional on the expected probability of the firm's return to profitability. We show a parsimonious model of one year-ahead loss reversal is useful in predicting the firm's return to profitability. Using the estimated probabilities of loss reversal to define samples of persistent (low probability of reversal) and transitory (high probability of reversal) losses, we show the pricing of losses, as well as their characteristics, varies as a function of their expected probability of reversal. We document a more pronounced stock price response to a transitory loss consistent with investors assessing the likelihood of exercising the abandonment option to be smaller. We also find the market responds negatively to persistent losses, especially in the latter part of the sample period. We also show the results are consistent with investors pricing the components of losses differently depending on the type of loss: they value only the aggregate accruals component of persistent losses and only the aggregate cash flow component of transitory losses. Further analysis shows the result for persistent losses relates to the presence of an increasingly larger R&D component that investors price negatively as if rewarding firms that make larger R&D outlays with larger returns. One consequence of the presence of a growing R&D component implies persistent losses become a weaker indicator of the likelihood of exercising the abandonment option.

This is a significant revision of Reporting Conservatism, Loss Reversals, and Earnings-based Valuation, http://ssrn.com/abstract=330660

Keywords: earnings, losses, cash flows, accruals, valuation, persistence

JEL Classification: G12, M41, D21

Suggested Citation

Joos, Peter R. and Plesko, George A., Valuing Loss Firms (June 16, 2004). MIT Sloan Working Paper No. 4491-04. Available at SSRN: https://ssrn.com/abstract=562043 or http://dx.doi.org/10.2139/ssrn.562043

Peter R. Joos (Contact Author)

INSEAD ( email )

1 Ayer Rajah Avenue
Singapore, 138676
Singapore

George A. Plesko

University of Connecticut School of Business ( email )

School of Business
Storrs, CT 06269-2041
United States
860-486-6421 (Phone)

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