The effect of smooth performance in firm value – European evidence

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Volume Title
School of Economics | Master's thesis
Date
2012
Major/Subject
Finance
Rahoitus
Mcode
Degree programme
Language
en
Pages
66
Series
Abstract
The purpose of this study is to analyze the valuation effect of cash flow and earnings volatility. In addition, I aim to find out how investors value earnings smoothing done using discretionary accruals. My study also aims to provide clarifying evidence to the discrepancy between the predicted valuation effect of financial performance volatility by CAPM and the call option nature of equity. I also analyze the validity of corporate diversification as a source of smoother financial performance and how this smoother financial performance affects firm value. Data set consists of European companies with non-missing observations for share price as well as quarterly cash flow and earnings between 2000 and 2010. Total number of companies in my sample is 778 resulting in total 2,211 firm year observations. The findings of my study show that volatile financial performance results in a discount in company value. Both cash flow and earnings volatility seem to have a negative effect on firm value, with the effect being stronger and more significant for earnings volatility. My results thus support focus of attention on earnings figures, which is widely adapted by investors and media. In addition my results suggest that investors prefer active earnings smoothing done by the management, especially with accruals. My results also clarify the discrepancy between CAPM and the call option nature of equity. Based on my findings, there is a strong negative relation between leverage and firm value, even after controlling for cash flow volatility. This suggests that benefits from volatility to the call option nature of equity are outweighed by the costs of potential financial distress. The findings of my study also suggest that corporate diversification doesn’t work as an effective hedge for providing smoother cash flow. Even though companies would benefit from smoother financial performance due to diversification, the widely reported diversification discount exceeds the benefits and the total value effect is negative.
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Keywords
Cash flow volatility, Earnings smoothing, Risk management, Corporate diversification
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