AC3103: SEMINAR 3

5-8. XYZ Ltd is a large retail company listed on a major stock exchange and its reported net income for the year ended 31 December 2015 is $5m. The earnings were announced to the public on 31 March 2016. Financial analysts had predicted the company’s net income for 2015 to be $7m. The financial analysts’ prediction was in effect up until the release of the 2015 earnings on 31 March 2016.

Assumptions:

1. No other news about XYZ Ltd was released to the public on 31 March 2016. 2. No significant economy-wide events affecting share prices occurred on 31 March 2016.

Required

a. Would you expect a change in price of XYZ Ltd’s common stock on 31 March 2016? If so, why?

Yes, a stock price decrease is expected, other things equal, because unexpected earnings were negative $2 million. This conveys bad news to the market. Security prices should react negatively to this information.

b. Consider the 2 situations below: i. The deviation of forecasted earnings from actual earnings of $2m is completely

accounted for by the closing down of a number of its retail outlets. ii. The deviation of the forecasted earnings from actual earnings is completely

accounted for by a fire in XYX Ltd’s largest retail outlet, which had caused the outlet to be closed temporarily for 6 months.

In which of these 2 scenarios would you expect the price change of XYZ Ltd’s common stock to be greater? Explain.

The share price decrease should be greater for scenario (i) because that situation reflects a persistent decline in earnings arising from shutdown of a number of retail outlets. In scenario (ii), the earnings decrease is transitory. Hence, XYZ’s common stock price change should be greater in scenario (i).

c. Suppose instead that significant economy-wide events on 31 March 2016 resulted in a major increase in the stock market index. Would this affect your answer in part a? Explain.

Yes. If economy-wide events were such that the whole market rose strongly on December 31, this could overwhelm the bad firm-specific information, and XYZ’s share price would rise. Other information released at the same time as the earnings announcement could produce a share price rise despite the bad earnings news. Such information could include strong balance sheet fundamentals (assuming balance sheet information is available at this time) and/or optimistic management forecasts of future firm prospects.

5-10. X Ltd is a growth firm that uses very conservative accounting policies. Y Ltd is growing more slowly and uses fair value accounting for its capital assets and related amortization. Otherwise, X and Y Ltd are quite similar. They are the same size and have similar capital structure and similar betas.

Required:

a. Both X and Y Ltd report the same GN in earnings this year. Which firm would you expect to have the greater security market response (ERC) to this good earning news? Explain.

X Ltd. would be expected to have a higher ERC. First, it uses high quality accounting policies. Consequently, a given dollar of GN has higher implications for future profitability and returns than for Y Ltd. In effect, the main diagonal probabilities of the information are higher for X than for Y because of its higher earnings quality. Second, Y’s reported net income may have lower reliability than X because it uses current value accounting for its capital assets. Readily available and well-working market values may not exist for capital assets, and alternative current value estimates may lack reliability due to the large number of estimates that are required and the possibility of bias. The market would be less responsive to unreliable information, other things equal. Third, X Ltd. is a growth firm. Theory and evidence exists that firms with growth opportunities have higher ERCs than non-growth firms.

a. Suppose that X Ltd had a much higher debt-to-equity ratio and beta than Y Ltd. Would your answer to part a change? Explain.

The answer could change, because firms with higher debt to equity ratios and betas tend to have lower ERCs. If these effects are strong enough to outweigh the effects in part a, the ERC would be lower for X Ltd.

5-12. IAS 1 recognises the need for full disclosure of the components of reported net income. Explain why full disclosure of net income components is important for investors are to properly interpret the implication of current reported net income for future firm performance. What is classification shifting? Why does classification shifting make it more difficult for investors to predict future firm performance from current reported net income? How could the problem of classification shifting be reduced?

Evaluation of earnings persistence is a particular problem when the firm has low persistence items such as non-recurring or unusual items of gains or losses. Unless these items are fully disclosed, investors may regard them as persistent when, in fact, they are not. Classification shifting is the deliberate misclassification of items within income statement to increase “core earnings”. (form of earnings management)

To make matters worse, current low persistence items might increase future core earnings, and these effects are not disclosed. This is a particular problem if the initial write-offs are excessive. This will decrease the usefulness of financial statements for investors.

5-17 On 8 May 2001, the Financial post reported “The street turns against Canadian Tire.” Canadian Tire Corporation Ltd’s share price had risen by $0.75 to $24.90 on May 2 2001, following a news release in which Wayne Sales, president and CEO at the time, said, “We are pleased with our ability to deliver double digit growth…” Canadian Tire’s reported earnings of $0.37 per share exceeded analysts’ expectations.

The market soon learned, however, that reported earnings included an $8m one-time gain on sale of certain Canadian Tire assets. Without this gain, earnings were $0.29 per share, 6% below earnings for the same quarter of 2000. Canadian Tire’s share price fell back to $22.95. The Post

reported that “passing off” a one-time gain as part of operating earnings “didn’t fool or impress analysts” and is something they “hoped not to see again”.

Required:

a. Use efficient securities market theory to explain the rise in Canadian Tire’s share price on May 2 2001 and the rapid subsequent fall in share price.

The initial rise in Canadian Tire’s share price occurred for 2 reasons: Reported earnings exceeded analysts’ expectations. Since analysts’ earnings

forecasts are a proxy for investor expectations, investors would raise their probabilities of future firm performance. The resulting buy decisions raised share price.

The rise in share price was reinforced by Mr. Sales’ comment that the firm is pleased with its ability to deliver double-digit earnings growth. This suggests reasonable persistence in Canadian Tire’s increase in earnings. The subsequent fall in share price was due to the market’s realization that the persistence of Canadian Tire’s earnings increase was less than at first believed. This was due to the inclusion of an $8 million one-time gain in operating earnings

b. Was Canadian Tire correct in including the $8m one-time gain in net income? Explain.

The sale of assets appears to be infrequent and not typical of Canadian Tire’s normal operations, and the timing of the sale would be under management’s control. It should be reported under OCI.

c. Evaluate the persistence of Canadian Tire’s reported net income of $0.37 per share (no calculation required). Does the fact that Mr. Sales ignored this item in his press release affect your evaluation? Explain why or why not.

Persistence is low. Inclusion of the one-time gain lowers persistence of operating earnings. Also, if the one-time gain is excluded, Canadian Tire’s earnings per share were lower than for the same quarter of the previous year. If this continues, even the gain-excluded earnings will not persist.

5-20 On 13 September 2005, the shares of Best Buy Co fell from $5.14 to $45.22 on NYSE, a decline of 10.2%. The decline followed the release of its second quarter 2005 financial results. Best Buy is a large North American retailer of consumer electronics and appliances, with over 700 stores in the United States and Canada, including the Future Shop chain. Best Buy reported earnings of $0.37 per share, compared with $0.30 for the same quarter of 2004. However, its 2005 earnings included an expense for stock based compensation. If the 2nd quarter of 2004 had included this expense, earnings for that quarter would have been $0.26 per share. Sales revenue rose 10% for the quarter, including a 3.5% increase in same-store sales (indicator for retail company performance). Its gross profit rose to 25.5% of sales from 24.2% a year earlier. In its new release accompanying the financial results, management predicted earnings of 28 to 32 cents per share for its 2005 3rd quarter. This prediction included the effects of Hurricane Katrina, which, in late August 2005, caused widespread devastation in parts of the southern US and led to a brief closing of 15 company stores. Management announced plans to open 86 new stores in US and Canada during

fiscal year ending February 25 2006. While management expressed concerns about the effects of high gasoline prices on consumer spending, it reiterated its guidance that future annual growth in earnings from continuing operations would be about 26%. Analysts had estimated 2nd quarter 2005 earnings of 38 cents per share, and third quarter earnings of 34 cents. The NYSE Composite Index closed at 7578.25 on September 13 2005 and 7762.60 on September 12 2005. Best Buy’s stock beta, as per its website, is 1.84. The risk-free interest rate at this time was approximately 0.0001 per day.

Required:

a. What percentage return on Best Buy’s stock price would you expect on September 13 2005, strictly as a result of market wide (i.e. systematic) factors? Use the market model and show your calculations. Note the theoretical relationship αj = Rf (1-βj ) The return on the market portfolio (i.e., the NYSE Composite index), ignoring dividends, on September 13 was (7762.60 – 7578.25)/7578.25 = 184.35/7578.25 = .0243

b. What was the abnormal return on Best Buy stock on 13 September 2005? Is this return consistent with securities market efficiency? Explain why or why not.

The abnormal return on Best Buy’s stock on September 13, 2005 was -.1020 - .0446 = - .1466. This decline of almost 15% is considerably worse than the expected increase of 4.46%. The market must have interpreted the information in the company’s earnings announcement as bad news. Explanations for the bad news interpretation:

The market was expecting earnings of 38 cents per share for the second quarter. Actual earnings came in at 37 cents. Under market efficiency, Best Buy’s stock price on September 12 would have incorporated this expectation. Thus, the market was disappointed.

Stock price also included an expectation of 34 cents earnings per share for the third quarter, whereas the company’s current forecast was for earnings in the range of 28 to 32 cents.

Investors were worried about the effects of hurricane Katrina on the company’s near-term profitability.

Investors were worried about the effects of high energy prices on consumer spending.

However, the company’s announcement also contained some good news from management, consisting of sales and gross profit increases, new store openings, and reiteration of expected 26% future earnings growth. The fall in Best Buy’s stock price seems consistent with securities market efficiency if we accept that the impact of the bad news outweighed that of the good news.

c. Evaluate the persistence of the news (i.e. the increase from 26 cents/share to 37 cents/share) in Best Buy’s second quarter 2005 earnings.

The negative effects of hurricane Katrina would be of low persistence, particularly since management states that the store closings were “brief.” Management’s concern about high gasoline prices also suggests low persistence of the earnings increase, since if consumer spending falls, this would reduce future profitability. However, other events suggest that the earnings increase will persist. These include the increase in sales, particularly same-store sales, the increase in the gross profit ratio, and the opening of additional stores. Furthermore, management has reiterated its guidance of 26% future growth in earnings from continuing operations. A reasonable conclusion is that the earnings increase is of medium to high persistence.