Academic journal article Advances in Competitiveness Research

The Role of Book Value in High-Tech Valuation

Academic journal article Advances in Competitiveness Research

The Role of Book Value in High-Tech Valuation

Article excerpt

ABSTRACT

This paper investigates the anomalous relationship between negative earnings and stock prices for the high-tech sector. We obtain evidence rejecting the claim that including book value in the valuation specification eliminates the anomalous relationship. Test results indicate that sales revenues are more value relevant than reported negative earnings in the valuation of high-tech loss firms.

INTRODUCTION

The negative price-earnings relation for firms that report losses, as reported by Jan and Ou (1995) and documented by Burgstahler and Dichev (1997) and Kothari and Aimmerman (1995), raises questions about the validity of the assumption of a positive and homogeneous relation between price and earnings, as expressed by the simple earnings capitalization model. A negative coefficient on earnings means that the more negative is a firm's earnings per share, the higher is its stock prices, which makes no economic sense at all. Collins et al. (1999) hypothesize and find that including book value of equity in the simple earnings capitalization model eliminates the negative relation. They explain that book value of equity is a proxy for expected normal future earnings, which is especially important for loss firms regarding valuation. The omission of book value in the simple earnings capitalization model renders the model mis-specified, introducing a positive bias to the coefficient on earnings for profit firms and a negative bias to the coefficient on earnings for loss firms.

We investigate the anomalous negative price-earnings relation for firms that report losses in the high-tech sector during the 1990 to 1999 ten-year period, a period when high-tech industry enjoys unprecedented growth. High-tech companies do not usually report profits or positive operating cash flows. They usually have big investments in intangible assets and large R&D expenditures, which, according to SFAS #2, must be fully expensed (Lev and Sougiannis, 1996). As such, earnings are not really as important and book value can hardly be a measure of a firm's true wealth (Barron et al., 2002).

We hypothesize and find the positive coefficient on earnings for high-tech profit firms and the anomalous negative coefficient on earnings for high-tech loss firms. We hypothesize and find that including book value of equity in the simple earnings capitalization model does not eliminate the negative price-earnings relation for loss firms. We hypothesize and find evidence suggesting that sales are more value relevant than earnings or book value for high-tech loss firms (Davis, 2002, Jahnke, 2000).

Our study contributes to the current literature by providing further evidence of the anomalous relation between price and negative earnings for high-tech loss firms. We demonstrate the persistence of the anomaly and rejecting the claim that the inclusion of book value of equity in the model eliminates the anomaly, for the high-tech sector. We also provide evidence of the value relevance of sales for high-tech firms.

Section II discusses the sample selection and data. Section III presents the testing results of the negative price-earnings relation for high-tech loss firms. Section IV provides the empirical evidence of regressing stock price on earnings, book value, and sales. Section V is a summary and conclusion.

HIGH-TECH SAMPLE AND SUMMARY STATISTICS

Our sample for the high-tech companies involves the drug, computer, networking and telecommunication industries. Table 1 is a description of the industries in the sample in the three-digit SIC code.

We incorporate all firm-year observation during the 1990 to 1999 period in the 2000 Standard and Poor's COMPUSTAT CD-ROM active and research databases. The research file is included in the study to mitigate survivorship bias. All variables in this study are measured on a per share basis. Firm-year observations are eliminated of which (1) December is not the fiscal year end, (2) stock price three months after the fiscal year end is missing or negative, (3) earnings per share data is missing, (4) beginning of year book value of equity is missing, (5) sales per share is missing or negative, and (6) the total number of common shares outstanding decreases 1/3 from the previous year as it is suspect of a reverse stock split to maneuver earnings per share. …

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