This study examines the development of investor trust in corporate disclosure during a time in a firm’s life when this matters most: at and after its initial public offering (IPO). Analyzing a sample of 3,202 US IPOs between 1985 and 2013, we provide evidence of two key features of investor trust. First, investor trust development is incomplete at the IPO and hence continues after the IPO. In particular, we find that (a) the variance of investors’ disclosure credibility perceptions across firms increases during the five-year post-IPO period and (b) firm-specific post-IPO trends in perceived disclosure credibility correlate with credibility signals known to investors at the IPO. Second, post-IPO trends and innovations in analyst coverage and institutional ownership correlate with trends and innovations in perceived disclosure credibility. Thus, analysts and institutional investors act as facilitators of investor trust in corporate disclosure after the IPO. Collectively, our findings shed light on the time-consuming nature of investor trust development and document a previously unexplored role for analysts and institutional investors.
{"title":"The Post-IPO Dynamics of Investor Trust in Corporate Disclosure","authors":"F. Moers, E. Peek, P. Vorst","doi":"10.2139/ssrn.3863652","DOIUrl":"https://doi.org/10.2139/ssrn.3863652","url":null,"abstract":"This study examines the development of investor trust in corporate disclosure during a time in a firm’s life when this matters most: at and after its initial public offering (IPO). Analyzing a sample of 3,202 US IPOs between 1985 and 2013, we provide evidence of two key features of investor trust. First, investor trust development is incomplete at the IPO and hence continues after the IPO. In particular, we find that (a) the variance of investors’ disclosure credibility perceptions across firms increases during the five-year post-IPO period and (b) firm-specific post-IPO trends in perceived disclosure credibility correlate with credibility signals known to investors at the IPO. Second, post-IPO trends and innovations in analyst coverage and institutional ownership correlate with trends and innovations in perceived disclosure credibility. Thus, analysts and institutional investors act as facilitators of investor trust in corporate disclosure after the IPO. Collectively, our findings shed light on the time-consuming nature of investor trust development and document a previously unexplored role for analysts and institutional investors.","PeriodicalId":12319,"journal":{"name":"Financial Accounting eJournal","volume":"16 1","pages":""},"PeriodicalIF":0.0,"publicationDate":"2021-06-09","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"90305143","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
I study how liquidity information influences banks' liquidity holdings using the disclosure of liquidity coverage ratio (LCR) mandated for a group of large US banks. While the disclosure rule aims to increase liquidity in the banking system, non-disclosing banks responded by reducing liquidity holdings. Using bank network relationships to measure how much a bank learns from LCR disclosures, I find that banks learning more cut their liquidity significantly more. In the aggregate, liquidity in the banking system declined and systemic risk increased after the disclosure rule adoption. My findings highlight an important, and potentially unanticipated, effect of liquidity disclosure.
{"title":"The Influence of Liquidity Information on Liquidity Holdings in the Banking System","authors":"Yao Lu","doi":"10.2139/ssrn.3861204","DOIUrl":"https://doi.org/10.2139/ssrn.3861204","url":null,"abstract":"I study how liquidity information influences banks' liquidity holdings using the disclosure of liquidity coverage ratio (LCR) mandated for a group of large US banks. While the disclosure rule aims to increase liquidity in the banking system, non-disclosing banks responded by reducing liquidity holdings. Using bank network relationships to measure how much a bank learns from LCR disclosures, I find that banks learning more cut their liquidity significantly more. In the aggregate, liquidity in the banking system declined and systemic risk increased after the disclosure rule adoption. My findings highlight an important, and potentially unanticipated, effect of liquidity disclosure.","PeriodicalId":12319,"journal":{"name":"Financial Accounting eJournal","volume":"6 1","pages":""},"PeriodicalIF":0.0,"publicationDate":"2021-06-06","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"86380563","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
We examine whether corporate boards factor the potential cost of competitive harm caused by a departing CEO into the forced CEO turnover decision. Using staggered changes in the state-level enforceability of Covenants Not to Compete (CNC) for identification, we find that enhanced CNC enforceability increases both the likelihood of forced CEO turnover and the sensitivity of forced CEO turnover to firm performance. We present additional cross-sectional evidence that shows such effects are more pronounced when firms face more severe product market threats or operate in industries with greater potential threats of predatory hiring. Investors react to turnover announcements more positively when CNC enforceability increases, indicating that enhanced CNC enforceability increases efficiency in CEO replacement decisions.
{"title":"Enforceability of Noncompetition Agreements and Forced CEO Turnover","authors":"Yupeng Lin, Florian S. Peters, Hojun Seo","doi":"10.2139/ssrn.3262366","DOIUrl":"https://doi.org/10.2139/ssrn.3262366","url":null,"abstract":"We examine whether corporate boards factor the potential cost of competitive harm caused by a departing CEO into the forced CEO turnover decision. Using staggered changes in the state-level enforceability of Covenants Not to Compete (CNC) for identification, we find that enhanced CNC enforceability increases both the likelihood of forced CEO turnover and the sensitivity of forced CEO turnover to firm performance. We present additional cross-sectional evidence that shows such effects are more pronounced when firms face more severe product market threats or operate in industries with greater potential threats of predatory hiring. Investors react to turnover announcements more positively when CNC enforceability increases, indicating that enhanced CNC enforceability increases efficiency in CEO replacement decisions.","PeriodicalId":12319,"journal":{"name":"Financial Accounting eJournal","volume":"118 1","pages":""},"PeriodicalIF":0.0,"publicationDate":"2021-06-05","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"79738089","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Sheng Cao, Xianjie He, Charles C. Y. Wang, Huifang Yin
We examine how government ownership in brokerage firms influences analyst research quality in the Chinese context. When the government has strong incentives to prop up market prices, analysts from brokerages with significant government shareholdings ("government-brokerage analysts") issued relatively less pessimistic (or more optimistic) earnings forecasts and revisions and more favorable stock recommendations; they were also slower to revise. Although less accurate than those issued by other brokerages, these forecasts significantly influenced investors' beliefs. During regular times, government-brokerage analysts issued relatively less optimistic (more pessimistic) earnings forecasts and revisions and less favorable stock recommendations; they were also quicker to revise and no less accurate than those by other brokerages. Government-brokerage analysts thus balance market credibility against government incentives. In doing so, they serve both market advisory and stabilization functions. We show that their market stabilization function also operates during times of high investor sentiment.
{"title":"Government Shareholdings in Brokerage Firms and Analyst Research Quality","authors":"Sheng Cao, Xianjie He, Charles C. Y. Wang, Huifang Yin","doi":"10.2139/ssrn.3140069","DOIUrl":"https://doi.org/10.2139/ssrn.3140069","url":null,"abstract":"We examine how government ownership in brokerage firms influences analyst research quality in the Chinese context. When the government has strong incentives to prop up market prices, analysts from brokerages with significant government shareholdings (\"government-brokerage analysts\") issued relatively less pessimistic (or more optimistic) earnings forecasts and revisions and more favorable stock recommendations; they were also slower to revise. Although less accurate than those issued by other brokerages, these forecasts significantly influenced investors' beliefs. During regular times, government-brokerage analysts issued relatively less optimistic (more pessimistic) earnings forecasts and revisions and less favorable stock recommendations; they were also quicker to revise and no less accurate than those by other brokerages. Government-brokerage analysts thus balance market credibility against government incentives. In doing so, they serve both market advisory and stabilization functions. We show that their market stabilization function also operates during times of high investor sentiment.","PeriodicalId":12319,"journal":{"name":"Financial Accounting eJournal","volume":"23 1","pages":""},"PeriodicalIF":0.0,"publicationDate":"2021-06-03","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"85033870","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
This paper documents new and empirically important interactions between cash-balance and leverage dynamics. Cash ratios typically vary widely over extended horizons, with dynamics remarkably similar to (and complementary with) those of capital structure. Leverage and cash dynamics interact approximately as predicted by the internal-versus-external funding regimes in Myers and Majluf (1984). Leverage is quite volatile when cash ratios are stable and vice-versa, while net-debt ratios are almost always volatile. Most firms increase leverage sharply as cash balances (internal funds) become scarce. Capital structure models that extend Hennessy and Whited (2005) to include cash-balance dynamics explain some, but not all, aspects of the observed relation between cash squeezes and leverage increases.
{"title":"Leverage and Cash Dynamics","authors":"H. DeAngelo, A. Gonçalves, René M. Stulz","doi":"10.2139/ssrn.3871170","DOIUrl":"https://doi.org/10.2139/ssrn.3871170","url":null,"abstract":"\u0000 This paper documents new and empirically important interactions between cash-balance and leverage dynamics. Cash ratios typically vary widely over extended horizons, with dynamics remarkably similar to (and complementary with) those of capital structure. Leverage and cash dynamics interact approximately as predicted by the internal-versus-external funding regimes in Myers and Majluf (1984). Leverage is quite volatile when cash ratios are stable and vice-versa, while net-debt ratios are almost always volatile. Most firms increase leverage sharply as cash balances (internal funds) become scarce. Capital structure models that extend Hennessy and Whited (2005) to include cash-balance dynamics explain some, but not all, aspects of the observed relation between cash squeezes and leverage increases.","PeriodicalId":12319,"journal":{"name":"Financial Accounting eJournal","volume":"14 1","pages":""},"PeriodicalIF":0.0,"publicationDate":"2021-06-01","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"82421562","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
This study investigates why financial analysts participate in non-covered firms’ conference calls. Consistent with the view that firms benefit from information commonalities and complementarities with connected peers, we hypothesize that analysts are more likely to participate in a non-covered firm’s conference calls if the non-covered firm shares information links with the covered firm. Using a sample of earnings conference call transcripts over the 2006–2014 period, we find that the probability of analysts participating in a non-covered firm’s conference call is positively associated with the information links between the non-covered firm and their covered firm, including the same industry link, the same region link, and the customer-supplier link. We also find that analysts who participate in the linked non-covered firm’s conference calls provide more accurate earnings forecasts for their covered firm compared with analysts not adopting such a strategy. In addition, we show that analysts with less general experience or from smaller brokerage houses are more likely to attend the linked non-covered firm’s conference calls while achieving a similar level of forecast accuracy. Furthermore, we find that analysts are more likely to revise earnings forecasts for their covered firm after participating in the linked non-covered firm’s conference calls. Our results are robust to employing the merger of brokerage houses as a quasi-natural experiment and using the text-based similarity as an additional measure of information link. Overall the evidence suggests that analysts participate in linked non-covered firms’ conference calls to obtain information about their covered firms.
{"title":"Why Do Analysts Participate in Non-Covered Firms’ Conference Calls?","authors":"Jie Han, Nan Hu, Ronghong Huang, Fujing Xue","doi":"10.2139/ssrn.3849804","DOIUrl":"https://doi.org/10.2139/ssrn.3849804","url":null,"abstract":"This study investigates why financial analysts participate in non-covered firms’ conference calls. Consistent with the view that firms benefit from information commonalities and complementarities with connected peers, we hypothesize that analysts are more likely to participate in a non-covered firm’s conference calls if the non-covered firm shares information links with the covered firm. Using a sample of earnings conference call transcripts over the 2006–2014 period, we find that the probability of analysts participating in a non-covered firm’s conference call is positively associated with the information links between the non-covered firm and their covered firm, including the same industry link, the same region link, and the customer-supplier link. We also find that analysts who participate in the linked non-covered firm’s conference calls provide more accurate earnings forecasts for their covered firm compared with analysts not adopting such a strategy. In addition, we show that analysts with less general experience or from smaller brokerage houses are more likely to attend the linked non-covered firm’s conference calls while achieving a similar level of forecast accuracy. Furthermore, we find that analysts are more likely to revise earnings forecasts for their covered firm after participating in the linked non-covered firm’s conference calls. Our results are robust to employing the merger of brokerage houses as a quasi-natural experiment and using the text-based similarity as an additional measure of information link. Overall the evidence suggests that analysts participate in linked non-covered firms’ conference calls to obtain information about their covered firms.","PeriodicalId":12319,"journal":{"name":"Financial Accounting eJournal","volume":"78 1","pages":""},"PeriodicalIF":0.0,"publicationDate":"2021-05-20","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"86888737","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
We create an alternative, simpler definition of analyst forecast timeliness leaders based on their response after the corporate quarterly earnings announcements, examining if these analysts’ forecasts are superior in informativeness and accuracy. Our Earnings Announcement Date Leader classification method of leaders and followers is able to identify superior analysts who provide forecasts of higher quality in all three properties, timeliness, informativeness and accuracy, contrary to prior definitions of timeliness. Furthermore, prior forecast accuracy is positively associated to the forecast informativeness of both leaders and followers, being more important for the former. Our findings are important for investors and other market participants, because they can use the EAD Leader classification to identify superior analysts and, consequently, more informative and accurate forecasts.
{"title":"Financial Analysts’ Response After Corporate Earnings Announcements and Forecast Quality","authors":"A. Charitou, Nikolaos Floropoulos","doi":"10.2139/ssrn.3849397","DOIUrl":"https://doi.org/10.2139/ssrn.3849397","url":null,"abstract":"We create an alternative, simpler definition of analyst forecast timeliness leaders based on their response after the corporate quarterly earnings announcements, examining if these analysts’ forecasts are superior in informativeness and accuracy. Our Earnings Announcement Date Leader classification method of leaders and followers is able to identify superior analysts who provide forecasts of higher quality in all three properties, timeliness, informativeness and accuracy, contrary to prior definitions of timeliness. Furthermore, prior forecast accuracy is positively associated to the forecast informativeness of both leaders and followers, being more important for the former. Our findings are important for investors and other market participants, because they can use the EAD Leader classification to identify superior analysts and, consequently, more informative and accurate forecasts.","PeriodicalId":12319,"journal":{"name":"Financial Accounting eJournal","volume":"123 1","pages":""},"PeriodicalIF":0.0,"publicationDate":"2021-05-19","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"74469363","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Michelle Hutchens, Stefan Richter, Bridget Stomberg, B. Williams
Increasing workplace diversity is a key component of the social pillar of environmental, social, and governance (ESG) activities. In this study, we use financial statement disclosures to identify firms that claim the Work Opportunity Tax Credit (WOTC), a federal tax program that incentivizes businesses to hire underrepresented workers, thereby increasing workplace diversity. Consistent with companies claiming the WOTC when the economic benefits outweigh the costs, we find participation is more likely for companies that rely on lower-wage labor, are profitable, and are headquartered in states with WOTC-type tax incentives. Next, motivated by increased demand for corporate-level ESG activities, we examine the outcomes of WOTC disclosure. Relative to a matched control sample, firms disclosing WOTC participation receive higher ESG ratings on social issues and are more likely to be owned by socially responsible investment funds. Consistent with increased investor demand for firms engaged in ESG activities, we find WOTC disclosure is positively associated with stock liquidity. However, we find no association with firm value. Our findings provide relevant insights to legislators as they modify the WOTC and to companies evaluating the potential ESG benefits of WOTC participation and disclosure.
{"title":"Taking Advantage of Employer Tax Incentives for Workplace Diversity","authors":"Michelle Hutchens, Stefan Richter, Bridget Stomberg, B. Williams","doi":"10.2139/ssrn.3849004","DOIUrl":"https://doi.org/10.2139/ssrn.3849004","url":null,"abstract":"Increasing workplace diversity is a key component of the social pillar of environmental, social, and governance (ESG) activities. In this study, we use financial statement disclosures to identify firms that claim the Work Opportunity Tax Credit (WOTC), a federal tax program that incentivizes businesses to hire underrepresented workers, thereby increasing workplace diversity. Consistent with companies claiming the WOTC when the economic benefits outweigh the costs, we find participation is more likely for companies that rely on lower-wage labor, are profitable, and are headquartered in states with WOTC-type tax incentives. Next, motivated by increased demand for corporate-level ESG activities, we examine the outcomes of WOTC disclosure. Relative to a matched control sample, firms disclosing WOTC participation receive higher ESG ratings on social issues and are more likely to be owned by socially responsible investment funds. Consistent with increased investor demand for firms engaged in ESG activities, we find WOTC disclosure is positively associated with stock liquidity. However, we find no association with firm value. Our findings provide relevant insights to legislators as they modify the WOTC and to companies evaluating the potential ESG benefits of WOTC participation and disclosure.","PeriodicalId":12319,"journal":{"name":"Financial Accounting eJournal","volume":"1 1","pages":""},"PeriodicalIF":0.0,"publicationDate":"2021-05-18","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"89521324","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
This study examines the effect of shareholder taxes on bank risk-taking. Economic theory predicts that personal tax rates affect individual risk-taking through risk-sharing with the government via full loss offsets. Exploiting the passive activity loss limitations and detailed ownership data for a sample of S corporation banks, I find that increases in shareholder tax rates are positively (negatively) associated with bank risk-taking when shareholders can (cannot) share in risk with the government through full loss offsets. These relations are driven by banks with few shareholder conflicts and less strict regulators. Overall, the results suggest that investor-level risk-sharing with the government through individual income taxes plays an important role in bank risk-taking.
{"title":"The Effect of Shareholder Taxes on Bank Risk-Taking: Evidence from S Corporation Banks","authors":"Jennifer L. Glenn","doi":"10.2139/ssrn.3771313","DOIUrl":"https://doi.org/10.2139/ssrn.3771313","url":null,"abstract":"This study examines the effect of shareholder taxes on bank risk-taking. Economic theory predicts that personal tax rates affect individual risk-taking through risk-sharing with the government via full loss offsets. Exploiting the passive activity loss limitations and detailed ownership data for a sample of S corporation banks, I find that increases in shareholder tax rates are positively (negatively) associated with bank risk-taking when shareholders can (cannot) share in risk with the government through full loss offsets. These relations are driven by banks with few shareholder conflicts and less strict regulators. Overall, the results suggest that investor-level risk-sharing with the government through individual income taxes plays an important role in bank risk-taking.<br>","PeriodicalId":12319,"journal":{"name":"Financial Accounting eJournal","volume":"4 1","pages":""},"PeriodicalIF":0.0,"publicationDate":"2021-04-28","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"77959240","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
While typically characteristic only of insolvent businesses, negative shareholders’ equity has become more common among healthy, profitable businesses. Many are large restaurant chains, including McDonald’s, Starbucks, Yum! Brands, and Papa John’s. Since none of the above reported negative equity a decade ago, a close study of each company’s financial statements over the period 2010-2019 revealed how these deficits came about. Each company was able to pay out, as dividends and share repurchases, well over 100% of its reported earnings during the period. Interestingly, this is not because earnings understated each company’s cash-generating capability; in fact, there is strong evidence that earnings overstated reality for McDonald’s and Yum! Brands. In general, the primary driver was massive debt issuance, followed by refranchising (selling company-operated restaurants to franchisees). Of the four companies, Starbucks has the highest ability to continue distributing over 100% of earnings, while Yum! Brands does not appear to have much more room to do so.
Each company was able to push equity negative because of the wide spread between its return on assets and cost of liabilities. Each has negative net working capital, which is essentially a cost-free source of funding, and was able to issue massive amounts of debt at low single digits rates. Meanwhile, return on assets averaged between 15-30% (due to powerful unrecorded intangible assets like brand and supply chain capabilities). The extreme case is Yum! Brands, whose debt at the end of 2019 was around twice the level of total recorded assets, yet their interest coverage ratio was a fairly comfortable 4.0x.
There are a few important implications for investors. First, negative equity is characteristic of companies on opposite ends of the business quality spectrum. Secondly, for many companies, metrics involving equity have lost their relevance and should be ignored. Next, issuing debt to repurchase shares can be a great strategy if cost of equity greatly exceeds cost of debt, but it carries substantial risk if done too aggressively (the primary risk being that interest rates are substantially higher in the future). Lastly, businesses that appear overvalued using traditional metrics like price-to-earnings may in fact by greatly undervalued, as is the case for one that can distribute well over 100% of reported earnings for an extended period of time.
{"title":"Profitable Restaurants Reporting Negative Equity: Causes and Implications for Investors","authors":"Zachary A. Workman","doi":"10.2139/ssrn.3825098","DOIUrl":"https://doi.org/10.2139/ssrn.3825098","url":null,"abstract":"While typically characteristic only of insolvent businesses, negative shareholders’ equity has become more common among healthy, profitable businesses. Many are large restaurant chains, including McDonald’s, Starbucks, Yum! Brands, and Papa John’s. Since none of the above reported negative equity a decade ago, a close study of each company’s financial statements over the period 2010-2019 revealed how these deficits came about. Each company was able to pay out, as dividends and share repurchases, well over 100% of its reported earnings during the period. Interestingly, this is not because earnings understated each company’s cash-generating capability; in fact, there is strong evidence that earnings overstated reality for McDonald’s and Yum! Brands. In general, the primary driver was massive debt issuance, followed by refranchising (selling company-operated restaurants to franchisees). Of the four companies, Starbucks has the highest ability to continue distributing over 100% of earnings, while Yum! Brands does not appear to have much more room to do so.<br><br> Each company was able to push equity negative because of the wide spread between its return on assets and cost of liabilities. Each has negative net working capital, which is essentially a cost-free source of funding, and was able to issue massive amounts of debt at low single digits rates. Meanwhile, return on assets averaged between 15-30% (due to powerful unrecorded intangible assets like brand and supply chain capabilities). The extreme case is Yum! Brands, whose debt at the end of 2019 was around twice the level of total recorded assets, yet their interest coverage ratio was a fairly comfortable 4.0x.<br> <br> There are a few important implications for investors. First, negative equity is characteristic of companies on opposite ends of the business quality spectrum. Secondly, for many companies, metrics involving equity have lost their relevance and should be ignored. Next, issuing debt to repurchase shares can be a great strategy if cost of equity greatly exceeds cost of debt, but it carries substantial risk if done too aggressively (the primary risk being that interest rates are substantially higher in the future). Lastly, businesses that appear overvalued using traditional metrics like price-to-earnings may in fact by greatly undervalued, as is the case for one that can distribute well over 100% of reported earnings for an extended period of time.","PeriodicalId":12319,"journal":{"name":"Financial Accounting eJournal","volume":"68 1","pages":""},"PeriodicalIF":0.0,"publicationDate":"2021-04-12","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"81233934","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
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