116 The STock MarkeT IS SMarTer Than You ThInk pending merger with Phillips Petroleum in part by asserting that the merger would offer greater earnings stability over the commodity price cycle. 21 In contrast, academic research fi nds that earnings variability has either lim- ited or no impact on market value and shareholder returns. Ratios of market value to capital are diminished by cash fl ow volatility, but not by earnings volatil- ity. Investors see through earnings smoothing that is unconnected to cash fl ow. 22 In 30 years of U.S. profi t data, there is no correlation between variability in EPS and a company’s market value. 23 Some researchers fi nd a statistically signifi cant, but practically negligible, relationship between the two: between the 1 percent of companies with the lowest earnings volatility and the 1 percent with the highest lies a difference in market-to-book ratios of less than 10 percent. 24 Part of the explanation for the results is that smooth earnings growth is a myth. Almost no companies demonstrate smooth earnings growth. Exhibit 7.13 shows the earnings growth of the fi ve fi rms among the 10 percent of large listed U.S. companies that had the least volatile earnings growth from 2008 to 2018. 25 Of the companies examined, Home Depot was the only one with ten years of steady earnings growth. Only a handful had earnings growth that was steady for four or EXHIBIT  7.13 Earnings Growth of Least Volatile Companies: Not So Smooth Earnings growth,1 % 2012 2013 2014 2015 2016 2017 2018 2011 2009 2010 13 30 23 22 25 25 16 18 13 34 Home Depot –8 26 6 6 7 12 1 8 –3 12 3M 9 11 15 1 3 –13 –1 14 17 18 McDonald’s 18 –9 5 12 –1 11 –7 12 18 –5 Automatic Data Processing –15 19 13 18 19 0 15 –1 14 17 Costco 1 Earnings is net income before extraordinary items, adjusted for goodwill impairment. Source: S&P Capital IQ. 25 These were all listed nonfi nancial U.S. companies with revenues of more than $1 billion in 2018. 21 Analyst teleconference, November 19, 2001. 22 See B. Rountree, J. Weston, and G. Allayannis, “Do Investors Value Smooth Performance?” Journal of Financial Economics 90, no. 3 (December 2008): 237–251. 23 J. McInnis, “Earnings Smoothness, Average Returns, and Implied Cost of Equity Capital,” Accounting Review (January 2010). 24 R. Barnes, “Earnings Volatility and Market Valuation: An Empirical Investigation” (LBS Accounting Subject Area Working Paper ACCT 019, 2003). The difference was 0.2, and the average market-to-book ratio for the entire sample was around 2. Myths about Earnings Management  117 more years. Most companies with relatively stable earnings growth follow a pat- tern similar to the four companies other than Home Depot in Exhibit 7.13: several years of steady growth interrupted by a sudden decline in earnings. Meeting Consensus Earnings Estimates When a high-profile company misses an earnings target, it certainly makes headlines, but the impact of short-term earnings on share prices should not be overstated. For example, empirical research has shown that earnings sur- prises explain less than 2 percent of share price volatility in the four weeks surrounding the announcements.26 Investors place far more importance on a company’s economic fundamentals than on reported earnings. Sometimes, however, short-term earnings are the only data investors have on which to base their judgment of fundamental corporate performance. In these cases, in- vestors may interpret a missed EPS target as an omen of a decline in long-term performance and management credibility, so they lower the company’s share price accordingly. As we describe in more detail in Chapter 34, the announce- ment of lower-than-expected earnings only drives share prices down in case of downward revisions of long-term fundamental prospects. Similarly, share prices do not rise if the market believes a positive earnings surprise is simply the result of some imaginative accounting, such as deliber- ate timing of book gains from asset divestments or acceleration of sales from deep discounts to customers. For such accruals-dependent earnings increases, subsequent shareholder returns are poor, relative to peers.27 And investors are wise to be wary when accruals contribute substantially to earnings, because this typically indicates that a company has reached a turning point and will post lower earnings in the future. Earnings Guidance Many companies believe that providing guidance on their expected earnings for the upcoming quarter or year can lead to higher valuations, lower share price volatility, and greater market liquidity for their shares at what they per- ceive to be limited costs. Unfortunately, there is no evidence that guidance de- livers any of these benefits. As we discuss in Chapter 34, we find that whether companies issue guidance does not affect their earnings multiples, returns to shareholders, or share price volatility. The impact of guidance on a stock’s li- quidity, if any, typically disappears in the following year, making it practically irrelevant from a shareholder’s perspective.28 26 W. Kinney, D. Burgstahler, and R. Martin, “Earnings Surprise ‘Materiality’ as Measured by Stock Returns,” Journal of Accounting Research 40, no. 5 (December 2002): 1297–1329. 27 K. Chan, L. Chan, N. Jegadeesh, and J. Lakonishok, “Earnings Quality and Stock Returns,” Journal of Business 79, no. 3 (2006): 1041–1082. 28 See T. Koller, B. Jiang, and R. Raj, “Three Common Misconceptions about Markets,” Journal of Applied Corporate Finance 25, no. 3 (2006): 32–38.