Earnings response coefficient

In financial economics, the earnings response coefficient, or ERC, is the estimated relationship between equity returns and the unexpected portion of (i.e., new information in) companies' earnings announcements.

Arbitrage pricing theory describes the theoretical relationship between information that is known to market participants about a particular equity (e.g., a common stock share of a particular company) and the price of that equity. Under the efficient market hypothesis, equity prices are expected in the aggregate to reflect all relevant information at a given time. Market participants with superior information are expected to exploit that information until share prices have effectively impounded the information. Therefore, in the aggregate, a portion of changes in a company's share price is expected to result from changes in the relevant information available to the market. The ERC is an estimate of the change in a company's stock price due to the information provided in a company's earnings announcement.

The ERC is expressed mathematically as follows:

$UR = a + b(\text{ern}-u) + e$

UR = the unexpected return

a = benchmark rate

b = earning response coefficient

(ern-u) = (actual earnings less expected earnings) = unexpected earnings

e = random movement

Good News (GN) firms enjoyed positive abnormal returns, and negative for their Bad News (BN) firms. This raises the question of why the market might respond more strongly to the good or bad news in earnings for some firms than for others. If the answer can be found, accountants can improve their understanding of how accounting information is useful to investors. This, in turn, could lead to the preparation of more useful financial statements.

Consequently, one of the most important directions that empirical financial accounting research took since the BB study (Ball and Brown (1968)) is the identification and explanation of differential market response to earnings information. This is called earnings response coefficient (ERC).

"Earnings response coefficient measures the extent of security’s abnormal market return in response to the unexpected component of reported earnings."

Reasons

Reasons for differential market response:

1. BETA: The more risk related to the firm's expected returns the lower will be the investor's reactions to a given amount of unexpected earnings.(Note: beta shows risk of a security so you can assume that a high beta means a high risk).
2. CAPITAL STRUCTURE: ERC for a highly leveraged firm is lower than for a firm with little or no debt, Any good news passed on means that the debt holders get this benefit instead of the investors. (Thus it is important to disclose the nature & magnitude of financial instruments including off-balance sheet).
3. PERSISTENCE: Source of increase in current earnings affects the ERC: If earnings are expected to persist into the future this will result in a higher ERC. If the component in the earnings is non-persistent (i.e. unusual, non recurring items) this will result in lower ERC.

Use & Debate

ERCs are used primarily in research in accounting and finance. In particular, ERCs have been used in research in positive accounting, a branch of financial accounting research, as they theoretically describe how markets react to different information events. Research in Finance has used ERCs to study, among other things, how different investors react to information events. (Hotchkiss & Strickland 2003)

There is some debate concerning the true nature and strength of the ERC relationship. As demonstrated in the above model, the ERC is generally considered to be the slope coefficient of a linear equation between unexpected earnings and equity return. However, certain research results suggest that the relationship is nonlinear.(Freeman & Tse 1992)

See also

• Capital asset pricing model
• Post earnings announcement drift

References

1. Collins, D. W. and S. P. Kothari (1989), 'An Analysis of Intertemporal and Cross-Sectional Determinants of Earnings Response Coefficients', Journal of Accounting & Economics, Vol.11, No.2/3 (July), pp. 143-81.
2. Chambers, Dennis J.; Freeman, Robert N.; Koch, Adam S (2005) The Effect of Risk on Price Responses to Unexpected Earnings. Journal of Accounting, Auditing & Finance, Vol. 20 Issue 4, p461-482
3. Kormendi, Roger & Lipe, Robert, 1987. "Earnings Innovations, Earnings Persistence, and Stock Returns," Journal of Business, University of Chicago Press, vol. 60(3), pages 323-45.
4. Hotchkiss, Edith S. and Deon Strickland, 2003. "Does Shareholder Composition Matter? Evidence from the Market Reaction to Corporate Earnings Announcements," Journal of Finance, 58(4), pp. 1469-1498.
5. Freeman, Robert and Senyo Tse, 1992. "A Nonlinear Model of Security Price Responses to Unexpected Earnings," Journal of Accounting Research, Vol. 30 No. 2 (Autumn), pp. 185-209.
6. William R. Scott,"Financial Accounting Theory third edition."