Earnings growth is a primary determinant of equity value. Firms may deliver earnings growth either by improving the profitability of capital (i.e., the accounting rate of return on invested capital) or by increasing the capital base on which that profitability is earned. Economic theory suggests that earnings growth achieved through incremental capital investments is less valuable to existing shareholders than growth obtained by improving profitability. Unlike improvements in profitability, increases in capital generate an incremental cost of capital.
This cost reduces economic income but is not fully reflected in reported earnings. Therefore, earnings growth due to increases in capital overstates economic growth. This study investigates empirically whether earnings growth obtained through increases in capital is indeed associated with a smaller price change than growth obtained through improvements in profitability.
While accountants have long recognized that reported earnings do not reflect the cost of capital (e.g., research using the residual income framework), the pricing of earnings growth is affected by two additional factors which may offset or even reverse the cost of capital effect. First, due to accounting conservatism and the realization principle, investments typically reduce reported profitability in the near term.
Thus, earnings growth from new investments understates growth in pre-cost of capital economic income. Second, extant research in accounting suggests that investors "fixate" on reported earnings and do not fully consider their source (e.g., accruals versus cash flow). It is possible that a similar inefficiency applies to the pricing of earnings growth. That is, investors may not be aware of the differential value implications of growth from incremental investments versus growth from improved profitability.
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The Differential Value Implications of the Profitability and Investment Components of Earnings
