Conventional wisdom suggests that earnings volatility is undesirable and, in particular, leads to a higher cost of capital. For example, Graham, Harvey, and Rajgopal (2007) provide survey evidence that corporate executives prefer smooth earnings, in part because they believe that higher earnings volatility increases the cost of capital. Consistent with this, many scholars and commentators have expressed concern that the growing use of fair value accounting increases earnings volatility and therefore the cost of capital.
Some prior research suggests the possibility that higher earnings volatility reflects greater noise in the measurement of earnings, reducing the informativeness of earnings about firm value (e.g., Dechow and Dichev, 2002; Dichev and Tang, 2009). Appealing to the notion that the informativeness of earnings affects a firm's cost of capital, prior work generally predicts a positive relation between earnings volatility and expected returns (e.g., Gebhardt, Lee, and Swaminathan, 2001; Francis et al., 2004).
In this paper, we take a novel perspective by observing that, while capturing the full effect of economic shocks to future cash flows will tend to make earnings more informative about firm value, it will also lead to greater earnings volatility. For example, while many argue that fair value accounting leads to more precise estimates of firm value, it is widely recognized that fair value accounting increases earnings volatility (Barth, 2004).
For additional intuition on why more volatile earnings may actually be informative about firm value, consider the case of an earnings process that aggregates multiple signals. We note that while recognizing additional components of income will generally make earnings more volatile, it may also make earnings more informative about firm value. In this paper, we develop this intuition more formally, and show that in contrast to the conventional wisdom, firms with more volatile earnings may actually have lower expected returns.
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Earnings Volatility and the Cross-Section of Returns
