Busting some myths about earnings management in the stock market

By Diana Menocal, Marc Goedhart,  Tim Koller, and Vartika Gupta, CFA

As we have discussed in the past, there is compelling evidence that stock market valuations generally reflect the fundamental performance of the company or industry. Despite this, some finance professionals may consider a company’s reported earnings per share (EPS) more meaningful than metrics tied to value creation, such as ROIC and growth.

Reported earnings, though, are frequently an unreliable indicator of a company’s value, as management practices can create a distorted view of actual performance. Let’s talk about four common myths about earnings management in the stock market that can lead finance leaders astray.

Myth 1: Earnings from M&A

By buying another business, the acquirer will increase its reported earnings. However, incremental earnings are not an indicator of value creation. Let’s suppose that Company A invested $1 billion in acquiring Company B, which reports yearly earnings of $50 million. At a 20 P/E purchase price, Company A will barely gain 5 percent on $1 billion invested. If Company A has a 10 percent cost of capital, at a minimum, it will need to double Company B’s earnings to earn the cost of capital on $1 billion invested.

Myth 2: Write-downs

Executives are often reluctant to take the earnings hit from writing down the value of assets, assuming investors will react negatively. Instead, investors assess the information the write-down conveys about the company's future performance. For example, oftentimes, companies write down goodwill from prior acquisitions, but investors already know the acquisition was not successful. Writing goodwill off can be seen as a positive signal from management that things will be done differently now. We looked at 40 of the largest goodwill impairments by companies in the United States and Europe since 2013, and as Exhibit 1 shows, share prices did not meaningfully drop in the days after the write-off announcement.

Myth 3: Earnings volatility

Some managers believe investors will pay a premium for steady earnings growth. However, academic research has found that earnings variability has either limited or no impact on market value and shareholder returns. And, almost no companies demonstrate smooth earnings growth.

Exhibit 2 shows the earnings growth of the four firms among the largest listed US companies that had the least volatile earnings growth from 2012 to 2022.[1] Of the companies examined, only one achieved ten years of steady earnings growth. Most companies with relatively stable earnings growth follow a pattern similar to the three other companies: several years of steady growth interrupted by a sudden decline in earnings.

Myth 4: Meeting consensus 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. Investors place far more importance on a company’s economic fundamentals than on reported earnings.

For instance, our surveys have shown that more than 85 percent of intrinsic investors do not consider it essential for a company to consistently meet its EPS consensus.[2] Sometimes, however, short-term earnings are the only data investors have on which to base their judgment of fundamental corporate performance. In these cases, investors may interpret a missed EPS target as an omen of a decline in long-term performance and management credibility. Similarly, share prices do not rise if the market believes a positive earnings surprise is simply the result of some imaginative accounting.

Focus on what actually drives value

There is compelling evidence that valuation levels for individual companies and the stock market clearly reflect the underlying fundamental performance in terms of return on capital and growth, and yet we find that executives are often overly focused on earnings and earnings growth.

It’s important to remember that earnings don’t drive value in their own right; only cash flows do. Of course, companies with attractive growth and returns on invested capital will also generate good earnings. But the market sees through earnings that aren’t backed up by solid fundamentals. Managers should also not be concerned about non economic events that reduce earnings, such as asset write-downs or the effects of changes in accounting rules. Nor should they be concerned about delivering smooth earnings. Focusing on what actually creates long term value is what counts.

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[1] The 500 largest nonfinancial US companies by market capitalization in 2022.

[2] McKinsey & Company Long Term Voices Survey, 2015.