Whenever TV pundits talk about investments, you generally hear them mention price/earnings (PE or P/E) ratios as the best way to value a stock, and there is usually talk about earnings estimates and whether a company beat or failed to live up to analyst forecasts. But behind the camera, most investment professionals recognize that a company’s value can be surprisingly hard to pin down, in part because you don’t know whether you can trust the earnings reports.
A new working paper at the Harvard Business School (“Earnings Management from the Bottom Up: An Analysis of Managerial Incentives Below the CEO”) summarizes an impressive amount of literature that shows how and why so many executives manipulate their company’s earnings reports.
The working paper found a connection between accounting shenanigans (shifting expenses into latter periods or future orders into the current period) and higher-than-average bonuses and stock incentive options for CEOs and chief financial officers–the executives who are responsible for compiling the data that goes into earnings reports. Not too surprising, right?
However, these exaggerated earnings don’t change the economic reality at the company; they give executives a larger bonus payment or more stock option wealth. After the manipulation, the stock temporarily looks more valuable to outside investors, who see the boost in earnings or the tempting PE ratio, then buy shares of the company and experience disappointing investment results. Those investment losses are an indirect, hard-to-measure transfer of wealth from investors to corporate executives–and earnings manipulation is yet another contributor to market volatility. If you hear about shareholder rights battles, proxy initiatives and analysts talking about companies with good stakeholder relations, chances are this is more relevant than somebody who simply parrots the latest earnings report.