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«April 18, 2006 Stern School of Business, New York University, New York 10012 Kellogg School of Management, Northwestern University, Evanston, ...»

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Weighing the Evidence on the Relation between

External Corporate Financing Activities, Accruals and

Stock Returns

Daniel A. Cohen, Thomas Z. Lys**

April 18, 2006

Stern School of Business, New York University, New York 10012

Kellogg School of Management, Northwestern University, Evanston, Illinois 60208


Bradshaw, Richardson, and Sloan (BRS) find a negative relation between their

comprehensive measure of corporate financing activities and future stock returns and

future profitability. Noticing that accounting accruals are increases in net operating assets on a company’s balance sheet, we question whether it is possible to distinguish between the ‘external financing anomaly’ documented by BRS and the ‘accrual anomaly’ first documented by Sloan (1996). We show that once controlling for total accruals, the relation between external financing activities and future stock returns is attenuated and not statistically significant. These findings are consistent with Richardson and Sloan (2003).

JEL classification: G10, M4 Keywords: External financing; Analysts’ forecasts; Accruals; Capital Markets; Market Efficiency.

* We would like to thank Jieying Zhang for helpful comments. All remaining errors are our own responsibility.

** Corresponding Author (847) 491-2673, tlys@kellogg.northwestern.edu

1. Introduction Bradshaw, Richardson, and Sloan (2006, hereafter BRS) examine the relation between firms’ external financing activities, future stock returns, future profitability and analysts’ forecasts. BRS summarize that, “The key innovation of our research design is the use of statement of cash flows data to construct a comprehensive and parsimonious measure of the net amount of cash generated by corporate financing activities” (page 1).

In other words, BRS’ major contribution is their focus on net external financing activities rather than individual components of corporate financing activities (e.g., debt versus equity) chosen by firms. In addition to investigating future stock returns and profitability following firms’ corporate financing activities, BRS analyze analysts’ short-term and long-term earnings forecasts, growth forecasts, stock recommendations, and target prices.

Overall, BRS ask an interesting and intriguing question that goes beyond the traditional pecking-order theory.

Their primary findings are that there exists a negative and statistically significant relation between net external financing and future stock returns, and future profitability, and a positive relation with optimism in analysts’ forecasts. These results, in turn, imply that the relevant information in financing activities is that the firm raised (or repaid) funds, rather than the specific means by which the firm raised (e.g., debt versus equity) or repaid (dividends and stock repurchases versus interest and repayment of debt) funds.

Using a trading strategy based on the overall measure of net external financing, BRS document that such a hedge portfolio generates an annual return of 15.5%. This return exceeds the hedge portfolio returns based on the individual components of net external financing. The overall results on the relation between external financing and future stock returns and future profitability imply that investors do not correctly infer the negative relation between financing activities and future performance.

BRS investigate both investors’ and analysts’ responses to firms’ financing activities.

Their research is designed to distinguish between risk and misvaluations as potential explanations for the association between future stock returns and firms’ corporate financing activities. They find a systematic positive relation between net external financing and optimism in analysts’ forecasts. Furthermore, the results suggest that analysts’ optimism is related to the type of security issued: over-optimism for debt issuance is restricted to short-term earnings forecasts, while over-optimism for equity issuance is also related to long-term earnings forecasts, growth, stock recommendations and target prices. The above findings lead BRS to conclude that analysts play a ‘central role’ in the overpricing of security issuances.

Based on their findings, BRS offer the following interpretations and implications:

(i) “… consistent with the misvaluation hypothesis, the predictable stock returns are directly related to predictable errors in analysts’ earnings forecasts ….

Overall, the results are consistent with the hypothesis that firms time their corporate financing activities to exploit the temporary misvaluation of their securities in capital markets.” (ii) “… our results suggest that the negative stock returns following new security issuances are primarily attributable to firm misvaluations rather than wealth transfers between stockholders and bondholders … we show that changes in debt are negatively related to future returns. This evidence is consistent with the firm misvaluation hypothesis, but inconsistent with the wealth transfer hypothesis.” (iii) “… analysts could self-select into covering the particular issuing firms that they naively forecast to have the best future prospects. Second, management could self-select into issuing securities during periods in which their inside information indicates that analysts’ forecasts are most optimistic. Third, conflicts stemming from incentives to generate investment banking and/or brokerage business could lead analysts to intentionally bias their forecasts.” By design, however, BRS’ analysis is closely related to the ‘accrual anomaly’ literature: the cash flow identity implies that financing and operating cash flows are negatively related. Moreover, operating cash flows equal net income minus accruals. In other words, accounting accruals are increases in the amount of net operating assets on a company’s balance sheet. As a result, it is important to establish whether BRS’s findings complement or subsume the results of the ‘accrual anomaly’ (Sloan, 1996).

Consequently, our discussion focuses on two key questions: (1) whether financing per se rather than the specific financing vehicles chosen matter, and (2) whether the results differ from what is known and has been referred to as the ‘accrual anomaly.’ Section 2 discusses the analysis of BRS. The sample selection is presented in Section

3. Section 4 focuses on the relation between external financing activities and accruals whereas the relation between financing activities and future performance is discussed in Section 5. Section 6 discusses the relation between analysts’ forecast properties and external financing activities. Conclusions and suggestions for future research are presented in Section 7.

2. Research Design BRS divide their analyses into three parts. First, the authors examine how investors respond to firms’ choices of raising capital. Second, BRS investigate whether external financing activities are related to fundamental variables as evidenced in future profitability. The third part of the analysis focuses on the relation between analyst forecast properties and firms’ external financing activities.

Net amount of cash flows received from external financing activities (∆XFIN), the

–  –  –

where ∆EQUITY (∆DEBT) represents net cash received from the sale and/or purchase of common and preferred stock less cash dividends paid (net cash received from the issuance and/or reduction of debt). Under the Modigliani and Miller assumptions (1958, M&M), financing activities have no impact on firm value. However, when the M&M assumptions are relaxed, firms’ external financing activities provide information on the operating cash flows and on investment opportunities of the firm. In the former case, unexpected external financing is likely to be interpreted that current and future cash flows are not sufficient to allow the firm to invest. Hence, it will be interpreted by investors as ‘bad news.’ On the other hand, external financing can also be indicative of increased investing activities. Since on average managers accept positive net present value projects (McConnell and Muscarella, 1985) increases in financing can be interpreted as a positive signal by capital markets investors. Finally, the mix of financing activities provides information regarding insiders’ beliefs on whether the current stock price is overvalued or undervalued (see Frank and Goyal, 2003; Myers, 1984; and Sunder and Myers, 1999 for a detailed analysis and discussion on the pecking order theory of capital structure).

BRS’ analysis is centered on six propositions that follow from their misvaluation hypothesis. Evidence on the first three propositions is provided in their Table 5. Panel A reports the results for P1 (i.e., there is a negative relation between net external financing

and future stock returns) by estimating:

–  –  –

Panel B of Table 5 reports evidence on propositions P2 (i.e., there is a negative relation between marginal changes in equity financing and future stock returns) and P3 (i.e., there is a negative relation between marginal changes in debt financing and future stock

returns) by estimating:

–  –  –

where SRETt+1 is the annual size-adjusted stock return. As Table 5 indicates, the evidence is consistent with the first three research propositions: the slope coefficients of ∆XFIN, ∆EQUITY, and ∆DEBT are all negative and statistically significant at conventional levels.

While these results are very compelling, two questions remain unanswered by BRS:

(1) how do those results relate to the accrual anomaly, and (2) what is the information provided by the specific choices of financing (debt and equity) chosen relative to the

–  –  –

“comprehensive and parsimonious measure of the net amount of cash generated by corporate financing activities” then the coefficients of γ1 and γ2 in the last row of Panel B of Table 5 should be approximately equal (which they do not appear to be – in section 4 we show that they are not). Alternatively, under the pecking order theory, the coefficient of ∆EQUITY should be smaller (more negative) than the coefficient of ∆DEBT.

Moreover, most of the variation in regressions (2) and (3) should be explained by ∆XFIN and not by the proportion of debt and equity issued.

In Table 6, BRS provide corroborating evidence by documenting that subsequent earnings (for the subsequent year and for period t+2 through t+5) are negatively related to both ∆XFIN and to ∆EQUITY, and ∆DEBT. This evidence is consistent with the results of Table 5: both ∆XFIN and its components, ∆EQUITY and ∆DEBT, are associated with negative subsequent performance. Hence, the picture that emerges is that investors fail to take this association between both ∆XFIN and its components, ∆EQUITY and ∆DEBT, when pricing securities into account. We further discuss these specific findings and provide an alternative interpretation in Section 4.

Further corroborating evidence is provided in Tables 7, 8, and 9 where BRS document that short and long-term earnings forecasts of sell side analysts fail to incorporate the relation between external financing activities and subsequent performance. While the evidence presented in BRS is compelling, the remainder of our discussion focuses on the specific interpretation given by BRS and whether the evidence documented is distinct from the accrual anomaly.

3. Sample Selection and Variable Measurement To investigate whether net external financing activities as measured by BRS are related to accounting accruals, we employ accrual metrics used in the literature. Given the shortcomings associated with each individual empirical measure of accruals (e.g., Collins and Hribar (2002), Dechow et al. (2004)), we employ multiple measures and are agnostic about the relative superiority of those metrics.

3.1 Sample Selection To supplement BRS’ analysis, we selected a sample following their procedures as closely as possible. (Please consult the Appendix for a summary of variable definitions.) From the 2005 COMPUSTAT annual tapes we select all firm-year observations with available data for the period 1971-2004. We exclude firm-year observations with missing data on COMPUSTAT to compute our main financial statement variables. In addition, we also exclude firms in the financial service industries (SIC code 6000-6999) since accruals for these firms are difficult to interpret.

As in BRS, we measure the net amount of cash flows received from external financing activities ∆XFIN, as: ∆XFIN = ∆EQUITY + ∆DEBT. ∆EQUITY is net equity financing measured as the proceeds from the sale of common and preferred stock (COMPUSTAT item #108) less cash payments for the purchase of common and preferred stock (COMPUSTAT item #115) less cash payments for dividends (COMPUSTAT item #127). ∆DEBT is net debt financing measured as the cash proceeds from the issuance of long-term debt (COMPUSTAT item #111) less cash payments for long-term debt reductions (COMPUSTAT item #114) less the net changes in current debt (COMPUSTAT item #301). To be consistent with BRS, we require the availability of COMPUSTAT data for each one of the above variables, with the exception of data item #301, which we set to zero, if it is missing. As in BRS, we scale these variables by average total assets and delete firm-year observations with an absolute value greater than

1. These criteria yield a primary sample of 144,025 firm-year observations for the period 1971-2004, and a sub-sample of 78,575 firm-year observations for 1988-2004. Based on the evidence of Collins and Hribar (2002) we use the statement of cash flows approach to calculate accruals for our 1988-2004 period sub-sample.

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